Stephen Maloney
Copyright 2009, Towers Perrin
All rights reserved
While crude oil markets are enjoying a breakout, why isn't natural gas keeping pace? Isn't there supposed to be some kind of multiplier relating the two commodities? Shouldn't rising hydrocarbon prices lift all boats? After all, the recession is over, right?
Maybe it's a storage problem so let's check the numbers.
As of October 9, 2009, US crude oil stocks were 337.8 million barrels, up from 309.2 million barrels a year ago. That's a 9.2% increase over last year and well outside the normal range for this time of year.
Natural gas stocks as of October 2, 2009 stood at 3,658 billion cubic feet (Bcf). That's up from 3,266 Bcf a year ago or a 14.6 % increase and also outside the normal range for this time of year.
So, we're not seeing an inordinate swing in storage volumes relative to normal ranges for this time of year.
Now, let's look at the prices.
WTI spot prices on October 9 were $71.75 a barrel, up from $69.80 the previous week. In contrast, spot prices for natty gas are around $3.82 per MMBtu and not showing much strength above the NYMEX $4 handle.
Let's put this in context. A barrel of oil is worth roughly 5.8 MMBtu. So, $71.75 per barrel of WTI crude prices a barrel's energy content at about $12.37 per MMBtu. On an energy content basis, oil prices are currently about 3.24 times higher than energy prices for an equivalent amount of natural gas. And, crude oil prices are in breakout.
By comparison, a year ago, WTI prices last year were $77.44 and heading south. Henry Hub prices were then around $8 per MMBtu. On an equivalent MMBtu basis, the conversion multiple last year was 1.67.
Natural gas prices are not keeping up with crude oil price increases.
Admittedly, a year-to-year comparison is not really fair. After all, US natural gas prices follow a cyclical pattern timed to the onset of winter. Prices tend to peak in late July-early August. That period also coincides with peak volatility reflecting the uncertain requirements of the upcoming
winter heating season and the uncertain potential for supply disruption associated with the beginning of hurricane season in the US Gulf Coast. So, there should be some risk premium to price into natural gas spot or prompt month prices. And, we should vary that premium through the year. As the winter heating season ends in late winter-early spring, the price topology can be as exciting as riding the "Rebel Yell" (ask Brian Hunter, formerly of Amaranth, to explain why Mar-Apr spreads are called the "widow maker").
Clearly, the evidence is "all hydrocarbons are the same" is NOT true on an equivalent heat rate basis. Maybe they once were, but not at this moment and not at certain times of the year.
What's changed?
First, crude oil is an international market while natural gas is currently dominated by pipelines.
In addition, we're seeing the increasing role natural gas is playing in domestic electric power generation. In contrast, crude oil has no role in electricity generation.
Utilities don't burn oil anymore to make electricity. Rather, they mostly burn US and Canadian produced natural gas and US coal. In fact, roughly a third of natural gas demand goes to generating electricity. And, over the past year, electric generation went down pretty hard due to the recession. When people talk about wind and solar reducing the dependency on foreign oil, they're wearing leisure suits and playing an 8-track tape from the 1970s.
Electricity generation directly taps into the real US economy (i.e., the one that employs working people - not NYSE). With US industrial capacity utilization running below 70%(!), it's not surprising that July net electric generation (a peak demand month) fell off the table some 7.6% this year. Coal was the big loser with its less liquid market taking a stomach churning 15% drop in generation. The (relative) big winner was natural gas demand for generation which was only down 0.4%.
The new dynamics of natural gas markets are breaking a lot of traditional notions. For example, while demand for generation softened, natural gas prices responded to market dynamics quicker than the coal market such that gas-fired generation actually stole market share from coal in many areas, including the Midwest. In effect, the higher spark spreads made gas-fired generators relative money makers this summer compared to coal generation while large segments of the US industrial sat idle. Wild.
We're still a long way from a US economy running at its normal 80% or so capacity utilization. The US economy will need a few years of white-knuckled growth combined with some serious capacity rationalizations to get there. Meanwhile, natural gas rigs are dropping off in an attempt to match supply to demand.
Shifting markets aren't the only change impacting natural gas markets. We also have seen a very quiet tropical storm season which has also moderated the volatility spikes we often see in the summer going into the fall.
