When The Chaos Is Behind You
Author: Brynne Kelly
While there were many curious eyes on the action in stocks like GameStop last week, less than a year ago all eyes were on crude oil markets and their historic drop into negative territory. Oil market participants were eager to find villains upon which to place blame (producers, regulatory bodies, etc.). Brokerage and clearing firms rushed to raise margins and limit trading volumes. Several popular crude oil ETF/ETN's were forced to change their capital allocations from front-month only exposure to a more distributed allocation across the curve. There was a lot of strain on the structural integrity of several of these products. It was believed that the breakdown in the structure of oil markets would lead fund companies to consider shutting these products down all-together.
But, just as quickly as headlines predicted the demise of oil ETF's, crude oil markets rallied and by year's end levered long ETF's such as GUSH (the Direxion Daily S&P Oil & Gas Exploration & Production Bull 2X Shares) were suddenly attractive again.
It's amazing what price stability can do for a market. If we look back at the path of front-month daily average futures for Brent and WTI, we see not only a steady increase in prices, but a reduction in the volatility of prices. The front of the market has essentially returned to levels see this time last year, before the pandemic ever happened.
But, just beneath the surface of this price recovery lies a more disturbing picture. One that can be seen by looking at the shape of the futures curve. One year ago, the continuous 2 year futures curve (purple line below) exhibited slight contango in the front of the curve before developing into a backwardated structure by month 4. The front of the market was trading around the $51.50 level. Fast forward to last Friday's close (1/29/21, green line below). The continuous 2-year futures strip is not only in severe backwardation, but the front 3 months are actually trading above year-ago levels.
Yet, as we move further out on the curve we see how little faith there is in this move higher in front month prices. The market is saying it has limited faith in WTI oil prices above the $50 level. The shape of the curve suggests that firmer prices are being attributed to the current level of production being withheld from the market (either due to specific OPEC+ cuts or to production economics) and is leery of the balance between supply and demand going forward.
As a result, there is MORE backwardation across oil curves than there was a year ago (green line vs purple line).
We are in a tricky spot at the moment. On the one hand, such pervasive backwardation across the curve could be viewed as bullish. And this bullish sentiment has drawn some excitement around energy equities and oil markets overall. For certain, some of that sentiment is worthy given the outright rise in oil prices from their lows and the impact that will have on yearly comps for oil producers. In reality, calendar strips beyond 2021 are still sitting below the crucial $50 level.
It appears that the front of the market needs to do more work to the upside in order to pull the rest of the structure with it. Once the chaos is behind you, it's time to see if the market has the underpinnings needed to march higher. Where would we look to find signs of this?
Crude oil markets do not exist in a vacuum. They are a reflection of the desire for production capacity as well as end user demand for refined products. The demand for production capacity is often expressed through outright price or call option volatility. Yet, the further out you move on the WTI curve, the more you can see how little faith the market has on this price recovery. Holding the current backwardation structure constant, outright prices would need to roll higher by about $3-$5 to pull the back of the curve towards the $50 level. Absent an outright move higher in prices, the entire curve looks vulnerable since selloffs in the front of the market rarely lead to a significant rally in the back of the curve. At best, it leads to narrowing backwardation or contango.
Calendar spreads are at a critical point. On a continuous chart, 12-month backwardation in WTI crude oil and RB gasoline managed to reach new 52-week highs in January (black and red lines below). Distillate spreads stalled out before reaching new highs (blue line below). Buoyed by the surprise production cuts by Saudi Arabia, market participants moved their bets back towards the front of the market.
Isolating oil spreads, we zoom out a bit and look at 12-month continuous calendar spreads over time in both Brent and WTI markets below. There is clearly still room to the upside before coming close to prior year high levels. This next push to the upside however would need to be front-led by growing proof that prompt markets are in need of supply. Traditionally, this would be enough to lead an already bullish market structure higher. However, in today's environment where an historic amount of production is being withheld from the market by OPEC+ on a 'month-to-month' basis, it's assumed that price rallies from here will be met with production increases. We are only at the beginning of the supply recovery journey. Right now, the market is using backwardation to test producers and the ability of the market to handle supply increases.
US weekly refiner inputs of crude oil have not recovered as quickly as the market had hoped. While they have recovered from the extreme lows seen last year, a clear trend has yet to emerge this year (gold line below).
Reduced input levels are helping to keep a lid on production as the only other outlet for US crude oil production is through exports. An examination of weekly US crude oil imports and exports (below) show that while exports are not growing (blue line below) they haven't fallen off of a cliff either. The overall US supply level is being managed not only through lower production but also through lower imports (yellow line below). This creates a somewhat manufactured supply/demand 'tightness'. This type of weekly imbalance is cleared via inventory changes.
On a brighter note, US commercial crude oil inventories have retreated from their pandemic highs (green line vs yellow line below). This suggests that the combination of current demand, crude oil import discipline and reduced production is finally leading to inventory reductions. Yet, given the backwardated curve structure noted earlier, the market remains skeptical about a smooth return to normal.
Refined product prices ultimately keep a lid on crude oil prices (except in rare occasions where disruptions in oil supply overtake product prices in the short-term). Absent short-term disruptions, gasoline and distillate prices provide validation of a bull/bear thesis in oil markets. For sure we can see that the yearly 12-month continuous gasoline crack spread to WTI has made quite a recovery this year (red line below). The same cannot be said about ULSD crack spreads (blue line below). We think crack spreads have more work to do to the upside in order for oil prices to continue higher (absent impacts from renewable fuel standards discussed below).
Renewable Fuel Standard
A major factor contributing to US refined products used for on-road consumption is the Renewable Fuel Standard which sets annual quotas for the quality of ethanol and biodiesel that must be blended into transportation fuels (see previous analysis of RIN markets here). The burden of meeting the blending requirements falls on those that refine or import oil. Those unable to meet any given year’s quota must fulfill it by buying Renewable Identification Numbers (RINs) in the open market from those who have blended gallons to spare. This creates a link between refined product markets and renewable fuel markets such as ethanol as ethanol makes up the lions share of the renewable fuel obligation. During times of high RIN prices, crack spreads may adjust higher to include the cost of adding the RIN, without any corresponding move in crude oil prices. So far this year, both ethanol futures and ethanol RIN's have been on the rise. This ultimately reflected in both gasoline futures and gasoline crack spreads. This dynamic could continue to keep a bid in gasoline markets due to the additional renewable blending cost irrespective of crude oil prices.
Low Sulfur/High Sulfur Spread
Another fundamental factor underpinning oil prices is the widening spread between low sulfur and high sulfur fuel oil (green line below). Low sulfur middle distillates have been tight due to seasonal heating demand. Major markets such as the US Northeast, North Asia and central Europe still have a significant portion of their residential space heating demand accounted for by either heating oil (US and Europe) or kerosene (North Asia).
We would like to see more of a recovery in this spread, however, before feeling comfortable that WTI can continue to move higher.
So, now that we have the chaos behind us, the journey begins. This is a journey that requires finding the fundamental underpinnings to move forward. Backwardation can only take us so far.
EIA Inventory Statistics
The EIA reported a total petroleum inventory DRAW of 8.30 million barrels for the week ending January 22, 2021 (compared with a build of 4.50 million barrels last week).
Year-to-date total inventory changes for 2021 stand at 2.20 million barrels (vs 10.50 million barrels last week), with crude oil inventory now down 8.80 million barrels for the year.
Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years continue to show signs of recovery out of the depths of despair we saw last year.