Demand Recovery Reaches Maximum Velocity
Author: Brynne Kelly 6/13/2021
Crude oil approached multi-year highs last week as the velocity of the demand recovery narrative nullified negative short-term data points. Last week, the U.S Energy Information Administration (EIA), the International Energy Agency (IEA) and the Organization of the Oil Exporting Countries (OPEC) released their monthly oil market reports. On Tuesday, the EIA forecast fuel consumption growth this year in the United States, the world's biggest oil user, would be 1.49 million barrels per day (bpd), up from a previous forecast of 1.39 million bpd. The IEA monthly report (released on 6/10) maintained it's forecast that oil demand will surpass pre-Covid levels by the end of 2022. However, some expect the pace of the demand increases to moderate after July, expecting 2/3 of the increase in oil demand from May 2021 to July 2022 to occur in this month and next month alone.
There is nothing more that oil markets love than a bullish forecast in end-user demand. The monthly oil reports that were released last week did nothing to dampen demand growth forecasts. Yet, market participants grapple with comparisons of 'outright' price level
appreciation from last year's lows. Last year is NOT the baseline, it's an anomaly. In fact, it's almost comical how one can simply erase last year's price action and replace it as if nothing happened (blue box below, shifted back in time, pre-pandemic). It's as if we have hit the reset button and the price action of 2020 is nothing more than an anomaly and we are simply going to pick up where we left off before the pandemic ever happened.
Yet, historically, we are approaching price levels that are dicey. This is visible not only in outright price charts but also in the all-important calendar spread market. When market action is bullish, it's reasonable to expect that it's front-led. The spot market supports the price action. This has not been the case until recently as front-month futures have been relatively weak into expiration. Until recently, that is (monthly calendar spread expiration below).
As of last Friday's close, the market has decided that the peak in the supply vs demand narrative will reach it's peak September (Sep/Oct calendar spread, gold line above). The mere fact that the peak in one-month calendar spreads continues to be deferred to the future suggests that the upside move may not yet be finished. Future expectations of the pain point between supply and demand continues to be 'kicked on down the road". As long as this is the case, the market can continue to rally. At some point, however, this narrative will need to be realized. For now, the market isn't too concerned with relative weakness in front-month spread expirations. The mere fact that the June/July spread was able to endure the monthly fund roll and hold on to backwardation was viewed as quite a bullish signal in the market (green line above). We believe it's incumbent on the future realization of front month calendar spreads to support further upside momentum in outright oil prices, as it took a positive expiration of the front month spread to catapult outright prices to new highs.
One month spreads are very granular and may not provide enough context to the sustainability of this rally. There have been many times over history where a short-term event has pushed front month prices higher/lower without a follow-on response in the rest of the curve. This usually means that the conditions that exist today are expected to be resolved in the future. For context on this, we compare 6-month calendar spread futures across time in WTI.
What's most notable about the chart above is that the deferred 6-month spread (red line above) has been the leader overall as the 'swing vote'. It is the harbinger of future sentiment. In 2021, the deferred 6-month spread has been the leader showing much more strength than the front 6-month spread, crossing the zero-line into backwardation first (red line vs purple line below).
That brings us to outright calendar strip prices. As of last Friday's close, the calendar 2022 strip was well above $60 while calendar 2023 staged it's first settlement above $60 (settling at $60.08). Will this be a trigger for producer hedging? If so, this could provide the catalyst for the next move higher in spreads: producers using front month strength to sell the back of the curve. To date, we have not seen hedging activity materially impact longer-dated futures.
Furthering the theme of the 6-12 month calendar spread leading the market, we isolate continuous front month futures with the deferred 6 month spread since 2010 (black line vs read line below).
On a macro level basis, both are attempting to violate 2018 highs. But, using only the last 12-months as a guide, the deferred 6-month calendar spread is beginning to hit some resistance. This reflects the expected 'peaking' of the demand recovery velocity and should be considered as influential in the velocity of the overall price momentum.
Is this a signal that future prices are reaching a level that finally motivates hedgers to sell and that selling will further widen-out calendar spreads? We think that will be up to the strength, or lack thereof, in the back of the curve. One thing to consider is that the front 6-month spread has only been stronger than the deferred 6-month spread a handful of times since 2012 (purple line vs red line below).
Underneath the demand recovery story is the rising cost of product blending mandates in the US. Last week, President Biden’s administration, under pressure from labor unions and U.S. senators including from his home state of Delaware, announced it is considering ways to provide relief to U.S. oil refiners from biofuel blending mandates, three sources familiar with the matter said.
Current law requires refined products to blend billions of gallons of ethanol and other biofuels into their fuel each year or buy credits from those that do. The credits, known as RINs, are currently at their highest price in the program’s 13-year history, and refiners have said the policy threatens to bankrupt fuel makers already slammed by sinking demand during the pandemic. Biofuel advocates counter that fuel makers should have invested in biofuel blending facilities years ago and can pass through added costs for buying credits to consumers at the pumps. Biden's administration has discussed options like a nationwide general waiver exempting the refining industry from some obligations, lowering the amount of renewable fuel refiners must blend in the future, creating a price cap on compliance credits, and/or issuing an emergency declaration, sources said. However, the possibility of the waiver is contrary to the platform the Democrats have run on, so the decision on the waiver appears to be a no-win for the administration.
For context, we look at the price history of US RB gasoline futures vs gasoline blending components. Clearly ethanol prices are at levels not previously seen. As a result, other gasoline blending components like natural gasoline (light naphtha) and normal butane prices are rallying. This suggests that the demand for gasoline is becoming real and that refiners are buying as much of the cheaper blending components as allowed into the summer RVP gasoline spec.
Light naphtha from NGL fractionation is often called natural gasoline or pentanes plus. In a refinery, light naphtha is often blended directly into gasoline. However, its low octane and relatively high vapor pressure typically limit it to 5% or less of the gasoline pool.
So far, we are noting the supportive nature of the back of the oil curve as well as the rally in front-month gasoline blending components. How does this translate to other areas of the market and are they supportive? For this we turn to Brent crude oil crack spreads as they reflect the marginal refining margin on the US east coast (which relies on imports to fill the gap left by the lack of refining capacity on the US east coast.
Clearly, US refining margins are outperforming those in Europe (teal line vs black line above). East coast refining margins are at multi-year highs while European margins lag. This has led to a short-term narrowing of the WTI/Brent spread (below).
Calendar spreads are approaching 2014 levels
US refining margins are outperforming those in Europe
WTI/Brent spreads are rallying
A break in any one of these relationships could be detrimental to outright prices. Until then "all systems are a go".
Of Note Over the Weekend
Iraq's Oil Minister Ismail: If OPEC sticks to its set production targets, oil prices could range between $68 and $75 per barrel in the second half of this year.
Group of Seven (G7) nations backed away from plans to set a target for making sure most new cars sold are greener vehicles, instead pledging only speed up efforts to move away from combustion engines. In the final communique Sunday, the bloc include an autos section that was far more modest than earlier versions being discussed.
NHC is monitoring 2 systems- the first is in the SW Gulf of Mexico, and it could become a tropical depression late week as it lingers there. The second is offshore of the Carolinas, and some development is possible as it moves away from land.
EIA Inventory Statistics Recap
The EIA reported a total petroleum inventory BUILD of 4.80 million barrels for the week ending May 28, 2021 (vs a draw of 0.50 million barrels last week).
Year-to-date cumulative changes in inventory for 2021 are DOWN by 44.30 million barrels (vs down 49.10 million last week).
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.