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The Market Voted: Production Cuts > Lockdown Effects

Author: Brynne Kelly (w/Lee Taylor technical levels)

Last week, oil markets had a lot thrown at them. First, on Monday, the UK Prime Minister announced the county's third national lockdown, and other European countries began to announce similar measures. Second, the OPEC+ meeting scheduled to conclude on Monday was extended into Tuesday. The meeting finally ended with an agreement to raise production by a scant 75,000 barrels per day over January levels, according to OPEC’s post-meeting press release. But, just as the market was digesting this outcome, Saudi Arabia made a surprise post-meeting announcement that it would cut an additional 1 million barrels per day of production for February and March delivery. Lastly, the market had to weather the chaos that ensued in DC as congress certified the 2020 presidential election results.

The market began the week braced for another round of selling caused by lockdown measures. It ended the week with a clear vote that 'production cuts' are greater than 'lockdown demand loss'. As a result, backwardation came racing back into the market in both Brent and WTI markets.

WTI 1-Month Continuous Calendar Spreads

Brent 1-Month Calendar Spreads

In fact, the market has all but recovered it's pre-pandemic backwardation structure (yellow line below). Only the front spread (Feb/Mar) remained in contango as of Friday's close. This is perhaps the only nod the market is giving to the lockdown news.

A million barrel per day cut by the Saudi's seem to have caught the market by surprise, not only in calendar spreads, but also in global arbs. The WTI/Brent spread weakened after the cuts were announced as Asian refiners looked to secure North Sea cargoes for delivery in February and March. Prior to the announcement of the cuts, the market would have expected the spread to perhaps tighten on the UK lockdown announcement, expecting Brent to lose value relative to WTI. Instead, front spreads widened out as it valued production cuts more than lockdown-induced demand losses (yellow line below = 1/08/21 spread curve settle).

With a weak global demand picture, the spread between WTI and Brent had been tightening all year, as we can see in the chart below (green line vs purple line). Export arbs had been vanishing as global demand losses mounted. The Saudi cuts helped to widen the arb in crude oil (spread is more negative). It appears as if these cuts were the straw that broke the proverbial camel's back and caused the market to readjust to new levels.

For most of 2020, the market had been trying to find new footing under a new reduced supply/demand dynamic. US production plus net imports (left chart below) moved significantly lower, which helped draw-down bloated crude oil inventories (right chart below).

The US has been using net imports as a weekly balancing tool against lower refinery utilization. As US production stabilized around the 11 million barrel per day level (right chart, below), weekly supply imbalances were made up via net imports relative to prior years (left chart below). It's the production plus net imports that truly shows the reduction in US supply for refiners (gold lines below = January 1/2021 EIA report).

Putting it all together, we have reduced oil inputs to refiners (left chart below, yellow line) and therefore, lower end-products supplied by refiners (right chart below, yellow line).

This adds so much uncertainty going forward. We expect volatility to increase as events begin to realize in 2021.

For the first time since February, 2020, the WTI strip for the balance of 2021 (Feb-Dec) settled above $50. Backwardation is leading the overall market higher, but never has there been a time where spreads are so uncertain. OPEC+ is currently withholding over 8 million barrels per day of production from the market through the end of March 2020.

The OPEC+ group has committed to meeting monthly to reassess the situation, which means the future can change in an instant if prices allow. This is going to lead to a lot of volatility in calendar spreads. For now, the market is happy to own the front and sell the back with the understanding that there is a call on production if prices supply gets too tight.

The oil market is very familiar with backwardation spikes. The usual culprits for this, beyond normal backwardation, are weather-related supply issues, nefarious attacks on supply or OPEC supply cuts. One of the more popular spreads used to express an expectation of backwardation in oil markets is the 12-month Dec/Dec calendar spread. Backwardation on this spread surged to almost $8.00 in 2019, when a drone attack temporarily knocked out Saudi Arabia's production. 2018 responded to the 22 major hurricanes that hit over the span of just 70 days with a spike in backwardation to almost $7.00 in the Dec/Dec spread (violet line below).

Similarly, the Dec-21/Dec-22 spread made new contract highs last week due to production cuts (purple line above). The rally in the spread last week, however, feels more like a vote against the back of the curve rather than a vote for the front of the curve. A vote that higher prices in 2021 won't be met with producer selling (as they are withholding production) but will eventually lead to production increases in 2021. This backwardation can continue unchecked as long as refining spreads keep pace and product inventories don't get out of hand.

Crack Spreads

Crude oil prices have been able to rise alongside crack spreads. Prior to this year, the 12-month continuous RB gasoline crack spread (to WTI) strip had not dipped below $10 since early 2016 (red line below). Couple that with the 12-month US distillate crack spread strip briefly dipping below the $10 level and we now find ourselves at barely an 80% refinery utilization rate.

It wasn't until product cracks began to rise that oil prices were able to punch through the $50-level (black line above). Refiners have been incredibly disciplined since the pandemic hit by keeping utilization rates low. As we noted earlier, this has finally led to a reduction in gasoline and distillate inventories. Last week's product builds failed to have a dampening impact on prices since year-end withdrawals from oil inventory and injections to product inventory are a seasonal norm during the holidays. The key going forward will be to keep an eye on these 12-month crack spread strips as they attempt to break above the $15-level, and also product inventories.

As an aside to the impact that 2020 margins have on refiners we note that, according to consultancy Wood Mackenzie, 1.4 million barrels per day, or around 9%, of refining capacity is under threat of rationalization in Europe in 2022-2023. Against the backdrop of potentially shut capacity in Europe over the next few years, other regions have been expanding with mega refining projects that are closer to upstream production like the Middle East, or closer to big demand centers like Asia Pacific.

Looking at 12-month gasoline and distillate strips, 2020 is the first time the 12-month strips have dipped below the $60/bbl level in any meaningful way since 2016 (red and blue lines below).

As we break above the $15-level in the crack spread strip and above $60 in product strips, will refiners begin to raise utilization rates? Will there be enough demand to absorb increased product output? Or was last weeks rally simply a reaction to the sudden reduction in supply by the Saudi's? Watch these two levels to see if they become support or if they fail.

EIA Inventory Statistics

Weekly Changes

The EIA reported a total petroleum inventory BUILD of 2.80 million barrels for the week ending January 1, 2021. This was much lower by comparison to previous year-end builds.

YTD Changes

Year-to-date, total inventory additions stand at a BUILD of 66.30 million barrels for the year ending January 1, 2021. The commercial crude oil build in 2020 however, did not set a record. That is still held by 2015 which saw a yearly build of over 100+ million barrels per day!

Inventory Levels

Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years remain above the 5-year average while gasoline and distillate inventories are slightly below their 5-year average.

Lee Taylor - Technical Levels (to return next week)

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