All in all, while domestic supplies of natural gas heroically stole some domestic demand from coal it otherwise couldn't keep pace with crude oil's breakout driven by USD collapse and Chinese demand. Still, there may be some late inning hopes - despite threats (or promises - take your pick) of global warming, it may well be a colder winter this year. Cold temps can be beautiful music for natural gas producers.
Clearly, traditional market dynamics for natural gas were impacted by this recession and the "dog that didn't bark" (no headline-making hurricanes to speak of). And, so, the spreads between WTI crude oil and Henry Hub natural gas have widened beyond traditional bands.
What about the future? Will the US natural gas market continue to experience domestic dynamics? Or, will LNG expose the market to the trans-Atlantic spreads and transform US storage into a swing player not unlike the WTI-Brent spreads?
In my next blog, I'll talk about LNG.
Stephen Maloney
Managing Consultant, Risk and Financial Services
Towers Perrin
steve.maloney@towersperrin.com
www.towersperrin.com/energy
Tuesday, October 20, 2009
Monday, October 19, 2009
Wal-Mart Continues its Aggressiveness
Craig Johnson, our Consumer chair, believes that recent moves by Wal-Mart to demonstrate its desire to continue its aggressiveness by seeking new avenues of competition.
Recently the company started to
Recently the company started to
- sell dozens of toys for $10 each
- offer a wireless service priced below competitors
- cut prices on 10 highly anticipated hardcover books to $10 on Walmart.com
After both retailers then cut their prices on those books to $9, on Friday Walmart.com shaved a penny off that price to come in at $8.99 each. Walmart.com has threatened to drop prices even further. The company said it would adjust its pricing as needed to ensure it offered the lowest prices on its top 10 pre-selling books.
Craig believes that this is a demonstration that they are "more aggressive and they will cede no ground to the competition, whether it's the Best Buy's of the world, or Toys "R" Us or ... Amazon." He is of the opinion that "any competitor that underestimates Wal-Mart, does so at its own peril."
Thursday, October 15, 2009
Belo: Positive Trends in Ad Spending
We have recently posted an update from our presenter on Belo Corp (BLC: $5.47). Another shareholder is encouraged by a pickup in ad spending reported by peers in the space. The positive trends appear to be carrying over into Q4. Belo operates in Texas and Pacific Northwest, areas which have not been hurt by the housing crisis as much as other regions in the US, and where population is projected to expand at higher than average rates. The likelihood of breaking covenants is less of a factor now. Q3 earnings by Gannett and others starting next week should show conditions in the space turning less challenging.
Tuesday, October 13, 2009
The Tatum/Roulston Report
The Tatum survey this month clearly reflects that businesses are not in the typical mode of positioning their companies for recovery. Current trends are mixed with a lack of consistency by sector and industry. Perspectives indicate regional factors, government behavour and the financial instituional environment weigh heavily on the corporate outlook.
Backlogs have shown improvement as the significant slowdown last fall and winter has now rightsized inventories and corporate overhead. Expense reduction seems to be largely completed to a level that most companies are not cutting further at this point. Instead they seem to be waiting for an indication of better things to come. The Tatum Survey indicates some pent up need for modest capital expenditures for companies to start to maintain maintenance but not much more. Backlogs are up to replenish inventory pipelines, but a lack of confidence in future visibility is clearly widespread. Continuing capital availability concerns weigh heavily on this economy and most concerning to us is that its difficult to identify any factors that will adjust this environment.
Although the markets have bounced back to reflect maybe an overreaction to the downturn, Wall Street seems to have an uncanny confidence in historical precedence that has a disconnect with Main Street. We have written before that the difference between recession and depression is emotional. Middle America has reacted to the market meltdown, unemployment, government activism and lack of access to financial credit much differently than the East Coast. With the exception of export driven stimulus from the weak dollar and some very isolated individual company(seemingly not even industry wide) recovery, the environment is very sluggish.
Confidence in any government action to improve the sentiment is not only non existent, its sarcastic. With virtually no banking predictability most companies are experiencing very little forecasting capability. Optimism is common, but with very little tangible eveidence of sustainable stability. With the last year's experiences still freshly in the rear view mirror, pundits that believe recent history will not be a lasting scar just don't understand how a dog feels after its owner kicks it. The thought process that the economy will soon be back on a historically comparable trend is somewhat ignorant of the effects of the emotional meltdown we saw over the last 12-18 months. It takes time to forgive and forget unless you may not believe things broke down in the first place.
