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Dennis Mangan, logi Energy: Market and Diesel Fuel Hedging Discussion

November 27, 2009

Crude Oil:
We closed down this week losing $0.67 to close at $76.05. We had a BUY SIGNAL and have partial hedges on at the 25% level. I remain negative but we follow the Indicators and they are still positive. The main reason for the strength is simply the US $ weakness. This week saw some $ strength as the credit problems of Dubai hit the markets very hard on Friday.

We have closed at the bottom of the weekly trading range 5 weeks in a row and this market appears set up for more weakness. If there is a $ strengthening about to take place this market should drop quickly and sharply to lower a price level. I expect a test of $67.50-$72.50 depending on any continued strength that we happen to see.

If though, the dollar weakens more from these levels, the market will probably not break a lot more. If the weakness is pronounced, we will probably test the swing highs at $81.50 and may advance up to the mid $80 range.

The HO Crack was up a little this week with the Gas Crack sharply lower as was the 3:2:1 Crack. This is not positive and if we see more weakness in the processing margins, Crude Oil will weaken. Overall the action just shows how inherently weak this market truly is.

We have had the announcement of three refiners shutting down operations and if we see the margins remain weak, and move down to lower levels more are sure to follow suit. Crude Oil will have a difficult time holding current price levels unless the Crack Spreads hold here or move higher.

The Crude Oil is now susceptible to price weakness if the Crack Spreads cannot hold. If the Crude Oil inventory grows, and demand drops, there is going to be a major price problem. The refiners are now right at breakeven and to hold these margins they must continue to hold down the run rate.

This will help Crude prices to remain stable and maybe get a rally going. If, the weakness in the Crack Spreads continues, we should expect more weakness in Crude Oil. If the 3:2:1 Crack Spread weakens sharply, Crude Oil could break then begin to have a very sharp break.

This will especially true for the back month Crack Spreads as they are trading at a very sharp premium to the nearby contracts in a number of cases. The huge Distillate Inventory, mixed in with horrible demand, does not lead one to suspect price will not eventually drop dramatically.

If we continue to have a mild winter, the Crack Spreads could enter into a meltdown stage and a price collapse. Do not doubt that under the right circumstances Crude Oil can collapse back down to the spring lows at $34, especially if there is a demand collapse.

If we have a normal to cold winter, which so far is not the case, with increasing demand, margins and price should be stable. The Vol Price Indicator is at the top of its range for the 12th week in a row, and this is bullish. The % Total Count is 79%, falling and this is bearish. The other two Indicators are at 81% and 79%, one rising and one stable and this is neutral to bearish.

Heating Oil:
We fell this week by 1.34 cpg and closed at 196.22 cpg. We have a Buy Signal, but we are using Crude Oil for hedging because the HO Crack Spread remains quite high. I expect to see weakness in this market versus both Gas and Crude Oil.

The facts are we have a very large inventory, that is not declining, and we have low demand. With those facts, I find it hard to expect a huge rally from here. Distillate production remains very high relative to demand. Demand, which is now much worse than just poor, must change or price will go down.

Inventory is 40 million barrels above last year with demand still poor at the 21st Percentile of the 10-year range. Production is at the 64th Percentile this week with Product Supplied is at the 21st Percentile. This could hardly be poorer at this time of year.

What it will take to rebalance the supply/demand equation? If something does not change price will suffer dramatically, unless the $ continues to drop. The fundamentals, which are worse than extremely negative, still has not caused price to fall because of the $ weakness.

If that weakness happens to turn into strength, we will see massive price weakness develop. The Crack Spread is still acting very negative for this time of year yet price has not fallen. If we now see a US $ rally we will see price problems quickly develop. We have too much inventory with too much production with too little demand.

These facts have been ignored, as the $ has been weakening, but the market stop ignoring them very quickly if the $ strengthens. When the $ changes direction is anyone’s guess, but when we see it we will see sharp weakness in the Oil complex and especially in Heating Oil.

Over the last 42 weeks, we have had no increases in product supplied on a year over year basis. Thus, it appears the only way to decrease inventory is to cut production. That is what we have seen over the last 7 weeks but inventory is only down 5 mm barrels from the all time high. Demand is depressed and until we see that change, the overall facts in this market will not change. By this coming spring, if we cannot get rid of some of this inventory, we have a major problem with storage.

If that happens we will see price decline no matter what the $ does. If that happens, expect to see a price collapse in Heating Oil and in the HO Crack Spread. If so, a drop of 75-100 cpg in Heating Oil and 20 cpg in the Crack Spread, or more, is likely. The market ran up from 115 cpg to 210 cpg, as inventory increased from 145 mm barrels to 171 mm barrels.

