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Price Level Intimidation in the Oil Complex

Author: Brynne Kelly 5/31/2021


Memorial Day weekend in the US marks the unofficial start to summer and was especially anticipated this year because it coincided with the relaxation of mask mandates across the country. Forward momentum has been building in the oil complex and a holiday weekend that is historically known to kick off summer driving demand was the perfect venue to foster demand optimism. The shift in the WTI futures curve over the last 30 days is a perfect example of this, continually pushing higher in anticipation of summer demand for refined products and ultimately, crude oil.

Given where we were just 12 months ago, oil prices in the $60's are intimidating. Despite the dramatic changes the industry has made to limit production and stabilize the market, the underlying tenor is one of cautious optimism. Muscle memory is kicking in and traders are falling victim to 'price-level fears', the fear that another abrupt loss of demand is right around the corner and the market will crash. In reality, there are very few times in history where there has been such dramatic drops in price. The most recent 3 being: (1) Shale production growth ahead of the US export ban being lifted, (2) the 2018 year-end market selloff, and (3) the covid-19 pandemic.

The common thread underlying the 3 events above is US production growth. The events of 2020 led to the most dramatic drop in US crude oil production in history. At the same time, never has future production growth been more uncertain given the damage done to the markets last year. Not only does the production forecast (per the most recent EIA Short-Term Energy Outlook) struggle to retake end-2019 levels, but also the slope of production growth is much flatter than that seen pre-2020.

The replacement value of future inventory sold in today's market is being called into question as calendar spreads are stalling while outright prices continue to move higher. This is a sign that the supply tightness is no longer viewed as a temporary issue rather, something more pervasive.


Current Price Levels vs History & Seasonality

The events of last year, and the price rally that ensued from a dip into negative territory, are weighing on people's psyche. A $60-handle on oil prices was unfathomable last year and even early this year. But, if you frame 2021 WTI prices using continuous front-month futures (green line below) in relation to 5 and 10 year prices averages (black and red lines below), we are currently trading smack dab in the middle of the two.

In addition, price action has followed that of historical averages - reflecting a seasonal move higher in prices during the first half of the year. From here, the general seasonal pattern has been a sideways to lower pattern during the second half of the year. This seasonality is also giving pause to fresh buying at yearly highs. Don't let price levels diminish the curve-ball thrown at production growth. Expecting producers to 'show up' in the manner they have in the past is unreasonable regardless of current price levels given the level of backwardation in the market.


The 12-month deferred contract in WTI when compared to it's respective 5- and 10-year averages reveals this dynamic. The 'back' of the curve is sticking more closely to it's 5-year average (green line vs black line below). In this way, the market still has a 2020 hangover, unwilling to translate future production issues into deferred prices in the same manner that the front of the curve has been able to.

The same historical comparison in RB gasoline and HO distillate prices reveal a similar pattern to that of WTI. Both have displayed seasonal moves higher so far this year and are sandwiched equally between their 5- and 10-year averages.

With global markets having cleared the inventory overhang and with the production trajectory looking grim, is there any reason to expect prices in today's constrained output environment to trend towards their 5-year average? If anything, the 10-year averages highlight the upside potential for prices.


Spreads vs History

The spread between the front and the back of the WTI curve is where we really uncover the the market's quandary. On average, there have been only a handful of times over the past 10 years that the spread between month-1 and month-12 futures has been in positive territory (grey and pink lines below = Month-1/Month-12 continuous futures spread). Yet, in 2021, this spread has been in significant positive territory, aka backwardation (blue line below).

Another key spread relationship is the one between key refined products like gasoline and distillate. The historical nature of this relationship can be seen below. Both on a 5- and 10- year basis, this relationship follows a fairly predictable seasonal pattern - gasoline trading at a premium to distillate in the summer and vice versa in the winter. This seasonal pattern has materialized again this year, albeit with gasoline's premium to distillate at slightly higher than historical levels. This relationship is one that we see as vulnerable given the pace of inventory draws seen this year in distillate (see next section on inventory levels).

In order to realize today’s momentum we need some accompanying velocity. Positive demand data over the Memorial Day holiday weekend could turn out to be the accelerator needed to build on reopening momentum and push prices higher. In addition, the recent Colonial Pipeline ransomware wasn’t an aberrant event, but a reflection of growing cyber-attacks coming in waves at the exact time cyber thieves know global supply chains are most vulnerable. It is hard to imagine a time when reward-risk stakes have been any higher or more likely to fall into the extreme.


Current Inventory Levels vs History & Seasonality

US Cushing inventory levels fell below their 5-year average earlier this year (purple line vs black line below).

