The Energy Letter Blog

Most investors are broadly familiar with the Energy Independence and Security Act of 2007, passed late last year. The Bill provided for, among other things, a large increase in the mandate for biofuels in the US.

But there are some lesser-known provisions that are worth some attention also. One is Section 526 of the bill that states:

"No Federal agency shall enter into a contract for procurement of an
alternative or synthetic fuel, including a fuel produced from
nonconventional petroleum sources, for any mobility-related use, other
than for research or testing, unless the contract specifies that the
lifecycle greenhouse gas emissions associated with the production and
combustion of the fuel supplied under the contract must, on an ongoing
basis, be less than or equal to such emissions from the equivalent
conventional fuel produced from conventional petroleum sources."

Today's US oil inventory statistics were unquestionably bullish across-the-board. Crude oil inventories tumbled by 3.2 million barrels against expectations for a 2.3 million barrel rise. Gasoline inventories were expected to fall by about 3 million barrels but actually fell by 3.4 million barrels.

And finally, distillate inventories fell by 3.7 million barrels against expectations for a 1.5 million barrel decline. Thus, whether we look at the crude oil report or the product inventories, today's inventory release from the EIA is bullish for crude oil prices.

Digging a bit deeper into the report a few more key trends are obvious. First, gasoline demand is actually slightly higher over the past four weeks compared to the same four weeks one year ago. Jet fuel demand is slightly lower and distillate demand is flattish. This hardly suggests that we're seeing much demand destruction due to a weakening US economy and sky-high oil prices.

Meanwhile, refineries are still operating at just 83.0 percent of their capacity. This suggests refiners are contining to respond to still-bloated gasoline inventories by cutting output.

Crude oil inventories were released yesterday and natural gas today. Crude rallied yesterday in the wake of teh report despite the fact that oil inventories actually rose much further than expected. I beliee there were two bullish aspects of the report. First, gasoline inventories dropped about twice as much as had been expected. And secondly, the demand figures released as part of the report suggest that there hasn't yet been much demand destruction in the US despite the slowing economy and high energy prices.

The trends in the report are broadly bullish for the beleagured refining industry. I do think we'll see a seasonal surge in this group into May though I have some longer-term concerns with respect to the industry.

Natural gas prices fell today, partly due to the fact that this week's drawdown was a little less than expected. However, unlike oil and gasoline, natural gas inventories support further upside for the commodity.

This week's inventory data marked a subtle shift. Crude oil inventories had been expected to rise but remained basically flat with last week's data. As my chart at the end of today's post shows, inventories are about average for this time of year.

The big porblem remains gasoline where inventories are not only above average but also above the 5-year high for this time of year. Gasoline inventoeis were expected to fall this week but they actually fell even more than widely predicted. This is bullish for gasoline.

One of the most obvious victims of the high gasoline inventories has been the refiners. Sky-high gasoline inventories put downward pressure on gasoline prices relative to crude and that hits the refiners. This is unusual because typically the period between late January and May is bullish for the refiners with crack spreads--a measure of refiners' profit margins--tending to rise during the run-up to summer driving season.

Natural gas inventories released today were bullish. The EIA reported a drawdown of 85 billion cubic feet, above analyst expectations and the 5-year average drawdown for this week of about 50 billion cubic feet. Natural gas inventories are now in-line with the five-year average and I suspect we'll undercut that average before the end of March. Gas prices ticked higher intra-day on the news but gas remains lower overall today.

The weakness in gas short-term stems mainly from a spillover effect from the oil market. With the dollar at least temporarily stabilizing, crude is finally falling to reflect the increasingly bearish fundamentals of falling demand and more-than-sufficient supplies. I highlighted some of these factors in yesterday's post.

But gas and oil aren't perfectly correlated. For the past two years crude oil fundamentals have been broadly bullish while natural gas fundamentals remained bearish -- oil prices rose and gas fell. I suspect we'll see somewhat of a switch in that this year -- gas prices, supported by strong fundamentals, can rise in spite of oil.

Oil inventories rose less-than-expected this week. This breaks a long string of reports where inventories of crude have been building at a faster-than-forecast pace.

Oil inventories have been rising quickly since the end of 2007 and are back to an average level for this timne of year. Typically, when inventories rise more quickly than expected, crude oil falls in price. But that hasn't happened this year and there's one reason -- a weak US dollar. In euro and yen terms, crude is actually flat to lower so far in 2008.

Ironically, this week's report was mildly bullish from a supply perspective -- the first bullish report in weeks, yet crude oil fell. There are two main reasons for this in my view. First, oil has run up considerably despite the weak market of late, therefore, some traders likely decided to take profits. From a technical perspective, oil still looks to be seeing a simple correction within the broader uptrend.

Natural gas inventories were off 151 billion cubic feet this week. That's a slightly larger-than-expected drawdown and above the average drawdown for this week. Natural gas inventories have been bloated for two years, capping all rallies in the commodity. But now, natural gas storage levels are as close to average as they've been in 2 years.