Backlogs have shown improvement as the significant slowdown last fall and winter has now rightsized inventories and corporate overhead. Expense reduction seems to be largely completed to a level that most companies are not cutting further at this point. Instead they seem to be waiting for an indication of better things to come. The Tatum Survey indicates some pent up need for modest capital expenditures for companies to start to maintain maintenance but not much more. Backlogs are up to replenish inventory pipelines, but a lack of confidence in future visibility is clearly widespread. Continuing capital availability concerns weigh heavily on this economy and most concerning to us is that its difficult to identify any factors that will adjust this environment.
Although the markets have bounced back to reflect maybe an overreaction to the downturn, Wall Street seems to have an uncanny confidence in historical precedence that has a disconnect with Main Street. We have written before that the difference between recession and depression is emotional. Middle America has reacted to the market meltdown, unemployment, government activism and lack of access to financial credit much differently than the East Coast. With the exception of export driven stimulus from the weak dollar and some very isolated individual company(seemingly not even industry wide) recovery, the environment is very sluggish.
Confidence in any government action to improve the sentiment is not only non existent, its sarcastic. With virtually no banking predictability most companies are experiencing very little forecasting capability. Optimism is common, but with very little tangible eveidence of sustainable stability. With the last year's experiences still freshly in the rear view mirror, pundits that believe recent history will not be a lasting scar just don't understand how a dog feels after its owner kicks it. The thought process that the economy will soon be back on a historically comparable trend is somewhat ignorant of the effects of the emotional meltdown we saw over the last 12-18 months. It takes time to forgive and forget unless you may not believe things broke down in the first place.
Finisar: Riding Buildout of Optical Networks
Finisar (NASDAQ:FNSRD) is another name from our recent small cap forum in Boston. Explosion in mobile data traffic and ever-increasing capacity requirements for fixed networks play to company's strength as the market leader in optical components. Margins are poised to rebound as some manufacturing facilities are transferred to off-shore locations and the overall product mix continues to improve with growth in revenues from higher-margin products. The company has secured a new credit facility and priced a $90 million notes offering to boost liquidity and retire outstanding debt with near-term maturity. The target is $15-$16 or 60% from the $9 level where the stock has traded since the last week's presentation. FNSRD has just undergone a reverse 1-to-8 split.
Comtech: Military Play with Call Option on Telecom Recovery
Our Boston presenter likes Comtech Telecommunications' (NASDAQ: CMTL, $31.93) strong presence in military communications. The stock fell from $40 to $20 back in March, when delivery under government contracts was pushed back one year. Now, the company is nicely positioned for fiscal 2010. Increased activity in Afghanistan will be an important factor in near-term growth. CMTL's higher-margin commercial sales are dependent on recovery in the telecom space. The company's operations are globally diversified, with solid presence in emerging markets. There is plenty of cash on the balance sheet to finance acquisitions, but Comtech itself is a likely takeover target for a number of companies. Trading at 5x EBITDA, the upside is 50-60%.
Monday, October 12, 2009
Decoupling trans-Atlantic crude oil markets
(From Steve Maloney at Towers Perrin, steve.maloney@towersperrin.com)
The continued decline of the USD has been an important factor in the equity price rally that began in March. We've seen the effects of USD weakness in other commodities, notably gold and crude oil. Storage is the new international bank with excess oil supply serving as a currency hedge. Clearly, this is no way to run a reserve currency but can be a great opportunity for companies positioned to play it.
The Obama Administration is clearly deploying a weak dollar policy in an attempt to restart the US industrial economy. Deficit spending and low interest rates come at a price. The Fiscal 2009 Federal deficit is at least $1.4 billion and next year looks even worse. According to Bloomberg, the dollar lost over 10% of its value on a trade-weighted basis the past six months, the biggest drop since 1991. Worse, the dollar represents less than 40% of new reserves, down from the 63% 10-year average.
With dollars practically free, the flood of USD dollars is fueling talk about restructuring the world's reserve currencies. Long before the 2010 resets and IMF policy changes, markets are already responding by breakouts in crude oil and gold prices.
Crude oil price dynamics can create interesting inter-market effects as well which reinforce the breakout dynamics.
