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Double Shock

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The crude market suffered a double shock on Thursday. The first shock was the unprecedented drop in crude inventory levels of -8.9 million barrels for the week ended May 23rd. Expectations ranged from no change to a build of 500,000 barrels. Gasoline inventories fell by -3.2 million barrels and also a sharp divergence from the expectations.

This was the largest weekly decline in crude since the week ended Sept 17th 2004. The decline was again due to a sharp drop in crude imports. Over the prior two weeks imports fell by 700,000 bpd in each week. They dropped another 400,000 bpd last week. Imports fell to average 8.8 mbpd and -1.8 million barrels per day below the normal range seen just four weeks ago. Imports are at the lowest level since Katrina. Crude inventory levels are 9.7% below last year's levels at this time. The drop in imports came as refinery utilization increased as the crude call by refiners rose to offset the increase in driving for the summer. This massive 3-week drop in imports, a multi-year drop in inventory levels and levels 9.7% below 2007 should have been extremely bullish for prices.

That brings us to the second shock for the day. The price of crude oil fell -$4.41 to close at $126.69 and that drop continued in overnight trading to $125.85. The size of the inventory decline was so startling that traders immediately assumed it was a reporting error. These things happen and are normally corrected the following week.

The Energy Information Agency (EIA) said it was a delay in unloading oil tankers along the Gulf Coast that led to the shortage. I have reported this many times. There are dozens of reasons that tanker traffic can become backed up either in leaving foreign ports or unloading in U.S. ports or both. The EIA said fog had delayed tanker traffic several times over recent weeks, sometimes lasting for days. Mexico is another factor as expected import volumes from Mexico have been shrinking.

It is easy to say that traders just ignore the inventory report as wrong due to timing and that is why the market sold off. I find that explanation very hard to believe. Another issue may have been the cause. The Commodity Futures Trading Commission (CFTC) announced on Thursday that it is six months into a wide-ranging investigation of U.S. oil markets with a focus on possible price manipulation. They also announced a handful of initiatives designed to increase transparency of the energy futures markets. Disclosure of the investigation and the potential for rule changes was a more likely reason for the sell off.

If the CFTC suddenly demanded accountability for the hundreds of billions in SWAPS representing 35-50% of the open interest in crude futures it could be very damaging to oil prices. Currently anyone can get long huge quantities of oil without being identified by entering into a swap arrangement with a major financial entity like Goldman Sachs. The swaps are see as a commercial position and escapes the accountability rules for ownership or position limits. If this rule was suddenly changed there would be a massive sell off in crude futures in order for these firms to reduce positions within the legal limits. Several analysts and politicians have called on the CFTC and lawmakers to change this rule. I believe the announcement by the CFTC of the investigation and possible rule changes was the major factor in the crude sell off.

The drop in crude did not help gasoline prices, which hit a new national record of $3.95 per gallon. Prices in California are moving well over $4 with diesel now over $5 per gallon. A sharp drop in demand of 112,000 barrels per day was reported by the EIA compared to the same week in 2007.   

Jim Brown

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