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Crude Oil: Spreads Gone Wild

Author: Brynne Kelly 6/20/2021


While not significant, we had our first glimpse at storm activity in the US Gulf Coast this past week, which caused several producers to withdraw staff and implement storm precautions at their offshore facilities. It was a reminder of things to come. Aside from that, there were some continuing bullish themes as Goldman Sachs reiterated their bullish outlook and suggested that global oil demand likely hit 97 million barrels per day in recent days. The Iran narrative continues to be in play as there seems to be no immediate resolution in sight.


Negotiators for Iran and six world powers on Sunday adjourned talks on reviving their 2015 nuclear deal and returned to their respective capitals for consultations as remaining differences still need to be overcome, officials said.


The lack of a deal between the US and Iran could make things complicated for OPEC+ in their upcoming July 1 meeting, where a decision will be made on it's oil output for August (and perhaps indications for the rest of the year).


Just last week we were talking about the velocity of the demand recovery narrative outweighing negative short-term data points. Then the FOMC minutes were released (on June 16) and the market sold off as investors were forced to weigh signs of a tightening global market against the Federal Reserve’s shift in monetary policy.


Despite all this noise, the real hero lately has been calendar spreads (aka, backwardation).

Simply put, calendar spreads are going wild, tempting upside resistance like a champ.


Just when it seemed like the inflation bubble might be deflated and outright prices seemed ready to let some wind out of their sails, calendar spreads stepped in and carried the day, refusing to come off giving the outright market no choice but to hold support by the end of the week and rally. Over the last 10 days, there has been nothing but a bid in front month spreads (purple line vs yellow line below).

Yet, historically when calendar spreads and outright prices are both bumping up against resistance, the entire complex becomes a flat price trade. Typically a calendar spread will move as much or more (on a percentage basis) than flat price.


What does one do when everything is at resistance? Dig a little deeper and further back in time to look for patterns of how the market reacts. To do that, we start with the ever-popular year-on-year spreads (or 12-month calendar spread as it is commonly referred to).

As evidenced by the chart above (rolling yr/yr calendar spreads = pink; rolling front month futures = black) there has been significant resistance by the market once the 12-month spread moves above the $5 level. In 'recent' history this is the 3rd time that said yr/yr calendar spread has tried to break above the $5.00 level since 2018. In each case, not only have spreads proceeded to retreat once they hit this level, but so have outright prices.


Well, we appear to have reached another crossroads above $5.00 in spreads. The market can have as much bullish sentiment as it wants, but once curve relationships hit a breaking point it sends a signal to the rest of the market. We are at one of those 'signal points'. We either fail here, as we have before, or we are about to catapult into a new range - similar to those seen in 2013-2015.


How do we assess this? Determine whether or not we are at a break out to new levels? To answer that, we look at previous recovery cycles.


The 2000's have been marked by shorter cycles in general. Technology has created a more robust feedback loop, and as a result, shorter price cycles. We are definitely in an era of faster declines and recoveries in prices. OPEC has proven they are quicker on the draw when it comes to production cuts. Forget all of the jaw-boning about OPEC meetings and their role, or lack thereof, in the overall market. OPEC+ has gotten their shit together and are acting like a Federal Reserve Bank put.

Below $50, OPEC acts and the market has responded in kind by moving from a bearish contango structure to a bullish 'tight supply' structure. Over and over again. When the market is oversupplied, below $50 and moves into contango, OPEC+ takes action (aka, cuts production). The above charts highlight shorter cycles of price response related to OPEC action (circle #1 vs #2 above). To refresh your memory, In November 2016, after prices had been in free-fall from $100+ to below $50, the 11 OPEC members at the time announced production cuts of about 1.2 million bpd. This continued through December, 2018 at which point the cuts were reduced to 0.8 million bpd.


Interestingly, the minute OPEC+ hinted at reducing output cuts in 2018, the market retreated. It seems clear that oil markets cannot operate without policy intervention. Said policy intervention creates boom/bust cycles. As a result, oil markets are vulnerable.


Shale producers are adding extra rigs more slowly than in previous recoveries and the total number of active rigs (365) is less than half the number (844-869) the last time WTI prices were at similar levels in 2018.


Intense pressure on the industry as a result of last year’s pandemic and associated price slump received widespread sympathy from consumers and an understanding that prices had fallen unsustainably low and needed to rise.


So, have spreads gone wild? It appears so. Simple 1-month calendar spreads are on fire. Anyone that was short front-month calendar spreads has gotten burned. While it seems absurd to pay almost $0.90 premium for delivery in September vs October, this is indeed happening. All hopes are now pinned on demand in September of this year relative to the rest of the year.

In fact, calendar spreads now reflect the short-term narrative that OPEC+ can't increase production under their current narrative as fast as demand is recovering.

BUT, it is exactly this front-month bullish narrative that is keeping oil prices afloat. What happens once there is no longer perceived strength in the front spreads? After all, it is the front of the market that pulls the back of the market out of despair. The move in front-month futures (gold line below) has now pulled the 2-year price strip above $60.


When will we see hedging activity in these outer year strips? It happened when the term strips first moved above $50. It is happening at a slow pace now that term prices have moved above the $60 mark. THIS IS KEY. The lack of selling pressure on the back of the curve has left the entire market in flux.

If term prices above $60 fails to attract producer hedging, the future of production is really at risk because hedged production gets produced.


We have heard a lot about inventory levels and the associated weekly concern about inventory changes. Yet, in total, there is nothing particularly special about inventory levels this year (in total, CL+RB+HO), other than they are following seasonal patterns while not at critical high or low levels.

While it's true that the tone of crude oil markets can lead the entire complex higher, this analysis wouldn't be complete without an examination of crack spreads which ultimately recognize true demand and govern price action.


For this comparison we again turn to the 12-month continuous futures strips compared to historical ranges. What is notable is that over the last decade, heating oil cracks have shown the stronger correlations to overall moves in WTI crude oi prices. In fact the correlation of heating oil crack spreads to WTI over the last decade runs around 74% while the correlation of gasoline crack spreads to WTI price moves is only around 61%.

Oil prices vs crack spreads are not overtly pressing historical ranges. There is not much to see here. Ranges are not being pressed. Revert to calendar spreads as a guide in the upcoming weeks.



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EIA Inventory Statistics Recap


Weekly Changes

The EIA reported a total petroleum inventory DRAW of 7.20 million barrels for the week ending June 11, 2021 (vs a build of 4.80 million barrels last week).



YTD Changes

Year-to-date cumulative changes in inventory for 2021 are DOWN by 51.50 million barrels (vs down 44.30 million last week).



Inventory Levels

Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years are no longer at excess levels and should continue to draw as long as backwardation in the market persists.





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