In the US, one of the more important price benchmarks is West Texas Intermediate (WTI). The WTI market comprises pipeline flows gathered in Midland which may be directed to the US Gulf Coast or to the storage facilities in the vicinity of Cushing, Oklahoma. Flow through Cushing continues up towards refineries and other processing facilities in the Chicago area. In 1983, NYMEX created the WTI contract with delivery in Cushing based, in part, on ready access to US refineries then concentrated in the US Gulf Coast. WTI is considered "sweet" in that it has less than 1% sulfur making the grade ideal as refinery feed for the higher resulting yields. With refineries driving US industrial production in the Midwest and the Gulf Coast, WTI prices were excellent marks for the physical product. As formulas-based trading emerged in 1986, financial markets synchronized with NYMEX and later the commodity markets of ICE and Dubai.
Similarly, Brent crude oil is located on the other side of the Atlantic Basin. Like WTI, Brent is a commingled crude with low sulfur content and ideal as refinery feed used for motor fuel and industrial products. Brent was originally drawn from both the Brent and Ninian systems in the North Sea. As the original Brent field declined, Platts introduced a new price benchmark in 2002 combining Brent with production from the Forties and Oseberg. Ekofisk was added to the mix in 2007. So, when we talk about Brent today, we're really talking about North Sea oil from several sources.
Since both WTI and Brent are sweet crude, one would expect the price spreads across the Atlantic Basin would reflect market coupling, modulated by the cost of freight. Consequently, we would expect WTI to price at a premium to Brent. This premium can erode or go negative due to pipeline interruptions, supply chain constraints, and US refinery outages. Such outages occur during the hurricane season impacting the US Gulf Coast in late-summer and early fall which present spikes when refineries or production is halted.
However, those traditional market dynamics have changed, partly due to shifts in the US physical market, amplified by the decline in US industrial production, and amplified by the collapse of the dollar.
The US physical market changed as a result of interconnection with Canadian products increasing the supply to Cushing. This supply enhancement was driven by the strong US economy of several years ago. As this supply grew ahead of the declining US economy, prices sifted to contango. This shift has been amplified by growing storage capacity in the Cushing vicinity. With storage costing some $1.25-$1.75 per barrel-month, the convenience yield was running in the range of ~50% annualized return for much of the past year.
The Brent market has seen similar dynamics, though without the pipeline and hurricane effects. Like WTI, the price curves are in contango which provides incentives for storing crude ahead of demand. While Cushing saw tank farms expand, Platts reported charters by BP and Shell of very large crude carriers starting a year ago mooring off the UK coast.
As crude prices fell, we also saw spikes in the WTI-Brent spread volatilities. These spikes can be explained, in part, by the disproportionate storage additions at Cushing compared to storage available for Brent. However, the final complication has been the decline in the USD, and falling refinery utilizations (and margins) reflecting the overall collapse of the US industrial economy. For example, US industrial utilizations remain stuck below 70%, compared to the long-term average of 80%. By comparison, lows in previous US recessions were in the range of 75%. These lows are even more pronounced in the Midwest where a substantial portion of Cushing flows were directed. US industrial demand has retreated to levels seen around 2002 or so. Today, Cushing inventories have ranged well above 30 million barrels, compared to inventories in the 2004-2005 period of 15 million to 20 million barrels.
By comparison, European industrial utilization declines lagged US declines. The lagging differential injected volatility and anomalous behavior in the spreads.
Looking ahead, the continued weakness of the USD combined with differences in supply chain dynamics between the US and Europe may create arbitrage opportunities in the WTI-Brent spreads that were heretofore episodic. Unless new dynamics emerge, the increased volatility combined with this weakness can continue to drive crude oil into storage ahead of production needs. As long as the industrial economy and the USD remains weak, storage will serve as an attractive currency hedge. But, with increased demand, there may not be as much letup in price pressures.
In my next blog, I'll talk about the effects of recent developments on traditional spreads between natural gas and crude oil markets.
Stephen Maloney
Managing Consultant, Risk and Financial Services
Towers Perrin
steve.maloney@towersperrin.com
The continued decline of the USD has been an important factor in the equity price rally that began in March. We've seen the effects of USD weakness in other commodities, notably gold and crude oil. Storage is the new international bank with excess oil supply serving as a currency hedge. Clearly, this is no way to run a reserve currency but can be a great opportunity for companies positioned to play it.
The Obama Administration is clearly deploying a weak dollar policy in an attempt to restart the US industrial economy. Deficit spending and low interest rates come at a price. The Fiscal 2009 Federal deficit is at least $1.4 billion and next year looks even worse. According to Bloomberg, the dollar lost over 10% of its value on a trade-weighted basis the past six months, the biggest drop since 1991. Worse, the dollar represents less than 40% of new reserves, down from the 63% 10-year average.
