Non-Related Thoughts on the Fed and Oil Prices

We had a slew of new records for the market indices this past week. In addition to each having posted their second-best weekly gains of the year, the Dow and S&P500 set new individual all-time closing highs. The Russell 2000, the index that tracks small-cap stocks, after closing above 1,000 for the first time ever in the prior week, set new closing highs in four of the past five weekly sessions. And, adding to the festivities, the NASDAQ ended at its best level since 2000! (1)

The first reports of the results for how the publicly-traded companies did in the second quarter began this week on a most positive note. Alcoa, traditionally the first to report and important in the sense that their products are used extensively by manufacturers and consumers alike, set the tone by beating expectations. Friday, JPMorgan and Wells Fargo crushed earnings expectations as well. These definitely helped move things higher.

Ben gives us a boost

On Wednesday, Mr. Bernanke offered a few remarks that led to a big market move higher on Thursday. On one hand, he stated that the Fed policy makers are “somewhat optimistic” about the economy, that housing is a positive and that household balance sheets have improved. On the other, the hand that lit off the market, he said that, “if financial conditions jeopardized the achievement of our inflation and employment objectives, then we would have to push back against that.”

What that means is that there will be a tapering of the Fed bond buying at some point. However, he made it pretty dang clear that short-term interest rates will remain low for some time after any tapering begins and the markets really liked knowing that.

The easing and the continuation of short-term rates are two different policies. I don’t think the Fed really changed much over the past couple weeks, contrary to how the market perceived it. These comments did help gold rally back and bonds ease up somewhat but the trend toward higher interest rates, based on an improving economy, still seems to be very much intact to me.

Oil prices

On Friday, the US crude price (West Texas Intermediate; WTI) had risen to $106.06 a barrel.(2) As a direct result of that, we’re likely about to see gas pump prices rise between 10 and 20 cents a gallon over the next few weeks. Headlines have recently been focusing the “largest drawdown in inventories in years.”

According to the Energy Information Administration (EIA), US crude oil production increased to the highest level of production since 1992 and that our annual production is expected to rise next year. (3) Next, the US oil price was about $91 a barrel at year-end and has stayed in the mid-90s, right up until just after the end of June. (4) And, we have about 13 million more barrels of oil in storage than we did at year-end. (5) By the way, that includes the “largest drawdown.”

So, if we have all this oil, what’s with the high price?

Well, it’s not just about US oil supply. Oil is very much a global commodity. World prices are currently set by the price of oil from the North Sea, aka, Brent crude. That price is currently higher than WTI by about $2 per barrel. WTI will tend to follow its direction. Lately, even though it produces no oil at all, the recent confusion in Egypt has added to the Brent price. That’s because Egypt controls the Suez Canal – the place through Brent and Mideast oil passes through the global markets. Uncertainty has added to the price.

Closer to home, most of the oil we import comes from either Mexico or the oil sands in Canada. This spring, the torrential rains in Canada shut down production for a period of time, slowing supply from there and adding to price pressures.

Of course, summer is the peak driving season in the US, so there’s that additional incremental demand – but that’s not going to drive the prices by itself. However, a lot of the recent drawdown that has helped jump prices could be attributed to oil wholesalers wanting to assure product for this increased demand before prices got higher.

Then there’s speculation. Over the past four years, traders have bid up prices, using headlines, uncertainty and perceptions to raise prices and then – before a whole lot longer – as issues are resolved, they sell their contracts, helping move prices lower.

Infrastructure issues

Other than global political issues, I believe one of the biggest drivers for our prices is the inability of our domestic oil transfer network to efficiently deal with the shale and sands production which no one had anticipated.

Ever scenic Cushing, Oklahoma, has been the hub for traditional US oil production for about as long as that production has been centered in Oklahoma and Texas. Pipelines and rail systems work very well in bringing the oil from those fields to Cushing. However, there’s a noticeable lack of the same support into the Dakotas, Wyoming and Alberta. While rail has been doing an admirable job with its available system – and the main reason for the continued build in storage – it’s more expensive than a pipeline network.

The main challenge now is creating adequate transport for the crude down to where the majority of US refiners are located on the Gulf Coast, especially with the forecasted increase in flows. Some help is coming soon. According to a report from Macquarie Group, the estimate is that there are pipelines capable of handling almost seven million barrels per day of capacity targeted to the Gulf Coast scheduled to be completed in stages from this year through 2015. As well as providing product for domestic use, the refined material will also be available to be sold into the global markets at the higher Brent-related prices.

The bottom line, according to Gulf Oil CEO Joe Petrowski, because record amounts of oil and natural gas are being produced in the US and Canada, and because of OPEC supplies being higher, oil prices should be about half of today’s $105 a barrel by the end of the year.

He cautioned that “$50 [a barrel] oil does not translate into $2 gasoline,” because it still has to be refined and transported.

Making his case for a steep crude drop, Mr. Petrowski said, “Traveling is picking up, but we’re using much less oil. In fact, we’re using no oil in the energy sector. [And] natural gas is taking a lot of the heating sector away.”

Investments

I believe you can find opportunities in a couple areas. There are a number of Master Limited Partnerships (MLPs) with exposure to oil and gas pipelines, transportation and processing, refining the storage sectors of the energy business. A review of the quality companies in that area can provide you some names that provide a good cash flow plus the potential for appreciation.

There are also those US refiners who have a cost advantage by having access to the relatively lower cost WTI crude. They then can process it into products such as gasoline to be sold into the global market.

I hope you’re enjoying a great summer!

Cheers!

Mike

509-747-3323

1.   CNBC, 12 July 2013

2.   Ibid.

3.   EIA press release, 9 July 2013

4.   CNBC

5.   EIA Petroleum Monthly 1 Jan 2013

To get an overview of economic conditions, use this link. It’s updated monthly.

http://www.russell.com/Helping-Advisors/Markets/EconomicIndicatorsDashboard.aspx

Past performance is not indicative of future returns. Investing in securities of any type involves certain risks, including potential loss of principal. Investment return and principal value in a bond and/or securities portfolio will fluctuate so that investments, when sold or redeemed, may be worth more, or less, than the original investment.

Investing in sectors may involve a greater degree of risk than investments with broader diversification. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

Michael J. Maehl, CWM®

Senior Vice President

Opus 111 Group LLC

400 S. Jefferson, Suite 400

Spokane. WA  99204-3142

509-747-3323  office

509-944-1790  cell