6/30/2012
Oil staged a huge rebound to $84.82 on Spanish bank bailout and gas slowly rises to tests 200D moving-average around $2.81.
After some hard negotiations, the Germans capitulated and agreed to a joint European banking supervisor and bailout of the Spanish banking sector. The fund will be available to the banks directly so as not to increase the debt level of Spanish government. Markets the world over seem to like the development, a little too much, in our opinion.
This first step toward fiscal union is a step in the right direction in the current mainstream economic circle. The peripheral economies in Europe have not been able to cope with the ongoing crisis effectively like the Americans due to the fact that they can’t devalue their currency. To remain competitive they have to lower wages and standard of living. This kills demands, not to mention a lot of social issues. The other problem with European banks is that the governments tend to view them as national champions, and it makes it hard for politicians to take a hard line and demand a real stress test and shape-up of their balance sheets. The muddle-through approach lets problems fester and we have a vicious cycle of banks and governments dragging down one another.
What does this mean for us?
We can expect the European governments to continue making slow progress, interrupted by periodic flare-ups like the current one. The short to intermediate term effects are a setback in growth expectation and a jittery market with a bearish bias. There are some safe-haven buying heading into US Treasury and US Dollar. Over the longer term, probably the next 9 months to a year, we will probably see some more money headed to commodities as equities enter a bear market and the inflationary effect kicks in.
We continue to see a bearish tone in the oil market. Against the backdrop of weak demand, plentiful oil inventories, negative consumer sentiment , the market found some short term support in the positive European news, lingering geopolitical risks from Iran, Norwegian oil strike, and the technical “oversold” chart.
Natural gas, on the other hand, maintained its upward momentum, helped by the production shut-in in the Gulf of Mexico related to Tropical Storm Debby. Continued hot weather throughout the much of the high-demand areas has kept the gas burning for power plants. We see short term price strength in the supply demand picture and volatility around the weekly EIA storage number release dates.
Oil
WTI has been posting some big numbers lately. The correction came hard and fast and the 8% rally on the last day of June looked more like a huge relief bounce than anything. Let’s take a look at the headlines in the last two weeks.
On any given day in this period, we observed that amidst all the background noise of economic numbers, tension between Turkey and Syria, US manufacturing data, the US Dollar, the broader stock market, the market’s default action is to drift down to the last support area in the mid-$70s. Debby-related shut-in, Iranian sanction talks, Norwegian oil workers’ strike, and other mildly or strongly bullish factors barely registered on days when they surfaced. There has been definite underlying bearishness until the Spanish banking bailout news came along.
So what now?
We think most of the selling from the $100-a-barrel crowd is done for now. This rebound, which we characterize as a relief bounce, from $77 could go on for a while, though we are not willing to guess how long. These relief bounces are notoriously hard to gauge and dangerous to play. And when they do reverse, the ferocity could catch you by surprise. They have low likelihood of success and high consequence of failure. In other words, we do not intend to trade this short term momentum. Instead, we will wait and see when it runs out of steam to initiate some short positions.
The market could surprise us in the coming weeks but we think the biggest bullish catalyst would come from the Middle East. A minor catalyst could come from another round of QE but we doubt a rally of that nature is going to last long. Domestic production continues to rise and we don’t see a significant slow down until WTI gets down to the $50s and $60s, the breakeven point of most producing basins including Midland and Eagleford Shale.
Natural Gas
After correcting down to $2.17 Natural Gas responded to the moderately bullish EIA storage injection (67Bcf vs 75Bcf consensus) on June 14 and rallied past $2.50. Building on that strength, the price action has been bullish, aided by relentless heat wave, low storage injection numbers, and Tropical Storm Debby. The latest report shows 3,063Bcf in working storage, representing 73% of total available storage.
Domestic oil rigs continue to pick up at the expense of gas. Gas-directed rigs now stand at 541, 62% of where it was a year ago. There are 1,421 oil-directed rigs, a 42% rise from last year. There has actually been an increase of number of rigs in the past year. As the ever more efficient rigs get re-directed from gas to oil wells, there has been a significant increase in both oil and gas production. The associated gas produced is the reason we are not seeing much reduction in overall gas production. As we mentioned before, the balance among decline rates on existing gas wells, the amount of associated gas, and the backlog of shut-in gas wells waiting to be brought back on is pretty delicate. No one knows the net effects of these factors and the timing. And if oil price cracks wide open causing a reduction of overall drilling it’ll be even more complicated. For now, the supply side of things seems to hang in a balance.
