The Global Markets

Early week optimism on the strength of better than expected US industrial production in July was erased later in the week by bearish weekly initial jobless claims and a sharp contraction in the Philadelphia Fed’s business outlook survey. Combined with a continuation of the rally in the US Dollar off the recent lows of two weeks ago, US equities markets were pressured lower on the week. The Dow Jones Industrial Average closed the week at 10,213, off 90 points from the prior week close and down just over 2% year to date, with major weakness coming in the energy, industrial, and financial sectors. The S&P 500 Index dropped 7 points on the week, closing at 1072 for a loss of under 1% for the week but down just short of 4% year to date. The US Dollar saw another week of solid gains as renewed concerns over both the European banking sector and sovereign debt issues pushed the Euro currency down briefly near 1.26 vs the Dollar after peaking out at 1.33 just over a week ago. A European Central Bank official suggested the ECB should continue unlimited lending to the European banking sector through the end of the year to ease liquidity concerns, undermining positive sentiment in the European currency. With trader sentiment having reached extreme levels of bullishness for the Euro and bearishness for the Dollar, the reversal experienced by the Dollar over the past week and a half was well telegraphed. The strengthening Dollar, the bearish move in the equities markets, and weak economic data continued to weigh on the oil market with NYMEX crude oil prices retreating to a six week low, dropping another $2 on the week to close at $73.46 on the expiring NYMEX September crude oil contract. Crude oil prices have now fallen 8% over the past two weeks, trading lower in 10 of the past 12 trading days. NYMEX refined product prices saw only moderate weakness compared to the fall in crude oil with NYMEX RB gasoline off only 1.5 cents per gallon and NYMEX heating oil losing just over 2 cents per gallon on the week as firmness in the cash markets due to refinery operating issues provided some underlying support. As a result, NYMEX gasoline crack spreads gained over a dollar on the week to settle near $7.25 per barrel with heating oil crack spread drifting up 50 cents per barrel, settling over $9.00 per barrel.  Gold prices closed higher for the third straight week, up $12 to $1227 per ounce as continued safe haven buying interest in the face of global economic worries offered support. US Treasury yields continued their move lower across the board as investors opt for the risk aversion trade of US government securities. Yields on the 10 year US Treasuries sank to near 2.6% as yields on shorter duration notes again fell to new record lows. As a precautionary note, trader sentiment indicators have now approached all time record levels of bullishness in bonds with US bond futures having closed higher for the past five months, suggesting  a near term correction could be imminent.  In overseas news, Japan’s second quarter GDP growth slowed to a crawl at just +0.4% vs an expected +2.3% as stimulus measures expire and the continued rise in the yen threatens to hit Japanese exports. Yields on Japanese 10 year bonds fell to a seven year low of 0.9% underscoring the ongoing deflationary pressures facing Japan. China is now expected to top Japan as the world’s second largest economy this year. After a torrid second quarter of growth in Germany fueled by strong exports, a key sentiment indicator of economic expectations points to a significant slowing with the ZEW expectations index falling from 21.2 in July to 14.0 in August though this is at odds with the upwardly revised forecast for 2010 German GDP growth of +3.0% from the German Bundesbank. Both Spain and Ireland held successful government bond auctions this week, but the yields required to place these bonds continue to escalate. Despite the European Union’s positive assessment of Greek austerity budget measures’ success, the spread between Greek bonds and the benchmark German Bund has widened out to the highest levels since May 10, suggesting the markets remain unconvinced the Greek budget and debt issues are anywhere near resolution. Unemployment in parts of Greece now approaches 70% and Greece’s GDP growth has slipped into negative territory as a result of spending cuts.  Rumors circulated in the currency markets about a potential downgrade of France’s triple-A credit rating, prompting further downside pressure on the Euro.