With dollars practically free, the flood of USD dollars is fueling talk about restructuring the world's reserve currencies. Long before the 2010 resets and IMF policy changes, markets are already responding by breakouts in crude oil and gold prices.
Crude oil price dynamics can create interesting inter-market effects as well which reinforce the breakout dynamics.
In the US, one of the more important price benchmarks is West Texas Intermediate (WTI). The WTI market comprises pipeline flows gathered in Midland which may be directed to the US Gulf Coast or to the storage facilities in the vicinity of Cushing, Oklahoma. Flow through Cushing continues up towards refineries and other processing facilities in the Chicago area. In 1983, NYMEX created the WTI contract with delivery in Cushing based, in part, on ready access to US refineries then concentrated in the US Gulf Coast. WTI is considered "sweet" in that it has less than 1% sulfur making the grade ideal as refinery feed for the higher resulting yields. With refineries driving US industrial production in the Midwest and the Gulf Coast, WTI prices were excellent marks for the physical product. As formulas-based trading emerged in 1986, financial markets synchronized with NYMEX and later the commodity markets of ICE and Dubai.
Similarly, Brent crude oil is located on the other side of the Atlantic Basin. Like WTI, Brent is a commingled crude with low sulfur content and ideal as refinery feed used for motor fuel and industrial products. Brent was originally drawn from both the Brent and Ninian systems in the North Sea. As the original Brent field declined, Platts introduced a new price benchmark in 2002 combining Brent with production from the Forties and Oseberg. Ekofisk was added to the mix in 2007. So, when we talk about Brent today, we're really talking about North Sea oil from several sources.
Since both WTI and Brent are sweet crude, one would expect the price spreads across the Atlantic Basin would reflect market coupling, modulated by the cost of freight. Consequently, we would expect WTI to price at a premium to Brent. This premium can erode or go negative due to pipeline interruptions, supply chain constraints, and US refinery outages. Such outages occur during the hurricane season impacting the US Gulf Coast in late-summer and early fall which present spikes when refineries or production is halted.
However, those traditional market dynamics have changed, partly due to shifts in the US physical market, amplified by the decline in US industrial production, and amplified by the collapse of the dollar.
The US physical market changed as a result of interconnection with Canadian products increasing the supply to Cushing. This supply enhancement was driven by the strong US economy of several years ago. As this supply grew ahead of the declining US economy, prices sifted to contango. This shift has been amplified by growing storage capacity in the Cushing vicinity. With storage costing some $1.25-$1.75 per barrel-month, the convenience yield was running in the range of ~50% annualized return for much of the past year.
The Brent market has seen similar dynamics, though without the pipeline and hurricane effects. Like WTI, the price curves are in contango which provides incentives for storing crude ahead of demand. While Cushing saw tank farms expand, Platts reported charters by BP and Shell of very large crude carriers starting a year ago mooring off the UK coast.
As crude prices fell, we also saw spikes in the WTI-Brent spread volatilities. These spikes can be explained, in part, by the disproportionate storage additions at Cushing compared to storage available for Brent. However, the final complication has been the decline in the USD, and falling refinery utilizations (and margins) reflecting the overall collapse of the US industrial economy. For example, US industrial utilizations remain stuck below 70%, compared to the long-term average of 80%. By comparison, lows in previous US recessions were in the range of 75%. These lows are even more pronounced in the Midwest where a substantial portion of Cushing flows were directed. US industrial demand has retreated to levels seen around 2002 or so. Today, Cushing inventories have ranged well above 30 million barrels, compared to inventories in the 2004-2005 period of 15 million to 20 million barrels.
By comparison, European industrial utilization declines lagged US declines. The lagging differential injected volatility and anomalous behavior in the spreads.
Looking ahead, the continued weakness of the USD combined with differences in supply chain dynamics between the US and Europe may create arbitrage opportunities in the WTI-Brent spreads that were heretofore episodic. Unless new dynamics emerge, the increased volatility combined with this weakness can continue to drive crude oil into storage ahead of production needs. As long as the industrial economy and the USD remains weak, storage will serve as an attractive currency hedge. But, with increased demand, there may not be as much letup in price pressures.
In my next blog, I'll talk about the effects of recent developments on traditional spreads between natural gas and crude oil markets.
Stephen Maloney
Managing Consultant, Risk and Financial Services
Towers Perrin
steve.maloney@towersperrin.com
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