Monday, April 27, 2009

Misplaced hope is Steel and Energy yields opportunity on the short side

Energy demand continues to deteriorate beyond bearish expectations, yet the ranks of the bulls have swelled as many look past near term supply demand imbalances on the idea that significant and rapid declines in rig counts will lead to equilibrium in supply and demand such that inventories will decline to levels closer to 5 year averages. I don't doubt that will ultimately happen but I do strongly doubt that it happpens as fast as most think. Furthermore, I'm confident that any recovery will be gradual and less vigorous than most suspect as I think a new normal, inconsistent with inventory levels during the recent period of strong global growth. We'll need a rapid and substantial economic recovery for crude and distillate prices to make meaningfully higher price moves and we'll need growth and hurricane related supply disruption for natural gas to find its new equilibrium anytime soon.

I continue to think that natural gas production, supply and inventories are not likely to fall as much as declines in rig counts suggest. I expect natural gas prices to remain soft until late this year and think that rallies can be significant but are likely to be short lived as fundamental support fails to manifest. Industrial demand continues to surprise on the downside. Demand from manufacturing, steel and chemical industries continue to weaken. We remain in the grips of a global inventory de-stocking dynamic which appears to have reversed in Asia as what I believe is opportunistic purchasing of raw materials like scrap steel, copper, lead and zinc by the Chinese. I think that raw material stocking is apt to subside going forward as it is unsupported by sufficient end market demand. Demand though likely stronger and more responsive to Chinese stimulus given the more rapid and proportional measures is likely in my opinion only to soften the blow of the current global recession rather than leading to a resumption of rapid growth.

Similarly, consumer demand for gasoline continues to soften, so refinery utilization is low and unlikely to rebound meaningfully as distillate inventories are also on the high side. And continued ramping of low cost middle eastern natural gas and LNG production is likely to keep natural gas prices under pressure globally. In this context, hope related to an economic recovery driven by infrastructure development supported by U.S., Chinese and Eurozone stimulus should fade. Thus I think the time is right to press the short side in steel and energhy once again as it appears a reality check is imminent. In this context, NUE, DVN, XTO appear particularly vulnerable to me.

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