The Economy

US economic data continued to weigh heavily on the financial markets this week. The August Housing Market Index of US homebuilder sentiment sank to the lowest level in a year and a half, falling from an already low 14 in July to just 13 in August, compared to a record low of 8 in January, 2009. This was the third consecutive monthly decline as the outlook in the residential construction sector remains poor. Single family housing starts declined 4.2% in July, well below consensus expectations. Housing permits for future construction also came in below market expectations, falling to the lowest level in a year. 30 year mortgage rates fell for the eighth time in the past nine weeks to the lowest level since at least 1971. Though the low rates continue to spark a sharp upturn in refinancing, they have failed to spur any significant increase in home purchases as estimates of the seasonally adjusted sales rates of homes have fallen to the lowest level in 13 years. US producer prices rose 0.2% in July, the first increase in four months, dampening some deflationary fears. US industrial production increased 1% in July, exceeding estimates of a 0.5% gain, lead by an increase in production of motor vehicles and parts, though seasonal adjustments related to normal summer auto plant shutdowns may have inflated this number. Capacity utilization increased from 74.1% in June to 74.8% in July, well above the bottom seen in the spring of 2009, but still below the 80% average rate over the past 20 years. The Empire State manufacturing index rose modestly from 5.0 to 7.1, though below the expected reading of 8.0, however both new orders and shipments indices fell into the negative range for the first time in over a year. The Philadelphia Fed Index of business activity in the Mid-Atlantic States fell sharply in August, the first decline since July, 2009, coming in at -7.7 vs an expected +7.0. Survey results for new orders, shipments, and employment all came in weaker, with a significant drop in the average employee workweek index, all signaling a slowing of economic activity into the second half of the year. The Conference Board’s index of leading economic indicators rose 0.1% in July, less than the expected increase of 0.2%, though the index has held generally flat since March. Weekly initial unemployment claims increased 12,000 to 500,000 from an upwardly revised prior week figure of 488,000, the highest level since last November. The four week average rose 8000 to 482,500, the highest level since December. US bankruptcy filings in the second quarter reached the highest level since the 2005 revisions to the US bankruptcy laws, up 11 percent from a year earlier. Moody’s reports commercial real estate prices declined 4% in June, now down over 41% from the peak in late 2007. The Economic Cycle Research Institute’s weekly leading index continued hold near double digit territory at -10.0% with last week’s bounce to -9.8% revised downward to -10.2%, still suggesting a heightened threat of a double dip recession.  The Association of American Railroads reported rail traffic in the latest week again showed a marginal increase of just over 3.5% vs the previous week as intermodal traffic of trailer and containers hit its highest level of the year. Overall traffic registered a 7.1% gain vs the same week last year, but remains 11.3% off the comparable week two years ago.

Inventory Summary

The Department of Energy’s weekly inventory summary reported numbers sharply at odds with the prior day’s release of inventory data from the American Petroleum Institute. While the API report showed very bearish inventory builds across the boards, with crude oil stocks up almost 6 million barrels and 2 million barrel builds in both gasoline and distillate stocks, the DOE report showed much more moderate figures. According to the DOE, US crude oil stocks unexpectedly fell 800,000 barrels, having declined 6.5 million barrels over the past four weeks. Crude runs at US refineries increased 172,000 barrels per day, with the overall refinery operating rate up 1.9% to 90% as refiners briefly bounced back from last week’s low 88% level. Crude oil inventories at Cushing, Oklahoma, fell 687,000 barrels. Crude oil imports were marginally higher, up from 9.44 to 9.56 million barrels per day. Total US crude oil inventories at 354 million barrels are about 10 million barrels ahead of the same week last year and 25 million barrels ahead of the three year average. Gasoline inventories saw a minimal decline of 39,000 barrels, breaking a seven week string of inventory gains, with implied demand up over 200,000 barrels per day to 9.46 million barrels per day. Four week average gasoline demand is up 3.5% vs the similar four week period last year, though year to date, gasoline demand is only up a marginal 0.5%. Total gasoline stocks of 223.3 million barrels are 6.5% above a year ago and 9.7% above the five year average as the summer driving season rapidly draws to a close. Distillate demand rose 274,000 barrels per day to 3.674 million barrels per day, the highest level since the week ending July 2, limiting the overall build in distillate stocks to 1.1 million barrels, within the range of expectations. Four week average distillate demand was almost 6% above last year, but still 16% off the peak demand levels of 2007. Total distillate inventories at 174.2 million barrels remain at record levels, almost 8% above last year and 27% over the five year average.