Tropical Storm Debby shut in some 17% of Gulf of Mexico gas production and 18% of oil for a few days. Combined with the extra power demand in the Midwest and the higher than normal temperature forecast for the summer, front-month gas price has been steadily creeping up. We are hearing that natural gas has a real chance of overtaking coal as the largest electricity generation fuel this year. Hurricane forecast however, indicated a below average hurricane season, minimizing the possibility of a supply disruption. Storage overfill scenario is probably shaky at this point, even though it is still at record high. In other words, the fundamentals of our October short trade look to be eroding fast due to assaults from multiple fronts.
Let’s look at the technical side of the trade. Since 2003, gas has trended down in the summer toward September every year due to similar supply/demand structure The only exception is 2005 when Katrina wrecked havoc in the Gulf and sent gas price soaring. In the same 9-year period, gas hit its low in September four times, October and August once, making a bet on end-of-summer low a high-probability one (67%). The underlying assumption of burning in the winter and storage filling from April through October is still valid. As we stated earlier, the magnitude of coal-to-gas switching at power plants is likely to be the biggest determinant of price action in the coming months.
When we examine the short interest we also see some favorable trends. So far this year, the non-commercial long-short spread has been tightening up. As a whole, traders and hedgers have been either bottom fishing due to low price or covering their shorts due to limited downside potential from $2-$3 gas. We’d like to see net short positions shrink further and reverse the persistent uptrend since 2009 and we will likely see that happen in the next few weeks. If this were to happen we might see another run up toward $3 before the trade goes our direction.
Source: CTFC
Although gas price has rallied to its 200D MVA (moving average) and potentially going higher, it is still firmly in a downtrend. The rally in our opinion is partly technical rebound and partly fueled by some shifts in fundamentals. We are wary of these shifts and will probably have to adjust our profit expectation for the trade downward. The longer the rally lasts, the less room there is for price to drop below prior low of $1.90. In the coming weeks, we expect to see continued volatility around storage number release dates and a slight bullish bias. Having said that, we are maintaining our October short positions.
Other Sectors
US Refiners have been enjoying relatively lower crude prices than their international peers, making market share gains in recent years. There has been a resurgence of refined products export from US based refiners. There are some discrepancies operating conditions for the Gulf Coast based refiners (heavy/sour crude) and Midwest based refiners (light/sweet crude) but as a whole they should perform similarly as domestic crude prices come down and more transportation options for Canadian heavy, Bakken, and Midland oil become available in the not-too-distant future. Overall, this group is importing less and exporting more amidst a flat to declining demand. We see continued economic woe in the foreseeable future. Therefore, we are not too excited about going long or short. On the other hand, the dislocation of NGL prices to oil price has dealt a big blow to NGL processors and the midstream sector. We are seeing signs that this could be a multi-quarter or multi-year phenomenon. Therefore we have a long bias toward names that have more of a fixed fee structure, e.g. pipelines, storages, and stay away from processors with large exposure to commodities prices.
Equipment/Service sectors continue to be bi-polar. With the softening of commodities prices and margin squeeze, drilling is expected to slow down for the next few quarters. We do not find reasons to be cheerful for drillers and equipment suppliers that are heavily exposed to upstream activities. Construction and suppliers that are geared toward infrastructure build-out are still doing well as they are working off their existing backlog. Some slowdown is expected but there is a lag. Until we start seeing companies initiate significant curtailment of projects we are staying neutral.
Coal’s pain continues. Natural gas has been eating its lunch as the preferred fuel for power generation heading into the summer. The steady loss of market share seems to have no end in sight. We have actually been bearish on coal for at least a year and we think the negative expectation for the rest of the year has been largely built in at this point. With low expectations and lack of further, significant downside catalysts, we will start looking for signs of a rebound as we progress into the summer and fall seasons. Between coal plant retirement and reduced competition due to companies exiting the sector we should see some improvement in coal companies that survive. We may even buy into some coal operators at that time.
