2021: Petroleum Year in Review
Producers Win, Consumers Lose
Author: Brynne Kelly 12/19/2021
The events of 2020 are a tough act to follow. The negative prices experienced in April 2020 were probably a once-in-a-lifetime event due to the abrupt Coronavirus lock downs which caught the world off guard. This led to a global inventory pile-up, production cuts by key producers and reductions in refinery runs in an attempt to counteract the sudden chaos that plagued the system. Producers were left holding the proverbial bag.
By the time 2021 rolled around, oil markets were anxious to put all of these events behind them and start looking forward towards recovery. At last it seemed as though the chaos of the global pandemic could take a back seat to normal supply/demand dynamics.
Market participants began to assess the long-term damage the pandemic may be doing to the energy complex. Where 2020 left producers holding the bag (as they tried desperately to find buyers for their product) 2021 is a different animal. This year it was consumers and end users who appear to be left holding the bag in the face of rising energy prices.
Certainly, the market remains conscious of pandemic-related risks, but the initial shock wore off by the start of 2021, a year in oil markets that will be hopefully be remembered for it's own merits.
Key 2021 Market Events
Winter Storm Uri: Texas, the energy hub of the US, came to a grinding halt in late February 2021 when the ERCOT power grid crumbled under the weight of cold weather. A state rich with energy production as far as the eye can see, was suddenly unable to continue operations without electricity as the dominos began to fall one by one as natural gas and electricity prices soared to new highs. Supply-chain weaknesses were exposed and have left us with a trail of weather uncertainty going forward.
Colonial Pipeline: The largest U.S. refined products pipeline operator halted all operations after it fell victim to a cybersecurity attack on Friday May 7, 2021. The incident was one of the most disruptive potential digital ransom operations ever reported and drew attention to how vulnerable U.S. energy infrastructure is to hackers.
The 19th OPEC and non-OPEC Ministerial Meeting (ONOMM): Held via videoconference, concluded on Sunday 18 July 2021. This was a pivotal meeting regarding production cuts. Finally, OPEC production would begin to increase rather than decrease (at a rate of 0.4 mb/d on a monthly basis starting August 2021 until phasing out the 5.8 mb/d production adjustment). Many were skeptical as to whether or not the market was ready to cope yet with more supply. The Meeting noted the "ongoing strengthening of market fundamentals, with oil demand showing clear signs of improvement and OECD stocks falling, as the economic recovery continued in most parts of the world with the help of accelerating vaccination programmes".
Hurricane Ida: Ida made landfall at 11:54 CDT, August 29, 2021 as an extremely dangerous category 4 hurricane near Port Fourchon, Louisiana, with maximum sustained winds of 150 mph and a minimum central pressure of 930 mb (27.46 inches). Sixteen years to the day after Katrina. The Mars pipeline system was seriously damaged and it took months for production to return to market.
US-Led SPR Release: In November, 2021 the US announced it would release of 50 million barrels from it's Strategic Petroleum Reserve (32 million of which are in the form of a loan). The 'loan' terms outlined that barrels would be lent to winning bidders between 12/16/2021 and 4/30/2022 and required to be returned to the SPR - plus a premium - over a future scheduled time frame.
The 23rd OPEC and non-OPEC Ministerial Meeting (ONOMM): Held on Thursday December 2, 2021. Reconfirmed the production adjustment plan and the monthly production adjustment mechanism approved at the 19th ONOMM and the decision to adjust upward the monthly overall production by 0.4 mb/d for the month of January 2022.
The combination of the December OPEC meeting, the announcement by several countries of their intent to release barrels from their Strategic Petroleum reserves and the discovery of a risky new coronavirus strain called Omicron became too much for the market to absorb all at once. WTI futures fell 13.06% as a result, hitting their lowest level since September 1. This made it the worst one-day move since April 2020. Similarly, Brent fell 11.55%.
2021 Market Review - Futures Curves and Spreads
The OPEC+ interventions on the market in recent years have helped the oil industry to see the beginning of the return of confidence and investments, Russian Deputy Prime Minister Alexander Novak told Russian TV channel Rossiya 24 in an interview in December. “We positively assess the joint actions since 2016. They allowed us to return investments and restore confidence in the industry. This is a strategically longer period for planning our activities,” Novak told Rossiya 24 in an interview to mark the fifth anniversary of the first OPEC+ agreement reached in December 2016.
This is a confident statement - a victory lap of sorts. Nonetheless, it's a plausible statement given the recovery we have seen in oil prices.
Crude Oil - Flat Price and Curve Structure
In 2020, we saw the complete devaluation of the energy complex (brown line vs red line below). The entire curve plunged well below $50, questioning the fate of future production growth. Prices remained below this level into early 2021 (cyan line below, 1/04/2021 futures curve). By mid-2021, the demand side of the equation began to take over as excess global inventories began to recede (navy line below, 5/03/2021 futures curve). We went from a system that was worried it wouldn't have enough places to store excess barrels to one that was becoming increasingly vulnerable to lack of investment and short-term supply disruptions (rather than demand destruction). By the close of business last Friday (gold line below) prices across the curve were above $60, well-above that level even in shorter-dated futures.
By August of 2021 the 12-month calendar 2022 futures strip was above the $70/bbl level (green line below). It remained above $70 long enough that participants began to wonder where the hedgers were. Wasn't this a magical gift of a number producers could only dream of in 2020? What became clear was that unlike past industry cycles, production wasn't responding meaningfully to higher prices. From a fundamental perspective this suggested that further oil price increases may be on the way. Even the calendar 2023 strip briefly flirted with the $70 level before being rejected (gold line below).
