The Five Stages of Grief in Oil Markets
Oil prices have fallen dramatically as stay-at-home orders started to roll across the globe, bringing demand to a halt. It might be tempting to think the worst is behind us, and it may be. But like everything else in life, there are stages of grief that make up our learning to live with - and move beyond - loss, also identified as a negative reaction to change. While these stages are not stops on some linear timeline, it's useful to identify where we, the various actors in the energy commodity value chain, are in the process.
This is how we break out the stages of grief as they relate to energy markets:
Sudden Loss of Demand - Denial
Refinery Run Cuts - Anger
Inventory Builds - Bargaining
Production Cuts - Depression
Rebound Positioning - Acceptance
1. Sudden Loss of Demand - Denial
The denial stage is one in which markets are in shock - going through the motions of existing routines, expecting normalcy to prevail. Certainly uninformed optimism can play here as well. There is not a lot of planning in this stage. Oil markets felt this shock as deliveries for April, 2020 became extremely complicated. Refiners, facing a drastic reduction in end user demand for their products, were forced to cuts runs. Producers, expecting to deliver oil to refineries, suddenly had to scramble to find a home for their barrels. Pipeline companies suggested they were preparing for lower throughput. Cash differentials to futures exploded to the downside as the days progressed, with cash WTI diffs trading as wide as $6.00-$7.00 below May futures.
In this denial stage, market participants are more focused on clearing current physical obligations than future planning. The front line for this in the US centers around the USGC, the place where incremental oil production goes to be picked up for processing or put on a ship to be exported, or both. As expected, we saw Gulf Coast barrels take a big hit. Midland differentials (the value of WTI produced in the Permian) had finally worked off the in-region excess as new pipeline capacity was added over the last 2 years. By last fall, Midland finally began trading at a slight premium to WTI. This premium was erased over the last 2 weeks.
The move was most pronounced in the front, with Midland prices falling much faster than WTI since the start of March. In fact, we saw close to a $10 swing in the spread - going from a $2.00 premium to an ($8.00) DISCOUNT to WTI by last Friday.
The same scenario played out in LLS (Louisiana Light Sweet) differentials to WTI. LLS markets are less capacity constrained than production in West Texas, so LLS had enjoyed big premiums to WTI as it is more readily priced as an export barrel.
Over the last 2 weeks, prices for LLS crude oil declined almost $8.00 MORE than WTI prices (chart below).
By contrast, WTI/Brent spreads were much more stable. Gulf Coast barrels are on the front-line taking the brunt of it. Because we are in the shock stage, participants are just dealing with the crisis at hand, which is the lack of demand for exporting or refining barrels in the USGC. WTI vs Brent is the 'index' that other markets are adjusting to.
2. Refinery Run Cuts - Anger
I put refinery run cuts in the anger stage because anger is often an attempt to put some structure around the chaos, a familiar emotion that provides a link to the rest of the world. A new normal has rolled across the energy industry and people are angry at producers and looking for some sort of logical response. Enter refinery run cuts. The loss of gasoline demand is estimated by some to be in excess of 40%. Gasoline is also not a great candidate for long-term storage due to seasonal blending requirements. Refiners are forced to make the first move and reduce output as gasoline prices collapsed and refining margins fall below zero.
This is a key dynamic. Gasoline prices collapse, margins turn negative and refiners cut throughput. Less throughput leads to a collapse in oil prices which in turn helps to stabilize crack spreads in order to compensate refiners for their remaining gasoline production. This push and pull has led to extreme volatility in gasoline cracks.
On the other hand, distillate cracks have remained relatively strong. The portfolio of complex refining capacity in US means that refinery output favors gasoline by almost a 65/35 ratio. Less complex refiners in the rest of the world have outputs that are closer to 50/50. Global price relationships have led US refiners to maximize gasoline output and rely on imports of distillates (via the HOGO spread - heating oil vs gasoil).
3. Inventory Builds - Bargaining
Bargaining is a time when markets remain in the past, trying to negotiate their way out of the pain. A time when producers add barrels to inventory with a promise to 'do better' in the future. It's the time when producers remain hopeful the future will save them without having to make any real changes.
Excluding the Strategic Petroleum Reserve, the US had about 190 million barrels of available crude oil storage capacity as of March 20, 2020.
This could reach capacity by July of this year, assuming max daily fill rates and all else remains the same (dashed blue line below). After that, barrels will need to seek out unconventional storage space either overseas or in floating tankers at a much higher cost.
For an alternative viewpoint, the dashed gold line above represents a scenario under which producers respond with 15% production cuts (bargaining) by the end of April.
4. Production Cuts - Depression
After bargaining, our attention moves squarely into the present. Uninformed optimism bleeds into informed pessimism. When a loss fully settles in, the realization becomes apparent that future conditions aren't going to provide the relief one bargained for. Depression sets in as one is forced to face reality. This is the stage where markets might finally see production cuts, as capital expenditures are reduced, rig counts decline and smaller producers are forced to exit the market.
5. Rebound Positioning - Acceptance
This stage is about accepting reality and recognizing that this new reality is the permanent reality. Accepting that the past has been forever changed and we must readjust. This is a time when new rules, dynamics and relationships emerge.
Looking ahead, once global trade recovers US oil will once again seek international buyers, and bloated inventories will need to be worked-off. PADD 3 (USGC) inventories will be the first to go and eventually regain their premium over WTI stored at Cushing. These spreads have the potential to be either amplified or dampened by global supply/demand dynamics in ways that are unimaginable today. Watch for trends in the calendar 2021-2022 part of the curve for how the market is voting on future conditions.
It's no real surprise that the spot market has taken the biggest hit due to the element of surprise. Production suddenly had to find a new home, and the quickest action is to lower prices enough to entice a willing buyer to take the product off of your hands - a buyer that may already have storage capacity or capacity contracts in place or one with better access to logistics (to move product or offset demand).
As noted earlier, there was still technically plenty of available storage capacity as of March 20, 2020. The cost of traditional storage capacity is estimated to be around $0.50/bbl, however front-month calendar spreads are much wider than that even though storage is not at capacity. As previously referenced, the impact of the sudden loss of demand hit the spot market hard. However, it may be irrational to think that the market will be as flat-footed come May deliveries. There are a LOT of assumptions that need to be made in order for the 1-month calendar spread structure shown below to realize.
We will leave questioning these assumptions to future reports, in the mean time we leave you with this question: What conditions need to exist for WTI this fall that would lead to less than $0.50 contango in 1-month calendar spreads (pink dot above)?
The five stages of grief are not linear, individuals, and the market, will likely iterate through multiple phases, but moving forward is key. Also, various actors in the energy value chain will be in different stages at any given point in time. Acknowledging that, and anticipating the next phase for an actor, can help you navigate this crazy market as we move forward.
We have yet to see the cumulative impact of current events on EIA inventory levels since the reports are not real time. The EIA inventory report for week ending March 20, 2020 reported a small total inventory DRAW of (.60) million barrels.
Year-to-date, this bring us to a Total Inventory DRAW of (2.70) million barrels. As discussed earlier, Inventory builds are expected to grow significantly going forward as demand remains under pressure.
Until now, inventory levels for 2020 (black bars) had looked relatively benign in comparison to previous years. With the anticipation of future inventory builds and the US announcing it's intention to reverse course and begin buying oil for the Strategic Petroleum Reserves, everything is now viewed using a different lens.
Lee Taylor - Technical Levels
(Technical Levels will be returning next week)