This is yet another bullish report for natural gas -- the 12-month NYMEX strip now stands at $9.70 per million BTUs. Yet, US natural gas prices are still below prevailing prices in Europe and Asia -- the current strip in the UK is at 54 perce per therm, the equivalent of about $10.50/MMBTU. That means that imports of liquefied natural gas (LNG) should remain subdued, helping to further normalize inventories. Below I offer a more complete analysis in video format and a chart of the current natural gas inventory situation.

The US Energy Information Administration (EIA), a unit of the Department of Energy, releases a report on US oil and refined product inventories each Wenesday morning at 10:30. On Thursdays, the same group releases their weekly data on natural gas in storage for the US.

We plan to make these key, market-moving inventory reports a weekly featrue on At These Levels. Below, I offer a video covering my take on this week's reports. And I am also posting charts summarizing recent trends in crude oil, distillates and gasoline inventories.

I am often asked how investors can go about protecting gains on winning positions without giving up too much upside or worrying about getting stopped out at an inopportune moment. One of the best ways I know of is to use options as a form of insurance.

For example, let's take an example out of my newsletter, The Energy Strategist. I recommend a US coal firm that's up about 50 percent since I recommended it -- coal stocks have been on fire over the past six months for reasons I've highlighted before in this blog.

I still think coal has more upside but 50 percent is a big gain that's worth protecting. One options based methodology would be to buy puts on the stock. For example, assume the stock is trading around $57.50 and you purchased it at $38 some months ago. Your profit on 100 shares would then be $1,950 ($5,750 - $3,800).

Further, you can buy the $55 puts for $4.50 or $450 per contract. If you buy the $55 puts, you would cover and insure your entire position through June 21st (that's June options expiration). The worst-case scenario would be if the stock fell to say $45 by June. Your puts would give you the right to sell the stock at $55. In this case, your profit would be $1,250. That's a sale price of $5,500 minus your $3,800 purchase price minus the cost of the options at $450. Thus, the put insurance would guarantee you a minimum of $1,250 profit on your 100 shares through June 21 no matter what the broader markets do.

At the same time, put insurance doesn't overly limit the upside.

I am often asked about the relationship between US natural gas inventories and imports of liquefied natural gas (LNG). The key point to remember here is that unlike oil, gas has not traditionally been a globally traded commodity. Most gas historically has moved by pipeline so it's a regional market. So, for example, North America was one market connected by pipelines and Europe another.

LNG is starting to change that because gas can be shipped anywhere in the world where prices are most favorable. So, for example, if gas prices are higher in the EU than the US, more LNG flows to Europe.

However, at this time LNG liquefaction and regasification capacity isn't sufficient to meet all needs. Because of that limitation, gas prices can still differ widely between regions of the world; there isn't enough LNG capacity to abitrage away those discrepancies. Check out my chart below for a closer look at relative global gas prices.

Washington D.C. has certainly been in the limelight these past few days. It seems that many are counting on the announcement of either a fiscal stimulus package or an inter-meeting rate cut from the Fed to bail the market out of its current malaise. There certainly have been countless rumours to that effect over the past few days.

The twelve month NYMEX natural gas strip is currently trading just shy of $8.40 per million BTUs, roughly the highest level since the first of November last year. The strip is my favourite measure of natural gas prices; it is simply the average of the next twelve months worth of NYMEX futures prices. This is a more meaningful figure than the near-month futures because it takes into account the natural seasonality of the gas market.

Natural gas prices have remained generally depressed over the past two years even as crude oil prices have surged to record levels. In fact, the price of gas relative to oil is as cheap as it was back in 2001, when gas traded under $2/mmBTU. Eventually, I would expect the natural gas/oil relationship to normalize with gas prices rising relative to crude oil.

But, in the short-to-intermediate term, the NYMEX natural gas market is heavily influenced by gas storage statistics released weekly by the US Department of Energy's statistical arm, the Energy Information Administration (EIA). Bloated inventories of gas in storage have capped every rally since early 2006. Check out my chart below for a closer look.

Market sentiment is a slippery data point. It's actually next-to-impossible to gauge sentiment at any given moment in time.

Clearly, lows for the broader market averages tend to correspond to extreme bearishness in sentiment. Similarly, at or near market tops, traders tend to be complacent. This is the basic theory behind old trading saws such as "buy when there's blood in the streets." But you could ask 10 different traders on any given day what their perception of sentiment is and you're likely to get 10 different answers.

However, I have found one indicator rather useful in this regard -- the Arms Index, sometimes called the Trading Index or simply "TRIN." Basically, TRIN compares upside volume on the NYSE against downside volume. I use a 10-day simple moving average of TRIN to smooth out its otherwise jagged volatility.

It's always amusing to listen to how the media treats coal. The prevailing belief seems to be that this is an unimportant, largely dead power source. But that is absolutely ridiculous -- coal accounts for 52 percent of US electricity generation. And most estimates show it actually gaining in importance over the coming decades, not declining.

And, we often hear about Europe's embrace of alternative and renewable energies such as wind, solar and even wave power. Germany, after all, has the largest installed base of wind power generation capcity in the world. But that's doesn't mean the Continent is independent either -- coal accounts for 50 percent of Germany's electricity generation, 34 percent in the UK and 93 percent in Poland.