Lower inventories at Cushing have translated to lower spreads between Midland WTI and WTI at Cushing. Traditionally, weakness in Midland relative to Cushing has meant a lack of US Gulf Coast demand (for refining and for exports). Don't let this weakness fool you. The move lower in the Midland/WTI spread curve over the last 30 days is more a function of the decline in Cushing inventories than a supply glut in the USGC. The market is attempting to keep barrels 'in region' vs enticing them via spreads for export.

When calendar spreads stall as prices are moving higher, this is a sign that bullish bets are moving further out on the curve. The relative 'discount' of future prices relative to spot is starting to look attractive. Bullish support coming from the back of the curve could provide the catalyst for the next leg higher in outright prices.


US Product Inventory Levels vs History

Comparing US EIA distillate vs gasoline inventory levels reveal a much larger decline in distillate inventories so far this year than gasoline inventories. Now that summer driving season is upon us, the expectation is that gasoline inventory draws will begin to exceed those of distillate inventory draws. Like crude oil markets though, product futures are also in backwardation through the end of the year. Backwardated markets don't tend to foster inventory builds. This is a problem. The oil complex remains in structural backwardation across the board.

Price increases have not led to production increases, rather they have led to inventory draws. The market is so comfortable with the idea that OPEC+ will return production to the market with ease. But, we have never had such a significant reduction in the overall utilization of the oil system. Heavy equipment like that used in the oil complex (refiners, pipelines, drilling) is made to be used. Lengthy periods of inactivity create a host of unprecedented breakdowns during the return to service. New equipment installed prior to the pandemic but lightly or even never used is no longer under warranty, while small unattended things like minor leaks holding over from as far back as late winter-early spring 2020 in some instances, are now anything but trivial.


Without exception, producers have diligently planned for a resurgence in demand but it's not easy to properly prepare for the unparalleled, massive global scale-up now in progress which compounds already compromised supply chains. For example, in Pennsylvania Gov. Tom Wolf chose Memorial Day to lay to rest the last of his COVID-19 restaurant and bar restrictions, with a return to full capacity. Yet, soaring food prices and increasing supply shortages threaten to put food prices nearly out of reach.



OPEC Meeting

A meeting of OPEC+ experts called the Joint Technical Committee (JTC) took place on Monday, May 31. According to Reuters, the JTC confirmed OPEC's forecast for a sizeable, 6 million bpd jump in world oil demand in 2021 focused on the second half, OPEC+ sources said. Tuesday's meeting is due to be attended by oil ministers from OPEC+. Two more OPEC+ sources said on Monday they do not expect OPEC+ to decide on output policy beyond July, since the outlook for Iranian supply is not yet clear. OPEC has another meeting planned for June 24.


OPEC+ is likely to stick to the existing pace of gradually easing oil supply curbs at a meeting on Tuesday, OPEC sources said, as producers balance expectations of a recovery in demand against a possible increase in Iranian supply. The Organization of the Petroleum Exporting Countries and allies - known as OPEC+ - decided in April to return 2.1 million barrels per day (bpd) of supply to the market from May to July, as it anticipated global demand would rise despite surging coronavirus cases in India.


“There are many moving parts when it comes to factors affecting the global oil market, such as the pace of change during the pandemic,” OPEC Secretary-General Mohammad Barkindo said after the JTC met. OPEC+ continues to be a “reliable and dependable component contributing to oil market stability.”


The 23-nation group is expected to rubber-stamp a production increase scheduled for July, completing the return of just over 2 million barrels a day of halted supply since the end of April. Ministers will have preliminary discussions on what to do after that, though they may not make a decision until the following meeting in late June or early July. While the alliance is formally committed to holding output steady at July’s level until April 2022, a strong recovery in fuel consumption in the U.S. and Europe may stir some debate. Russia and the United Arab Emirates have often been more eager than Saudi Arabia and some other members to boost oil sales and take advantage of higher prices



Of Note Over the Weekend

  • According to Cox Automotive, available new-vehicle supply in mid-May was 1.95 million, down from 2.24 at the end of April. Supply is now 42% below last year, or 1.4 million units. The supply shortage means buyers will likely pay more, as well, if they find a suitable vehicle.

  • Malaysia will implement a total lockdown from tomorrow to stem rising Covid-19 cases in the country, shutting down almost all economic and social sectors for at least two weeks.

  • Al Jazeera reported over the weekend that India’s capital New Delhi will start relaxing its strict coronavirus lockdown next week if new cases continue to drop. The South Asian country on Sunday reported 240,842 new infections nationwide over 24 hours – the lowest daily number in more than a month – and 3,741 deaths.


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EIA Inventory Statistics Recap


Weekly Changes

The EIA reported a total petroleum inventory DRAW of 8.00 million barrels for the week ending May 21, 2021 (vs a draw of 4.90 million barrels last week).


YTD Changes

Year-to-date cumulative changes in inventory for 2021 are DOWN by 48.60 million barrels (vs down 40.60 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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