The green energy sector has suffered significant lack of enthusiasm. As we mentioned before, this being an election year, neither party has an incentive to encourage the development. We are keeping an eye out for opportunities to play the downside. This may mean a meaningful rally followed by a reversal. We need to be patient.
Special Discussion – Midstream/Pipelines Update
Companies in this sector own facilities that gather oil and gas produced from wellheads, remove the undesirable components (acid, sulphur, water, etc), process the fluids into different grades (methane, propane etc), transport them to different markets or downstream refineries, storage them as necessary. Some activities fall under the definition for downstream sector but generally we are referring to the gathering, processing, and transportation sector excluding petroleum refining, which is usually a standalone area of discussion.
Since about 2005 US domestic shale gas has experienced a boom, bringing a renaissance to infrastructure build-out on a massive scale to handle all the additional production volume. Shale oil has come of age more recently and the application of horizontal drilling technique to other matured fields will be next. Through the process of “creative destruction” coined by economist Joseph Schumpeter this has created a new frontier for many new companies to emerge as major players and many established companies to defend their turfs and compete with a renewed focus on growth. This growth phase was interrupted by the 2008 financial crisis and is now entering what we believe to be the beginning of a maturing phase. We expect the pace of mergers and acquisitions to pick up as the onset of weak economics begins to erode margins.
The midstream and pipeline sectors of the oil and gas industry are populated by Master Limited Partnerships (MLPs) due to their supposedly stable cash flow. Investors craving for yields and stability have sought them out, prompting even some Exploration and Production (E&P) companies with matured producing properties to utilize the structure to raise capital and fund their operations. Generally the interstate transportation of liquids and gas has a more stable fee structure with tariffs determined by FERC. Conversely since the deregulation of natural gas the midstream gathering and processing sectors have been free to set rates. With the advent of shale drilling there is much competition for volume among operators, resulting in various degrees of exposure to gas and NGL prices.
Mont Belvieu NGL, Ethane, and Crude Price Comparison
More recently with the divergence of natural gas and oil prices we have seen midstream operators try to shift to more fixed fee contracts on dry gas while maintaining exposure to liquids prices. The collapse of NGL price relative to crude in addition to the drop in crude oil price itself has led to a panic exit among investors. This look overdone in the short term but we believe it is the onset of a longer term trend. Years of rapidly expanding drilling programs and the recent acceleration of liquids focused drilling seem to have caught up to reality, as evidenced by the plant tailgate prices at Mont Belvieu and Conway, the two major hubs for NGL processing. Until industry and manufacturing figure out how to make use of the excess supply we are likely to see depressed price level stay. NGL is somewhat tied to the general economy similar to crude oil, but mainly used in plastics and industrial products. In the domestic midstream space, the implication to us is that there may be an opportunity to arbitrage pipelines and processors as a long/short pair trade. Generally speaking, we try to avoid shorting high yield MLPs directly, instead we utilize options if there is sufficient liquidity.
Comparing year-to-date performance, we see some solid names in the oil and gas transportation/storage space that pay good dividends, and deteriorating performance in the midstream processors. The key driver to the midstream names up to this point had been growth. We see some of that on an on-going basis but as a commodity price scare and a possible slowdown scenario loom large we exited the midstream players but kept the pipelines. EPD, PAA, ENB, OKS and KMI all have large diversified portfolios of crude, liquids, and gas pipelines, compression/pumping, terminals, and storage facilities with stable and predictable cash flow. Their relative performance show that. Of the smaller players, GEL and BWP have fared pretty well so far and we expect the trend to continue.
Source: Yahoo Financial
Uptrend for pipelines intact...
Uptrend for processors questionable...
Current Theme
Market actions the past two weeks did not warrant a change in our trading theme. As we mentioned before, we are watching the natural gas numbers every week for clues on power demand for a possible shift into Scenario G2 (hot summer, high coal switching, low production). So far we have an early hot summer, encouraging price condition for power plant coal-to-gas switching, but on the supply side we are not seeing a significant production cutback, even with a tropical storm. The implication is that while the fundamentals still point toward a storage peak price drop we may not see a break below the April low. In addition, we may have to tolerate a little more adverse price action to keep our short position.