It is hardly unreasonable that we go back to where the up move began. If the demand function stays depressed the price drop could be long and deep. The Vol Price Indicator is at the top of its range for the 11th week in a row, this is bullish. The % Total Count is 79%, falling and this is bearish. The other two Indicators are at 78% and 76%, one rising and one stable and this is neutral to bullish.

Heating Oil Crack Spread:
We were up 0.26 cpg to close at 15.15 cpg this week. The rally seems now to have stalled. We closed on the high of the week and we must have some follow through this coming week. If we fail, and take out this weeks low, we should move down to under 10 cpg.

Inventory size and lack of demand is the story and it continues to pressure the market. Continued lack of demand will allow us to maintain close to record inventory levels for a long time and this will not help price. Eventually this will end badly for price if something does not change.

How we lower inventory without a demand increase is the question. If the inventory does not start to fall sharply soon we will have a storage problem by spring. If inventory does not fall to under 150 mm barrels by spring, we may see inventory build to 180+ million barrels by early next summer. That equals a major storage problem and a major price problem. A number of refiners will then be at the brink of collapse. This will be especially true if we have a major bear market on product prices.

As of now, the huge inventory and poor demand is a lid on price increases. The lows at the 15.00 cpg level are holding but I expect them to fail and we then should move to the 7.50-10.00 cpg area. Unless the can demand improve, the swing lows will more than likely be tested. If the low of 5.10 cpg is violated the break should carry us to the -2.00 to +2.00 cpg level. If we exceed, and hold, the 17.50 cpg level, which is highly doubtful, a run up into the 22.50-25.00 cpg level may happen.

Considering inventory levels and demand weakness the logical conclusion is that we will see more price weakness than strength. Distillate Inventory is at 98th Percentile, with Production at the 64th Percentile, Imports at the 37th Percentile with Product Supplied at the 21st Percentile. Those facts are simply terrible. If refiners do not scale back and inventory builds, as we enter winter, the Crack Spreads can collapse and dramatically.

If we do not soon see demand increase, with a production drop, the inventory will not be able to decline and the price will. Refining run rates must go down to the 75% level to help get rid of excess supply. The Vol Price Indicator rose to the top of its range this week and this is bullish. The % Total Count is 57%, stable and this is neutral to bullish. The other two Indicators are 54% and 54%, one rising and one stable and this is neutral to bearish.

Gasoline:
This week we broke 5.44 cpg to close at 192.62 cpg. If we cannot exceed the June high of 207.11 cpg we will see a large break eventually develop. Nine separate times we have tried to take out that high and if we ever manage to get the job done we should then go up sharply.

If we do not we will sell down sharply at some point. Inventory is now 9,609,000 barrels above last year and if it increases price will have a difficult time in achieving a major rally unless demand picks up. In five weeks year ago inventory comparison will be 208,103,000 when price was 84.40 cpg. If inventory remains unchanged from here, inventory will be 2.0 million barrels higher and price will be 112 cpg above last years price.

Then on a year over year basis, we are 112 cpg higher, with the same inventory and demand price will look very high. Then as we compare the facts, on a year over year basis, it will be tough to make a bull argument. The current fundamental facts are that inventory is up 4.84% from a year ago with production is up 2.52% and demand is up 2.77%.

The facts are neutral to friendly but no better. The question is what happens if inventory increases and demand does not increase. Indicators continue to be a mixed bag. If 207.11, is taken out price momentum should carry us to a sharply higher price level.

This, if it happens, more than likely will be caused by continued US $ weakness rather than fundamental data. There is no major fundamental reason for prices to go up now. This week Gas Inventory is at the 68th Percentile, Production is at the 93rd Percentile, Imports are at the 54th Percentile and Product Supplied is at the 57th Percentile. This is better than the Distillate market but is a poor set of relative facts overall to support current prices.

The key is if Gas demand falls from here, then we have a major problem, especially if inventory begins a sharp build up. If inventory goes to the 220-225+ million barrel range, price problems will probably happen and we could see price at 125 to 140 cpg and possibly down to 80 cpg depending on the US $. This is possible if demand drops and the $ strengthens. The Vol Price Indicator is at the top of its range for the 3rd week in a row, and this is bullish. The % Total Count is 46%, falling and this is bearish. The other two indicators are at 44% and 46%, both falling and this is bearish.

Gasoline Crack Spread:
The Gas Crack broke sharply this week falling 3.84 cpg to close at 11.55 cpg. Since the last week in July we have dropped 28.18 cpg or 71% from the high of 38.86 cpg. Inventory build and demand dropping as driving season ended initiated the break. We currently have a Sell Signal and the Indicators still point lower.

The problems in Gas are not as bad as in the Distillate market, but by next spring, they may end up being worse. This will be dependent on demand and inventory builds over the next 4 months. This time of year Gasoline inventory builds, and that is the last thing we need to see happen considering the huge distillate inventory we currently have.

