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Calendar Spreads: The Proxy For Bull/Bear Sentiment That Rarely Realizes

Author: Brynne Kelly 10/17/2021


US oil prices hit a fresh seven-year high on Friday amid a surge in global demand and an ongoing supply crunch. WTI is now at the highest level since the Organization of the Petroleum Exporting Countries launched a price war against US shale producers. In November 2014, OPEC surprised oil markets by refusing to curb its production amid soaring shale output. Crude prices then went into freefall as the oil group sought to force higher-cost US producers out of the market.

An underlying recovery in consumption -- driven by road-fuel, freight activity, and latterly air travel -- is now being exacerbated by the so-called energy crisis. With natural gas trading at close to $200 in per-barrel terms in Europe, the consensus among analysts is that oil demand globally will be boosted by a further half a percentage point as companies rush to secure any fuel that can be used as a substitute, from diesel to fuel oil to crude


On the supply side, US crude oil supply (measured as production plus net imports) remains at the low end of its 5-year range.

Countries and governments continue to pay lip service to price rallies as they weather the storm. Over the weekend, Japanese Prime Minister Fumio Kishida said that the country will urge oil producers to increase output and take steps to cushion the blow to industries hit by the recent spike in energy costs. "We are closely watching movements in the crude oil market as well as the impact on domestic industry and households," Kishida told reporters after calling an emergency meeting of Cabinet members, including Chief Cabinet Secretary Hirokazu Matsuno and industry minister Koichi Hagiuda to discuss the matter. Kishida said he instructed the ministers to work with the International Energy Agency to call on oil-producing countries to increase output and to "swiftly take appropriate action" to help industries that may be negatively affected. "We will take concrete steps in our respective roles," Matsuno told a press conference, without going into further detail.


Yet, Japan’s goal of reducing carbon emissions by 46% by 2030 is based on the assumption it will restart 30 of its nuclear reactors, a top ruling party executive said. Akira Amari, secretary general of the Liberal Democratic Party, made the remarks Sunday in a televised debate broadcast by NHK ahead of the Oct. 31 general election. Much of Japan’s nuclear capacity has been offline since the 2011 Fukushima disaster and Amari said only nine reactors are currently in service.


The market continues to rally, but it's doing so against a backdrop of seemingly imminent risk that either supply shortages can magically be eased via increased output or some regulatory change or that demand destruction materializes due to high prices.


We saw one example of a regulatory change last week when Beijing cut the crude oil import quotas for independent refiners for the rest of the year in the latest move to curb their growing oil market clout, Reuters has reported, citing industry sources. According to the report, the latest crude import quotas for independents is 14.89 million tons. This brings the total for the year to 177.14 million tons, which compares with 184.55 million tons for 2020. Basically, China is less willing to import oil at higher prices.


Imports aside, Beijing is still having trouble securing enough energy supplies for the winter amid soaring gas and coal prices. Orders for boosting domestic coal production have been issued, and China is also ramping up its gas supplies. It is also changing its list of priorities, with decarbonization getting trumped by energy security.


The trifecta that could derail an oil price rally is if OPEC+ unexpectedly boosts its output, warm weather hits the northern hemisphere, and the Biden administration taps the strategic petroleum reserves.


For some perspective, here is a look at benchmark energy futures as of last Friday's close (WTI = green line, Brent = orange line, Henry Hub NG = black line):


The eye-popping levels at which European natural gas and Asian LNG prices have traded are being used as an indicator that the energy complex overall is in short supply for the upcoming winter season. The severe backwardation in NG and LNG futures curves highlights this (fuchsia and blue lines above) and doesn't subside until May-22, when prices finally fall below US ULSD futures (cyan line above). It's this huge disconnect between winter and summer natural gas and LNG futures prices that has the world on edge. How far down in the stack of cheaper alternatives (heating oil, gasoil, crude oil) does the world really have the capacity to dig? We've heard the estimates of global fuel switching capabilities. What the markets are now trying to digest is whether or not this is already priced in or whether oil markets have more room to the upside since fears of supply shortages tend to lead to hoarding behavior. Backwardation often reflects such hoarding behavior in that participants would rather hold on to a barrel that is declining in value versus risk selling now and being unable to replace it in the future. Stocking up on supplies is often the most sough-after tactic to reduce fears ahead of a crisis.


That bring us to the behavior we are witnessing in calendar spreads across the complex which are soaring to new heights, being used as a proxy for bull/bear sentiment regardless of outright price levels. First we look at one-month calendar spreads in WTI below.