On the oil side, the Iranian threat keeps the market on its toes while the Norwegian oil workers strike is adding the suspense. The strike is widely believed to be resolved within weeks and represents only a blip in the supply disruption. Tropical Storm Debby’s effect on the Gulf of Mexico production barely even registered with traders. For now the immediate concern for oil is the anticipation of QE3 by the Fed causing US Dollar to rise and WTI to fall, or the outright collapse of large European economies taking down the rest of the world. While OECD leaders responded forcefully and in unison during the 2008 crisis, we can expect a hard slog and gradualism both in the US (election year) and the Euro zone (new governments, disagreement on austerity/growth measures) this time.
In the coming months we think the bearish bias will dominate the stock market. We believe that basic materials, energy, and financial sectors are the weak links and will continue to lag other sectors. The market may take a while to set up a coming crash but we will be prepared. While the development in the oil and gas sector is bringing cheap fuels, good jobs, and energy security to the country, there will be winners and losers when the market forces sort themselves out. Cheap and plentiful gas is promising to create a huge demand in transportation to replace gasoline, revitalize manufacturing, reduce greenhouse gasses, and cut federal deficit. In the meantime we will profit from our insight and ability to stay in sync.
Scenario O2- G1:
- US economic growth expectation slows down before summer;
- US stock market breaks uptrend and corrects for the rest of 2012;
- Crude Oil follows macroeconomic trend and declines for the rest of 2012;
- Weather this summer relatively hot but not extreme;
- Natural Gas downtrend continues through October storage peak, and rises toward winter and 2013.
Our current theme calls for the following strategy. While this is a road map for our investment direction, we do not necessarily hold all of these positions at one time nor do we believe every company in the sector exhibits the same characteristics. It also does not describe the leverage to use – this depends on the volatility of the underlying instrument and the level of conviction we have in each position. In execution of this strategy, we incorporate pricing analysis, market sentiment, technical analysis, liquidity, timing, and many other portfolio construction / optimization considerations.
- Oil Futures: flat, wait for confirmation.
- Natural Gas Futures: short September/October contracts.
- Oil focused producers: flat small to mid-sized companies that operate in liquids/oil rich basins.
- Gas focused producers: short small to mid-sized companies that operate in gas rich basins.
- Equipment/Service companies: short drillers, flat materials suppliers.
- Refiners: flat; demand likely to slow down soon but offset by lower feedstock prices.
- Midstream/Pipeline: long high yield MLPs with little exposure to commodity prices.
- LNG: long companies that are positioned to export/transport North American gas.
- Alternative Energy: flat on wind, short solar players; weak sector economics.
Red = short bias
In constructing the portfolio, we aim to arbitrage the relative values of different commodities and sectors or companies within the sectors to generate alpha. Not much has changed since June 15 and we see no need to alter the portfolio makeup. Oil drifted down and rallied back to around the same point. Gas powered up toward 200D MVA but we did not see enough fundamental changes to change tact. The general equity market was flat and made no meaningful range changes to worry us, even with big rally on June 29. It is taking it time to set up a pattern. Gas stocks were relatively stronger than oil stocks for obvious reasons but none has violated their prevailing trends. Refiners surprised us with their strength and we think it is something worth investigating.
The current target portfolio is approximately 75% short. We are conserving some room to prepare for a set up for oil to roll over from a bigger bounce or to pick up some long positions in 2013 natural gas when it drops back down. From our analysis, we still believe gas will roll over from this point, head toward prior low before rising back up in the winter. When that happens we want to be ready to load up on some. We might also do the same for coal stocks as they kind of run in sync with gas at this point. The other plays on stocks and options are somewhat more opportunistic. We will take advantage of more opportunities to enter downside positions when there are occasional rallies toward major resistance areas based on technical analysis.
Oil weighted producers have predictably tracked oil price down and bounced up the last two weeks, making their attempt at the first resistance level near 50D MVA. Some bounced faster than others but they are mostly just responding and behaving according to macro conditions. WLL, GPOR, OAS, ATPG, PXP, CPE, ROSE, BRY are a few examples. We see a lot of trouble ahead for this group, as the correction has just begun and there have been lofty expectations built in to their prices. We are staying flat at this point due to uncertainties in the oil price near term but are prepared to enter short positions when we see signs of oil price turning back down after this rally fizzles out, and when the stocks rebound toward their resistance area near 50D MVA.