If inventory builds above 220 mm barrels, we will see price problems. Inventory this last year held at a high level over the summer and fall because we had shrinking demand and no weather or refinery problems. This caused by the poor economic conditions we weathered, as the stock market tanked and unemployment rose to the highest levels in 26 years.

With inventory 34 million barrels above a year ago on 9/18, the lid on a major price advance was in place. The floor over the last 6 months though has been $ weakness and if that ends…! With those facts, the idea of a major lasting rally is tough to fathom.

The rallies we see should be short and the breaks should wipe out the gains twice as fast as they took place. A number of scenarios can cause a sharp price break. I do not see any realistic scenarios developing that will cause a sustained rally. There is no inventory shortage and there will not be with the present facts. Unless the demand improves, we will not have a lasting rally.

Last year saw inventory build over 19 weeks by 41,482,000 barrels. If that repeats this year, even to a much smaller degree, with current fundamentals, we will see a huge break in the Crack Spread. The Vol Price Indicator rose above the bottom of its range for the second time in a row this week and this is neutral to bearish. The % Total Count is 30%, rising and this is bullish. The other two indicators are at 22% and 22%, one stable and one rising and this is neutral to bullish.

3:2:1 Crack Spread:
The 3:2:1 Crack Spread fell 2.48 cpg this week closing at 12.75 cpg. I remain negative on this spread after the rally we have seen. The back months of the 3:2:1 are at a sharp premium to the nearby spreads with some at 20 cpg. Considering the current supply and demand scenario, they should be weak. The premium of the back month spreads, to the nearby spread, leaves room for a major break to develop if the fundamentals get worse than what we currently see. If demand does not improve these spreads could lose a lot of ground from here.

Distillate inventory, with poor demand, should prove too much in the weeks ahead. This will effectively limit upside advances until those facts change. The continued impetus, with a premium price structure, should be for more price weakness with an occasional rally.

If Gas inventory builds up expect price pressure to come into this market. The real question is, “What will make the spread move up from here?” With current inventory/demand what will drives product prices higher relative to Crude Oil? I cannot see anything that should cause the spread to move sharply higher and then maintain those higher levels.

Until we see inventory fall and the demand increase, price should remain relatively weak. We will see rallies, but the point is can they last? A decline to the record low, at 1.51 cpg, will happen if inventory does not drop. If we see demand fall this winter price will decline sharply and may carry us to a new record low. Something must change in the supply/demand balance or price is on its way to massive problem. The Gas Crack must not weaken, which it did this week, because there is no way the HO Crack will carry this spread.

I expect more price weakness with a possibility of record low prices at better than 50/50. The weakness may end up being especially powerful in the back months, which carry a sharp premium to the front months. The premiums will attract professional selling on every rally. With this supply/demand balance, we cannot hold the premium price structure in the back months. Either demand improves or production falls sharply.

If one of those things does not happen, inventory will build, and there is little chance for a major bull market run. I suspect the spread traders will sell this spread every time it rallies, just as they have been. If demand gets worse from here, we go lower. We must see refiners keep production down. If demand ultimately rules the market price, as of now, with this demand, price is in trouble. The Vol Price Indicator rose from the bottom of its range for the second week in a row, and this is bullish. The % Total Count Indicator is 35%, rising and this is bullish. The other two Indicators are at 28% and 28%, one rising and one falling, and this is neutral to bearish.
HO-Gas Spread:
The HO-Gas Spread gained 4.10 cpg this week, closing at 3.60 cpg. The spread looks tired, I expect to see price stall at 7.50 cpg, and if we get through -2.00 cpg, we should head sharply lower. We have huge inventory in Distillate to work through so even if we do see sharply colder temperatures supply may prove too much to overcome as far as price advances are concerned.

With the extremely poor Distillate demand that we see, and with over production, Heating Oil is going to have some extreme difficulty moving up versus the Gas. The HO Crack remains extremely high considering inventory level and demand that we are currently witnessing.

Gasoline would seem the more likely candidate to rally than Distillate. I expect this spread to return to sharp weakness, especially after the run up we had. Current price action looks like it is setting up a break. That could develop quickly if we do not see a reversal and rally from these levels. We traded up to 10 cpg and but it appears that we now have more bias developing to the downside.

The weakness seems to be setting in slowly and expect that will continue and intensify. The spread is in a weakening mode, and if there is no demand increase, for distillate, the next wave of weakness should be very sharp. We broke below the 0-cpg level and this sets us up for a decline to -20 to -30 cpg going into winter and then the spring.

The Vol Price Indicator remains at the bottom of its range for the 6th week in a row, and this is bearish. The % Total Count Indicator is 52%, falling, and this is bearish. The other two Indicators are now at 61% and 69%, both are falling and this too is bearish.

Dennis Mangan

November 29, 2009

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