The energy sector fared poorly during the third quarter of 2014 with many energy commodities posting double-digit losses. The higher US dollar, temperate summer weather and increasing inventories caused prices to fall. Let us look at the individual energy markets that trade on the US futures market and see what happened and what may lie in store from here.
Crude Oil Review
NYMEX light sweet crude oil dropped 12.15% during the third quarter and was down 2.98% through the first 3 quarters of 2014. NYMEX crude closed 2013 at $93.60 and traded in range from low to high of $87.85 to $107.73. NYMEX crude is up 261.75% from the opening price in 2000. Issues and tensions in the Middle East and Russia pushed NYMEX crude to the highs of the year during June, when many speculators bought crude oil futures contracts believing that prices would break out to the upside. The price failed due to increasing supplies from US and Canadian production. NYMEX crude spent the majority of the third quarter making lower highs and lower lows. Open interest fell from 1.75 million contracts in June to fewer than 1.5 million at the end of the quarter as disappointed longs took their lumps.
Brent crude oil fell 14.43% for during the most recent quarter and was down 11.43% as of September 30. Brent traded in a range of $95.60 to $115.71 so far during 2014, closing the third quarter close to the lows. Brent's premium to WTI closed 2013 at $12.93 per barrel and moved lower to close Q3 at a $3.51 premium. Brent crude oil had been trading at a significant premium to NYMEX crude since the Arab Spring in 2011. The decrease in this premium signals a lack of supply concerns over Middle Eastern oil. Even as violent flare-ups and war continues to plague the region, oil continues to flow. New supplies from North America have alleviated supply concerns we have witnessed in years past. The long-term norm for the Brent-WTI NYMEX spread is actually a small premium for NYMEX crude. This is due to that fact that the NYMEX crude is lighter and sweeter, meaning it has lower sulfur levels making it easier and cheaper to refine into products like gasoline.
Another interesting development during Q3 was the flattening of the futures curve in NYMEX crude. As an example, the November 2014 versus December 2017 calendar spread began the third quarter trading at $13.49 backwardation -- the 2017 price at a discount to the nearby crude futures contract. That differential traded at $16.68 on June 12. During the course of Q3, the backwardation moved lower closing Q3 at $6.38, a move of almost 62% in the spread. The spread actually traded down to $3.17 on September 10. The lower backwardation is yet another sign that there are few supply worries about crude oil on the horizon. A flattening of the crude oil crude has resulted in bearish price action in nearby futures contracts in NYMEX. The forward curve in Brent oil futures is in contango (future prices higher than nearby prices) out to 2016 and flat past that. These changes in market structure could be telling us that while there are no supply worries nearby and geopolitical events have little or no affect on price today, higher-cost production and supplies require higher oil prices in the future. If crude were to drop below production cost for this higher-cost crude extreme volatility could return to the oil market.
Crude Oil Outlook for Q4
The price action and momentum in crude oil is currently pointing to lower prices. Supporting lower prices in the short term are large inventories, lower demand from China and Europe, a stronger US dollar, a narrowing Brent premium over NYMEX crude and a flattening of the NYMEX curve and Brent futures curve in contango. The downside target for NYMEX crude is somewhere around the 80-85 level. I believe there is an implied put option on crude around the $80 level because in order to maintain energy independence, the US must continue to drill and extract higher-priced crude oil. Long term I am bullish on the price of oil because of demographic factors -- population and wealth growth across the globe. For the balance of the year, I believe we will see a continuation of lower highs and lower lows, so long as there are no surprises from oil producers in the Middle East. Crude oil closed at $89.74 on October 3.
Oil Products Review
NYMEX exchange traded oil products, RBOB gasoline and heating oil moved lower during Q3 with the price of crude oil. During the quarter the price of gasoline shed 19.11%; it is down 7.98% for the first three quarters of 2014. Gasoline traded in a range of $2.4209 per gallon to $3.152 for the first nine months of the year. Q3 closed close to the dead lows. Gasoline is up 264.59% since 2000. Heating oil dropped 9.49% for the quarter and was down 9.83% for the first nine months of 2014. Heating oil traded in a range of $2.6378 to $3.37 during the first nine months of 2014. Like gasoline, heating oil closed the quarter by making fresh lows for the year. Lower demand and increasing inventories of oil products combined with lower crude prices caused the price dips. A stronger dollar has also helped push product prices lower.
Oil Products Outlook for Q4
Gasoline and heating oil prices are in firm downtrends. Both opened the fourth quarter by making new lows, gasoline closed at $2.3787 and heating oil at $2.6150 on October 3, 2014. Gasoline should find support at $2.25 and heating oil at $2.40 given seasonal demand for heating oil during the winter season. While I expect a drop of approximately 10% in NYMEX crude oil, I believe the drop in oil products will be somewhat less dramatic.
Crack Spreads Review
Crack spreads were volatile and mixed during Q3. The gasoline crack dropped 50.83% during the quarter, while the heating oil crack was up 7.52%. Much of the divergence is due to seasonal shifts at refineries from gasoline for driving season to heating oil for heating season. On the year, however, both crack spreads have dropped dramatically; the gasoline crack was down 35.2% and the heat crack was down 31.64% through the first 3 quarters. This will have serious impact on profit margins for oil refining companies. Crack spreads are the best way to monitor oil-refining profits on a real-time basis. The gasoline crack closed at $11.21 per barrel, while the heat crack closed at $20.16 on September 30.
Crack Spreads Outlook for Q4
Gasoline and heating oil cracks should hold close to current levels, and could recover during bouts of selling in crude oil futures as downward pressure in products is less than in crude. Refineries will suffer and might even become losing propositions if these spreads, particularly the gasoline crack, falls further.
Natural Gas Review
Natural gas was down 5.63% during Q3 and is down 4.25% through the first 9 months of the year. This year, natural gas has traded from a low of $3.724 to a high of $6.493. The commodity is up 89.91% since 2000. Natural gas traded at the highest price since December 2008 last February as cold weather gripped the US. There were big inventory drawdowns last winter due to increased heating demand. This summer, huge injections of natural gas from new reserves in places like the Marcellus and Utica shale replaced depleted inventories. As of September 26, stockpiles of natural gas remain 10.7% below last year's level at this time and 11.4% below the five-year average. Another cold winter could cause price spikes in this historically volatile commodity. Natural gas closed the quarter at $4.121 on the active month November futures contract.
Natural Gas Outlook for Q4
Natural gas is in a trading range with resistance at $4.31 and support at this year's low of $3.724. The temperatures this winter will determine the direction of natural gas; expect prices to follow weather forecasts throughout the winter season.
In the US, ethanol is a product of corn. As such, ethanol prices fell 15.32% in Q3. Ethanol was down 20.73% through the first three quarters of 2014. Ethanol traded in a wide range during the first nine months of 2014, with lows coming at the end of Q3. Ethanol traded up to the highs in March when corn futures were north of $7 per bushel. Chicago ethanol futures closed Q3 at $1.5906 per gallon.
Ethanol Outlook for Q4
Ethanol will be plentiful as the corn crop and inventories are huge. Ethanol prices dropped below $1.50 on October 3.
The bottom line on energy:
A stronger US dollar, weakness in the Chinese and European economies and a general downtrend in energy commodities thus far in 2014 promises that we are in store for volatility in Q4.
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