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Is There a Weak Link in Oil Markets?

Author: Brynne Kelly 9/26/2021



Another weekend and another upside revision in analyst price targets for crude oil. On Sunday, Goldman Sachs raised its year-end Brent crude oil forecast by $10/Bbl. Specifically, they stated that "Brent oil prices have reached new highs since October 2018, and we forecast that this rally will continue, with our year-end Brent forecast of $90/bbl vs. $80/bbl previously". Also on Sunday, RBC Capital markets reported that "global floating storage has fallen to the lowest level since the pandemic began".


There’s a new energy and optimism in oil markets that’s been absent the past several years. This is clearly evident in oil markets via shift higher in the 2022 - 2026 futures curves since the beginning of the year (yellow line = last Friday's settle; red line = January, 2021).

Both the US and China have released barrels from their respective Strategic Petroleum Reserves with limited price impact to the over all market. In fact as we see below, every meaningful dip in calendar strip futures has been bought since we broke above the $60 level. Last Friday, the calendar 2022 strip closed just shy of the $70 mark (green line below, settling at $69.75). The last time a calendar strip breached this $70 level to the upside was in 2018.

Even the calendar 2023 strip has managed to hold above $60, closing at $63.54 last Friday.


When a market continues to climb towards new highs, the natural reaction is to look for a weak link in the overall complex to poke holes in the validity of the rally. For this, we use relative value spreads, time spreads and inventory to see if we can find a 'weak-link' candidate.


Relative Value

A recent tailwind for the oil complex has been the developing story in natural gas and LNG markets due to seasonally low inventory levels. Specifically in Europe and Asia. This has helped drive US natural gas prices well above $5.00 for the upcoming winter strip. Yet, crude oil prices have rallied even more on a relative basis. The spread between US natural gas and WTI crude oil (on a heat content adjusted basis) is shown below.

Prior to the pandemic, this spread relationship had been holding around either side of $6.50/mmbtu (WTI over NG, red and cyan lines below). As we entered 2021, the spread relationship had broken down and was trading closer to $5.50, but remains around $7.50 as of last Friday after seeing a high above $8.00 in July.

Initially, this could look like a bit of a headwind to oil prices, that perhaps this spread has gotten too wide and could lead to less fuel switching.


However, when comparing WTI to US Gulf Coast (USGC) LNG prices the picture looks much different. Now we see that WTI crude oil is trading at more than a $10/Mmbtu discount to US natural gas that has been liquefied and ready for export out of the US Gulf Coast.


This is the situation that global markets are facing as they look to shore up supply for the upcoming winter season. With oil prices well below LNG prices, you can bet that any switching that can take place, will take place. Another tailwind.


WTI versus Refined Products (aka, Crack Spreads)

Oil rallies that result in lower crack spreads can be a sign that oil prices may have gotten ahead of themselves or that the fundamental underpinning for the oil rally may be faulty.


Both distillate crack spreads to WTI (left chart below) and gasoline crack spreads to WTI (right chart below) have rallied this year. The red line on both charts represents the spread at the start of 2021 and the gold line represents last Friday's settlement. The rally in oil has not pushed refined product crack spreads to new lows, in fact they have rallied. Another supportive underpinning to the rally.


Gasoline versus Distillate

One of the few places where we can spot some relative weakness is in the relationship between gasoline and heating oil. Much of this can be attributed to seasonality. The winter season is when distillate/heating oil usually takes the lead and we are seeing that in the chart below.

Something to keep an eye on, however, is the relative gasoline weakness in the back of the curve.


Benchmark Oil Spreads

Using the major oil benchmarks we compare how Brent has fared relative to Oman and WTI. Since the July 2020 lows, Brent has regained its premium over Oman (black lines below) and lost ground versus WTI (gold lines below). In both cases, however, Brent remains at a premium to both. All eyes will be on Brent futures and these spreads to look for any foundational cracks in the overall rally. Should either of these spreads come under too much pressure going forward, this could signal a pullback in overall prices.


Time Spreads

Twelve month calendar spreads often signal the level of bullish or bearish structure in the market. One of the more popular ways to express this is via the Dec/Dec twelve month calendar spread.

Both the Dec-21/Dec-22 and Dec-22/Dec-23 spreads are above $5.00 as of last Friday. This is territory that, in recent history, has only been seen in moments of significant short-term supply disruptions (due to weather or other damage) and is usually short-lived. You have to go back to 2014-2015 to find a meaningful move above the $5.00 level in the spread for any significant period of time. This is something to watch. While spreads CAN collapse due to a rally in the back of the curve, it's more typically a result of weakening fundamentals in the front of the market. Absent that, calendar spreads can stall while the entire curve moves in lock-step higher or lower. That scenario would suggest, over time, that current levels of backwardation have become normalized.



US Inventory

The pandemic brought laser-focus on to inventory levels. We have gone from record high inventory levels to slightly below-normal inventory levels in the US. All eyes will now be on changes from here through the end of the year. So, is there a pattern in US crude oil inventory changes during this time period in previous years?

It appears to be a mixed bag in recent history, with a slight bias towards inventory builds during the last 4 months of the year. What we DO know is that so far in 2021, the US has drawn down more inventory than in any other year since 2015. By a lot.


This has been a supportive factor for oil prices and it's possible that a slow-down (or even reversal) in the recent pace storage draws could provide the impetus for a breather in the current price rally.


Overall though, it's difficult to find a weak link in the complex. The energy complex continues to dig in it's heels and refuses to retreat. The rest of the complex has followed-suit.



Of Note Over the Weekend:


Japanese media reports all COVID-19 states of emergency will be removed on Thursday of this week


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EIA Inventory Statistics Recap


Weekly Changes

The EIA reported a total petroleum inventory DRAW of 3.80 for the week ending September 17, 2021 (vs a net DRAW of 10.60 last week).



YTD Changes

Year-to-date cumulative changes in inventory for 2021 are DOWN by 138.60 million barrels (vs down 134.80 million last week).



Inventory Levels

Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years are have gone from way above historical levels to surprisingly below historical levels and should continue to draw as long as backwardation in the market persists.





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