Market Outlook

The supply and demand fundamentals for petroleum continue to be negative with high US inventories, sluggish global demand growth and abundant OPEC spare production capacity. With distillate stocks at or near all time record levels and gasoline demand typically falling 3-5% after Labor Day, the prospect of any improving fundamentals could depend on an unlikely ramp up in demand or significant reductions in supply, either through operating rate reductions or storm-related disruptions. However, the correlation between crude oil prices and the S&P 500 stock index has recently been running as high as 70%, more than double the average of 34% since 2008, with oil prices functioning as a barometer of overall economic health as reflected by the equity markets rather than necessarily reflecting oil market fundamentals. The renewed rally in the US Dollar provides a further obstacle to sustainable rallies in Dollar denominated assets. The overall tone of economic data remains generally bearish with a poor outlook for job growth and a very weak housing sector. Upcoming revisions to the US second quarter GDP number, originally reported at +2.4%, but likely to be significantly downgraded, will add further weight to the financial markets. Bond spreads in Europe signal the problems in both the banking and sovereign debt sectors are heating up again. The stampede of fund flows away from equities and into the relative safety of US government securities and high quality corporate bonds also signals a paradigm shift in investor psychology. With risk aversion becoming the new normal, downside market risks remain substantial as we enter the traditionally weak month of September.  After a period of relative calm in the tropics over the past two weeks, one of the quietest periods on record globally, expect a proliferation of tropical development as we head into the peak month of September. Though Tropical Storm Danielle in the central Atlantic Ocean poses no likely threat to the continental US, the overall pattern suggests the potential for close in storm development in the Gulf of Mexico this week, and as the core of the heat in the US migrates toward the Ohio Valley and the Northeast over the next 2 weeks, the path for storm development threatening the US coastline reopens.  

Refined Products Markets

August Gulf Coast gasoline basis values continue to show relative firmness as the low RVP gasoline season draws to a close in early September on news of refinery operating problems at several Gulf Coast refineries, including coker unit problems Houston Refining, additional unplanned downtime on the FCC unit at Motiva-Port Arthur, a week of unplanned downtime on the FCC unit at Total-Port Arthur, and a major planned maintenance turnaround upcoming at ExxonMobil-Baytown. Prompt 9.0# RVP gasoline basis values pivoted around the -8.00 cpg level vs September NYMEX RB gasoline as refiner selling has started to dry up. The September/October NYMEX RB spread appears to have bottomed near +4.50 cpg, in from +10.0 cpg at the start of the month, reflecting ample availability of lower RVP barrels in New York Harbor as gasoline imports remain strong. September basis values are likely to remain firm with the active refinery maintenance schedule and the expected ramp up in the hurricane season. Basis values in both Chicago and the Group also remain steady to firmer with significant refinery maintenance upcoming and the ongoing Enbridge crude oil pipeline shutdown forcing refinery run cuts in Michigan and Ohio. There continues to be strong shipper demand for barrels moving off the Gulf Coast up Explorer and TEPPCO pipelines to capture the midcontinent arbitrage value. Spot ethanol prices continued to move sharply higher this week, up as much as 15 cents per gallon in some markets on a widening price backwardation, with corn prices also holding well above $4.00 per bushel. Corn prices saw further support from weaker crop yield expectations and additional export sales. The Department of Energy reported weekly ethanol production basically flat vs the previous week, near 860,000 barrels per day, the third consecutive week of strong production numbers with daily ethanol production still representing just over 9% of daily gasoline demand. The 4.928 million barrels per day of conventional gasoline blended with ethanol was up 1.7% for the week and up 16.7% vs the same week last year. Despite the steady gasoline basis values, the modest deterioration in underlying NYMEX gasoline values combined with the steady climb in ethanol prices moved the Gulf Coast gasoline/ethanol spread further into the negative range with spot Gulf Coast unleaded regular at $1.8425 and spot Gulf Coast ethanol at $2.0550 per gallon. Trader buying interest for August Gulf Coast ULSD drove basis values as high as +6.00 cpg vs September NYMEX heating oil as the arbitrage window for cargo exports to Europe briefly re-opened, but subsequently closed, dropping basis values back to +5.50, still sharply higher than the +2.00 cpg level trading at the start of the month, despite the continued record level of US distillate stocks.