In my webcast below, I take a closer look at recent trends in the coal industry and why I expect this theme to be a big winner in the New Year.

Basically, the IEA has admitted that the agency has focused too much attention on the demand side of the oil market equation -- basically, demand growth from the developing world and its effect on pricing. At the same time, the IEA has ignored or not fully covered the supply side.

Specifically, it appears that the IEA is underestimating the speed at which existing oilfields decline. In other words, mature fields areound the world are seeing production fall at a far faster-than-expected pace.

It's hard to escape politics living and growing up inside the Beltway. And, for better or for worse, politics does have a very real impact on our investments.

Oftentimes, political discussions turn to the latest results of various polls undertaken by various news organizations or pollsters. By polls are inherently flawed and not just when it comes to US political races.

Back in 1992 Britain's Conservative Party led by Prime Minister John Major appeared to be well behind the Labour Party in most polls. Pollsters were using a wide variety of different techniques and sampling formulae but the result was the same. But when the election actually happened, the Conservatives recaptured a substantial majority. Polls in Britain were simple dead wrong.

One of the most misunderstood sub-sectors in the energy industry is refining. Contrary to popular belief, these companies do NOT make more money when oil prices rise. In fact, rising oil prices can actually hurt the refining business.

This is exactly why we saw several of the big integrated oils report dissapointing earnings for the third quarter -- while their production business is solid, refining margins collapsed during the quarter.

To make a long story short, refining margins spiked to unusually high levels in mid-year, then fell after the onset of summer driving season. I am on the lookout for a similar move in 2008.

For a more complete analysis, click check out my webcast below (click on "Continue reading").

Oil inventories will remain tight near term but these supplies will start to show up in statistics next year. At the same time, the clearly slowing global economy suggests that oil demand will moderate somewhat in the first half of 2008. Lower demand and looser supplies spells a drop in oil prices.

This is complete rubbish. The fact is that some stocks and industry groups rally because of fundamental growth and improvement, not speculation.

Take a look at two examples. First up, let's examine the Nasdaq Composite in the late 1990s, a market that most would agree, at least in retrospect, was truly a bubble.

Today's statement from the Fed looked more dovish to me than the statement on October 31st. Specifically, note that on both occaissions the Fed cut rates by 25 basis points and there was one dissenter.

On October 31st, the single holdout was Thomas Hoenig who wanted to leave rates unchanged. This time around, the dissenter was Eric Rosengren who wanted a 50 basis point cut.

And then compare the following two paragraphs:

...economic growth was solid in the third quarter, and strains in the financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction.

Vs.

...economic growth is slowing, reflecting intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks...[these developments have] increased the uncertainty surrounding the outlook for economic growth and inflation.

Last weekend I outlined my case for a bounce in the US dollar against the euro and sterling. I believe that the action in the dollar this past week suggests that bounce may have already begun.

My basic thesis remains that the Federal Reserve has been the most aggressive in easing monetary conditions so far. But, Europe is not immune from the credit crunch and will also be impacted by a slowing US economy. I believe that the Europeans will, sooner or later, follow the Fed's lead by easing aggressively. This will kick off a sort of global easing cycle. And, with the dollar so oversold, this adds up to the potential for a large bounce in the US currency.

I thought that today I would highlight a few indices and indicators I watch in monitoring global credit and monetary conditions. First up, I track the Zero Maturity Money Supply commonly known as "MZM." Check out my chart of the index below.

Oil inventories fell nearly 8 million barrels, well more than the 1.25 million barrel drop that had been expected. On the other hand, gasoline inventories rose 4 million barrels against expectations for a 620,000 barrel increase. Finally distillates (heating oil, diesel, etc.) saw inventories rise by 1.4 million against expectations for a 300,000 barrel drop.

The most shocking number is that huge drop in crude oil inventories, a far higher drawdown than had been expected. This is really just a continuation of the pattern we have seen over the past few months of oil inventories drawing down through a period when they normally rise.

If I had a dollar for every time I've heard one pundit or another mention weakness in the Dow Jones Transport Average over the past few months, I'd be a rich man. But to talk about the transports as some sort of homgenenous group is completely ridiculous.

The fact is that the Transports consist of several sub groups. Three of the most important: rails, truckers and airlines. To make a long story short, the truckers and airlines have been slammed this year while the railroads are looking strong. But there's a good reason for this divergence.

The action in the dollar reminds me a great deal of late 2004 and early 2005. Back then sentiment on the currency was extraordinarily negative just as it is today. But the dollar surprised everyone by mounting a sizeable rally against major currencies such as the euro and sterling. A similar move this year would put the euro back at $1.25 or so.

We all know that the US is at the center of the credit market turmoil but that doesn't mean the nation is the only country affected. For example, Britain is certainly vulnerable as evidenced by the high-profile bail-out of Northern Rock by the Bank of England.

And while economic growth outside the US remains reasonably solid, I
find it hard to imagine that it'll be immune. Note, in particular, the
obvious deterioration in Germany's index of leading economic indicators
-- the largest economy in the EU is clearly slowing down.