We have seen this pattern all year. The market turns bullish, calendar spreads rally to new highs and then collapse as expiration approaches. The worry here is that calendar spread rallies rarely realize into expiration. Earlier this year, as the pandemic recovery began to take hold, one-month WTI calendar spreads soared above the $1.00 level before being weighted down into expiration. Now that winter spreads are on-deck we need to see some stronger realization of backwardation going forward in order to support the bull thesis of 'winter supply shortages'.


Next, we look at 12-month calendar spreads in WTI to see the historical 'walk' the spreads have taken in the past.

The Dec-21/Dec-22 spread settled just shy of the $9.00 level last Friday (lime green line above). The last time this spread saw levels like that was in 2013 (green line above). In most cases, the 12-month spread tends to collapse into expiration similar to one-month spreads. That being said, 2013 gives us a reminder of how wide spreads can go since the Dec-13/Dec-14 spread topped out at almost $14 before pulling back.


Calendar spreads trading at such levels make them almost as dangerous as trading flat price. The percentage moves in spreads in response to flat price moves are much higher which should lead to lower position sizing. Which in turn adds to the volatility. In the past, spreads at these levels have proven to be temporary rather than ushering in a new norm.


Relentless buying of the front of the market relative to the back typically occurs when consumers are attempting to hold on to spot barrels for fear they will be scarce in the future. A barrel in inventory is considered more valuable than a barrel yet to be produced.


Crude oil isn't the only market where spreads are being used as a proxy for bull/bear sentiment. We see the same thing in natural gas markets. Specifically in the March/April spread, which is a seasonal spread between winter and summer. This is only the second time in the last 8 years that this spread have moved above $1.50. This year the spread is being helped along by the structure of futures curves in the LNG markets (shown earlier).

The 'fear of running out of gas' by the end of the winter (March) is once again reaching new levels this year and is being expressed via the March/April spread (gold line above). But, just like with oil spreads, historically they collapse as expiration approaches. March typically ushers in the end of winter across much of the US and therefore all the inventory that was held on to finally needs to be cleared out ahead of summer injection season which starts in April. The dynamic of selling out of winter gas in March and the subsequent buying of gas to inject into storage in April has historically driven this spread towards flat at expiration.


For perspective, we compare the one-month calendar spreads (heat content adjusted) of US NG, UK NG, US WTI, US ULSD and LNG. Backwardation is most severely pronounced in LNG markets from February-22 through May-22, with the widest spread landing in the March-22/April-22 calendar spreads in Asian LNG and UK Natural Gas futures at close to $12/Mmbtu as of last Friday's close.


All across the complex it appears that inflation is being turbo-frontload, hence backwardation. One of the few places we do not see this front-loading is in US heating oil cracks. The chart on the left below shows the shape of the futures curve for HO/WTI crack spreads and the chart on the right shows the shape of the WTI futures curve.


With distillate being suggested as a potential candidate for fuel switching, it's interesting that the crack spread for this winter isn't being 'front-loaded' over the back of the curve. This is one to watch as there appears to be room for these to move higher in the front of the curve.


One final observation about seasonality. We are currently at a seasonal low for refiner utilization. From now until the end of the year, typically the amount of crude oil input to refiners in the US steadily increases. We expect to see the same this year.


There doesn't appear to be any slow-down in the aforementioned front loading because: 1) wage growth is about to spiral up, 2) China needs to buy more natural gas to deliver on air pollution promises ahead of the Winter Olympics in Feb-22 and 3) Energy-inventories look scarily low across the board (maybe except for the US). But, as shown above, spreads are at their widest levels in recent history. Be careful outstaying your welcome prior to expiration!



Of Note Over the Weekend:

  • The Chinese National Development and Reform Commission (NDRC) issued a notice allowing the market trading price of coal-fired power in sales contracts signed between GENCO's and users or distributors to be raised or lowered by up to 20% of the benchmark on-grid tariff, from the current 10% and 15%, respectively, effective 15 October 2021. The 20% limit for raising prices will not be applied to energy-intensive users, which are likely to pay a higher price when power is in short supply. There are also no limits on the spot power price.

  • The Iranian naval forces prevented pirates from attacking one of the country’s oil tankers in the Gulf of Aden. Iranian Navy Rear Admiral Shahram Irani said in an interview that the pirates, aboard five speedboats, attacked the Iranian oil vessel early Saturday to hijack it but they were forced to escape following a heavy exchange of fire with the Navy's 78th flotilla of warships.

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EIA Inventory Statistics Recap


Weekly Changes

The EIA reported a total petroleum inventory BUILD of 3.20 for the week ending October 8, 2021 (vs a net BUILD of 4.40 last week).



YTD Changes

Year-to-date cumulative changes in inventory for 2021 are DOWN by 126.70 million barrels (vs down 129.90 million last week).



Inventory Levels

Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years are have gone from way above historical levels to surprisingly below historical levels and should continue to draw as long as backwardation in the market persists.





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