Outright prices began to buckle a bit, however, under the weight of SPR releases and continued monthly increases in OPEC+ production. Keep in mind that these supply increases (as defined in the US SPR release schedule) end in April, 2022. Additionally, the OPEC supply increases are currently on track to end in September of 2022 (barring any changes made to their existing schedule in future meetings). Between the two, over 146 million barrels are expected to be added to the market in 2022 (400k/day OPEC = 96 million barrels from Jan-Sep 2022 and 50 million from the US SPR).
Crude Oil - Time Spreads
The front-loaded nature of the supply additions noted above puts in focus the level of backwardation witnessed this year in oil markets. As 2021 progressed, the market focused more on short-term upside risks than down-side risks and backwardation began to take hold. The chart on the left below depicts one-month WTI calendar spreads realized in 2021. the chart on the right shows the level of one-month backwardation in 2022 futures.
So far this year, the market has been unable to realize the optimistic levels that futures spreads have reached at expiration. This pattern has caused many players to move their bullish time spread bets further out on the curve in order to avoid expiration weakness but still capture upside momentum.
It was, after all, the expiration of the 12-month Dec-21/Dec-22 calendar spread in WTI that was able to maintain record historical backwardation into expiration (of the Dec-21 leg) albeit well off its highs (lime green line below). Interesting given the nature of supply additions noted earlier.
Is this just a result of thin year-end markets or something deeper lying beneath the surface? The narrative that has developed in the latter half of 2021 is one of capital investment deficiencies that will harm supply growth going forward. Seems odd that the market would be willing to part with inventory today while at the same time questioning their potential to replace those barrels in the future via production. What reconciles this? Higher prices and a contango structure? This is a tough sell when it's widely known that producers of commodities are more prone to hedge their price risk than consumers. Producers usually hedge 1-2 years out while the marginal consumer usually is a price taker in the spot market. Putting pressure on spot market prices using inventory (SPR, etc.) not only doesn't entice production, but it also doesn't lower consumption. What is the old adage - High prices cure high prices and vice versa?
Speaking of the consumer, gasoline and distillate futures prices have experienced the same trend as crude oil as seen in the two charts below (US gasoline on the left and ULSD on the right).
In relation to crude oil though (as seen via crack spread futures below), refined product futures are not showing as robust of a move. Both the gasoline and distillate cracks have stalled a bit since their initial move higher earlier in the year. Should we start to see these come under pressure in 2022, this might be an indication of consumer fatigue at these levels.
Total US inventories (crude oil + gasoline + distillate) are now the lowest they have been since 2014 (2021 = purple line below). This total includes SPR inventories which we know will continue to draw for the next several months according to the release schedule.
It's relevant to look at combined inventory levels since, at the end of the day - it's all crude oil, just in different forms. As it stands now, we will begin 2022 with historically low inventories. A welcome thought if you expect the new Omicron variant to induce demand destruction and therefore we will need the storage space. A scarier thought absent that. Enough said.
Imminent Risks to Consider
Winter technically starts on Dec. 21 but, for the two weeks leading up to it, it has felt more like spring across much of the United States. The central and eastern Lower 48 are in line for an extended period of unseasonable warmth.
U.S. natural gas futures fell 2% on Friday to a one-week low on record output and forecasts for milder weather through late December than previously expected.
The predicted warmth builds on record-setting high temperatures that kicked off December across large parts of the Lower 48 states. Four states tied or established record highs for the month last week.
In Europe on the other hand, European and British wholesale gas prices continue to rise on supply concerns as temperatures across Europe are set to fall below seasonal norms from next week, supporting a bullish outlook until year end.
We have yet to enter the peak of winter weather. Memories of winter storm Uri earlier this year and it's impact on energy markets are still fresh. Has the situation in Europe caused enough fear and 'pre-buying' to dampen a price response to actual cold weather once it arrives?
Things are heating up politically and are about to get really hot in the European Union. Whether it's the border migrant crisis of Belarus or the tension related to the situation in the Ukraine, or the nuclear tensions stemming from negotiations with Iraq, there are a lot of unknowns. Given that production has not recovered completely to pre-2020 levels and inventory levels are low, there appears to be less spare capacity to absorb a major geopolitical event. Especially one that would disrupt market equilibrium from the supply side.
New Covid Restrictions Due to the Omicron Variant.
While this threat looms on a daily basis, it's fair to say that the downside risk related to new Covid restrictions are not the same as the ones we faced in 2020. It is no longer the huge "unknown" unknown that it was in March 2020. The market is inundated with Covid statistics on a daily basis and the various countries' responses have become fairly predictable. It's a headwind for sure, but also something we now, sadly, are experienced with. The world has and is figuring out how to continue daily operations in the face of lock downs.
For the moment at least.....
2021 has been the year of recovery. Prices have not only stabilized, but have risen significantly as the marginal unit becomes costlier to produce. Non-competitive assets are being weeded out through competition (pipelines, refiners, producers). Capital has shunned the traditional producer model and is more particular. There are less and less 'on-demand' resources available with each passing day (those that can be brought to market within 30 days). The market acknowledged this via increasing backwardation. This year, it was the consumers who were caught off guard rather than the producers. Significant risks remain for 2022 to reconcile.
Of Note Over the Weekend
The Netherlands went into lockdown on Sunday and the possibility of more COVID-19 restrictions being imposed ahead of the Christmas and New Year holidays loomed over several European countries as the Omicron variant spreads rapidly.
UK health minister doesn't rule out new COVID curbs before Christmas
NBA postpones five games due to COVID-19 outbreak
EIA Inventory Recap
The EIA reported a total petroleum inventory DRAW of 10.0 for the week ending December 10, 2021 (vs a net BUILD of 4.60 last week).
Year-to-date cumulative changes in inventory for 2021 are DOWN by 153.40 million barrels (vs down 143.40 million last week).
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.