Gas weighted producers such as XCO, UPL, SWN, BBG, QEP, CNX, KWK, predictably tracked gas price upward the past two weeks. Much negative expectations from low gas price have been built in to this group. They are still vulnerable to a downward pull as soon as gas price turns down, in addition to the general stock market souring. There are too many things that can go wrong but not enough upside catalysts. As we mentioned, the credit facilities and borrowing base are going to be an issue in the new few months when banks revisit the price deck and reserves calculations. We are maintaining our shorts on this group and potentially adding new positions.
In the midstream/pipeline space, we are biased toward the transportation and storage sub-sector and neutral on the processors with more exposure to dropping NGL prices. See Special Discussion section.
Service/equipment providers are generally not looking well at this point. With slowing prospects and eroding margins in the coming months we can’t get excited about the drillers and upstream service/equipment providers. PTEN, NBR, HERO, RIG, HAL, SLB are some examples in this group that look ripe for short entry. We maintain our short bias. Engineering and construction companies such as PWR, WG, ORN, URS, JEC are a mixed bag. We don’t see much upside in taking a long or short position at this point.
At this juncture, our target portfolio is not ideal in a sense that it is heavily directional since we exited the oil trades in May. We aim to use more spread positions to mitigate the highly synchronous behaviors of several positions in the portfolio, for instance gas producers/service and equipment, gas futures/gas producers. We are maintaining a lower leverage and waiting to gain more visibility into drivers of the oil market and economic conditions in order to make additional moves. Stay with us.
Alternative Development
We see several potential scenarios that could play out for the rest of 2012. There are many uncertainties associated with the nascent economic recovery in the US and Europe. The emerging economies appear to have run into a slow patch. Certain supply disruption events such as Iranian sanction on oil and hurricanes in the Gulf of Mexico are likely to cause violent but short term price volatility. We will evaluate these events on a one-off basis as the magnitude and duration of impact are hard to incorporate into the scenarios.
We think any of the following scenarios could take hold. As soon as we realize that we are heading down the wrong track with our current investment theme, we will switch gear and reposition our portfolio.
Scenario O1:
- US economic growth continues but sluggishly through this summer;
- US stock market continues uptrend since Oct 2011 but reverses in 3rd or 4th Quarter 2012;
- Crude Oil follows macroeconomic trend and stays above $100;
Scenario O2:
- US economic growth expectation slows down before summer;
- US stock market breaks uptrend and corrects for the rest of 2012;
- Crude Oil follows macroeconomic trend and declines for the rest of 2012;
Scenario G1:
- Weather this summer relatively hot but not extreme;
- Natural Gas downtrend continues through October storage peak, and rises toward winter and 2013.
Scenario G2:
- Weather this summer relatively hot but not extreme; but coal to gas switching at power plants pick up significantly, or production slows down faster than expected;
- Natural Gas price bottoms out before October storage peak, and rises toward winter and 2013.
Base Scenario:
- US economic growth continues but sluggishly through this summer;
- US stock market continues uptrend since Oct 2011 but reverses in 3rd or 4th Quarter 2012;
- Crude Oil follows macroeconomic trend and stays above $100;
- Weather this summer relatively hot but not extreme;
- Natural Gas downtrend continues through October storage peak, and rises toward winter and 2013;
Certain supply disruption events such as Iranian sanction on oil and hurricanes in the Gulf of Mexico are likely to cause violent but short term price volatility. We will evaluate these events on a one-off basis as the magnitude and duration of impact are hard to incorporate into the scenarios.
Disclaimer:
This publication is solely for informational and educational purposes. Where the results of analysis are discussed in this publication, the results are based on application of specific assumptions and personal opinion. These results are not intended to be predictions of events or future outcomes.
Kronos Management is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services to any person. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your investment. Before making any decision or taking any action that may affect your investment, you should consult a qualified professional advisor. Kronos Management shall not be responsible for any loss sustained by any person who uses or relies on this publication.
