Enough has been discussed about the spread between the price of London Brent crude oil versus WTI crude in Cushing Oklahoma. The important take away from the relationship is that U.S. crude is cheap with an oversupply glut in Cushing, Oklahoma. This is blowing out the crack spreads. That is, the profit margin that an oil refinery can get by “cracking” the hydrocarbon chain of crude into petroleum products.
Source: Bloomberg
The spread between the price of finished refining products and crude oil typically peaks around May, like clockwork.
Seasonal Chart for the Crack 321 Spread for the past eight years:
Source: Bloomberg
When I talked about the refiners on January 11th, I said their charts look like a “Picasso”, i.e. works of technical art. Besides the pure refiners like Valero, this kind of downstream revenue benefits the larger integrated companies like:
Downstream Revenues (Percent of Revenues from refining & marketing)
- VLO – 98%
- CVX – 84.4%
- XOM – 81.3%
- COP – 78.9%
- MRO – 83.6%
The last item I find interesting concerning the crack spread is in today’s retail sales numbers. The percent increase found in the gasoline sales component has been in a steady rising state since last summer. Even now, during the off-season, sales have been strong.
Source: www.Econoday.com
The other topic I wanted to highlight is interest rates. Since the discussion of Quantitative Easing 2.0 (the Federal Reserve Bank’s program to buy U.S. treasuries) which began in August 2010, Treasury Bond prices have been falling causing Treasury Bond yields to rise. That sounds counter intuitive, but when you understand how large and how many players are involved in Treasuries, it’s a very big pond with many other big fish and many other large collective schools of smaller fish. The market is clearly fighting the Fed here, and winning. Interest rates are rising because investors are worried about inflation and they’re selling their bonds, it’s that simple.
Pimco Cuts U.S. Holdings – WSJ, January 15th, 2011
The other side of the coin is the international community’s concern over the size of our debt. If they start getting concerned over default risk, well, then they sell bonds and demand a higher rate of return. Kind of like what has happened to Greece, Ireland, Spain, Italy, and Portugal.
U.S., Japan told time running out to deal with debt – Reuters, January 28th, 2011
Currently, we have a steep yield curve. The definition is as follows:
“A sharply upward sloping, or steep yield curve, has often preceded an economic upturn. The assumption behind a steep yield curve is interest rates will begin to rise significantly in the future. Investors demand more yield as maturity extends if they expect rapid economic growth because of the associated risks of higher inflation and higher interest rates, which can both hurt bond returns. When inflation is rising, the Federal Reserve will often raise interest rates to fight inflation.” - Pimco’s Yield Curve Basics
Source: www.stockcharts.com
As a consequence, notice the correction in long duration Treasuries corresponding to the rise in the yield curve. Look to see if whether it'll hold in this area or break long-term support and correct even futher.
Source: www.stockcharts.com
Not suprisingly, the Flow of Funds data from ICI shows money is still leaving the bond market in droves.
In tax-free bonds…
Source: https://www.ici.org/research/stats/flows/flows_02_09_11
And in taxable bonds…
With Bill Gross selling Treasuries, the Chinese holding less, and income investors leaving tax-free municipals, it’s likely we’re looking at the beginning of a major secular shift in interest rates. Emerging markets are raising interest rates to combat food inflation. If the Chinese are going to be able to afford higher food inflation, they’re going to have to earn higher wages. Higher wages mean high costs to create goods. That means higher import prices into the U.S.. That means inflation is headed our way and rates will likely continue to rise.
Technically, I’m waiting to see if the 2010 lows are violated. It’s a likely area of support so it may take some time; however, the writing’s on the wall. Bill Gross sees it. China sees it. Standard & Poors sees it. Our burgeoning debt bubble isn’t making matters any easier for the bond investor in the U.S.. Reading Timothy Geithner’s testimony to the House Ways and Means panel today, you can understand why.
