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A Vulnerable Recovery In Oil Prices

Author: Brynne Kelly

In their meeting on Saturday afternoon, OPEC and its partners agreed to a one-month extension of the May-June supply through the end of July. Going forward, the OPEC monitoring committee will now meet every month to assess compliance as well as the supply/demand environment through December. They seem committed to compliance with agreed cuts by country and even stated that any member that fails to meet their designated cuts in May or June will need to make them up during July-September. The only exception is Mexico, whose cuts are allowed to expire the end of June.

For reference, the original OPEC+ supply cut agreement by country is shown below with reference to the above-noted extension:

Iraq, Nigeria and Kazakhstan have been called out as the largest violators of the supply cut agreement, and therefore will have to increase their cuts during the July through September time frame. In total, the pledged cuts from these 3 countries in the agreement equal 1.868 million barrels per day.

The obvious implication here is that even if the total supply cuts are reduced by 2 million bpd come August, they will be partially offset by 'make-up' cuts by those that didn't reach compliance in May through July. Accordingly, the market is more than willing to entertain the thought that markets could move towards backwardation in the short-term, or at the very least for the balance of 2020 relative to future years.

In anticipation of this highly-telegraphed extension, all calendar strips moved above $40 last Friday (including the balance of 2020 strip which closed at $40.038). Prior to this year, the last time a 1-year calendar strip entertained the $40 level was from above when the 2018 strip briefly dipped to $40 at the beginning of 2016!

But, now that the front of the market regained the $40 level, the next logical step to sustain any outright price rally would be a move into backwardation to validate market strength. This would also facilitate the draw-down of excess inventories. Betting on backwardation at this early stage has never been more perilous, primarily due to inventory levels. Backwardation usually occurs as a violent response to an unexpected supply shock or after a prolonged period of inventory draws. The unexpected 'supply shock' being anticipated by the market currently relies heavily on demand for refinery inputs in excess of current production due to forced production cuts. As a result of this expectation, calendar spreads have recovered significantly (as seen below), but are vulnerable of getting ahead of themselves.

For now, the market is willing to embrace the manufactured supply tightness created by production cuts and push the oversupply issue further out on the curve to a time when production is fully restored. There is optimism that refinery utilization rates will steadily increase as lock-down restrictions are eased and travel resumes faster than production is restored to pre-pandemic levels.

To understand the magnitude of the vulnerability, we look at the reduction in refiner inputs and outputs relative to weekly changes in US inventory levels. First up we compare the amount of crude oil input to refiners (black line) vs the output of petroleum products (blue line) and the weekly changes in US petroleum product inventories (orange bars), excluding propane/propylene.

The continued build in total product inventories, despite a reduction in refiner output, shows how significant the demand loss was. It would be reasonable to assume that increases in refiner inputs/utilization would be led by an increase in product demand. However, with product inventories at record levels it's also intuitive to expect that a return to normal demand could initially be offset by inventory before the balance becomes 'tight'.

Drilling down further, we look at inventories of gasoline, distillate and kerosene-type jet fuel separately (black line in following 3 charts) vs refiner outputs of each (colored lines in next 3 charts).

Of the three charts above, the most significant reductions in refinery output are seen in gasoline and jet fuel (blue and pink lines above). The quick reaction to economic conditions kept gasoline and kerosene-type jet fuel inventories from reaching all-time highs. Distillate production (orange line above) stayed fairly constant and therefore absent demand led to massive increases in inventory levels.

It's no surprise that as a result, gasoline crack spreads (red line below) not only recovered, but finally surpassed distillate cracks (blue line) to WTI for the rest of the summer (July-September).

Before you get ahead of yourself though, the optimism in summer gasoline cracks is more muted in the winter strips (Nov-Mar strips).

This is a tough environment for significant increases in WTI prices without significant increases in gasoline prices. Absent the latter, net refining margins (expressed via the 3:2:1 crack spread) will get crushed should oil prices stage an over enthusiastic rally.

In the short-term, the integrated oil majors could sustain a compression of 3:2:1 refining margins as long as they benefit from higher prices for the oil they produce. Especially if higher prices unlock the 'system' as a whole, meaning that there are no constraints in moving oil from producer to consumer - from the wellhead to the pipelines to refiners to exports. At the end of March/beginning of April companies were aggressively protecting system capacity in the face of an unknown future. Production cuts were uncertain, recovery was uncertain. Some of these uncertainties have been removed (via production cuts and some clarity on the re-opening of the economy).

As a result, we expect outright oil prices to have some 'room' to the upside regardless of spreads in the short-term. In fact, we expect an attempt at backwardation in the front of the market even if refining cracks are weak. However, without evidence of inventory draws or real product demand this move will be very short-lived.

A quick note regarding tropical storm Cristobal. As of June 7, the BSEE (Bureau of Safety and Environmental Enforcement) reported the following:

Inventory Recap

US inventory levels by PADD vs total storage capacity by PADD:

Weekly Stats

The EIA reported a total inventory BUILD of 14.7 million barrels for the week ending May 29, 2020. Once again, Cushing inventories posted a draw and the US Strategic Petroleum Reserve posted a build (movement FROM Cushing TO the US Gulf Coast).

Year-to-date, this bring us to a Total Inventory BUILD of a record 155.50 million barrels. This surpasses all previous year-to-date builds in total by a long-shot.

Commercial Inventory levels (ex-SPR) are shown below, compared to prior year levels for the same week ending as well as against total storage capacity. This week's 10 million barrel build in distillate pushed inventory levels to record highs.


Lee Taylor - Technical Levels


Resistance: 45.18 / 45.98 / 48.40

Support: 40.53 / 39.63 / 38.65

The Brent market also ventured into the gap area left by Corona virus back in March. The August Brent contract seems to be a little overbought on the relative strength index so keep an eye on that. Aug/Sep Brent filled its gaps several weeks ago, but it is facing major resistance at +.14. Keep and eye on QU as its overbought and should see a pullback to -.28 before another move up.


Resistance: 41.05 / 41.88/ 43.94

Support: 38.18/ 37.33 / 35.18

The energy markets seemed to take its lead from the US equities market, although it did have a few things going on of its own accord. The impending OPEC meeting, plus storm Cristobal, gave enough push for WTI to venture into the gap area which had been left back in March. There are two numbers to look at, 41.05 (July chart) or 41.88 (continuation chart). That will be main resistance levels to look at this week. We should see more buying come in upon filling these gaps.


Resistance: 1.2230 / 1.2348 / 1.3029

Support: 1.1517 / 1.1171 / 1.0999

July RBOB still seems to be overdone to the upside technically. It did hold 1.0262 early last week so it was able to stabilize and drift higher. I think RBOB will drift sideways this week because it is overbought. Focus on 1.2348, as it is the bottom of the gap on the continuation chart. Sep/Oct RBOB has traded well technically and this week will be an important one for the spread to continue its upward move if it can hold 800. If it settles below, look for a move quickly back to 714.


Resistance: 1.1384 / 1.1884 / 1.2300

Support: 1.1159 / 11068 / 1.0611

July Heating Oil is beginning to follow the energy complex. It still has a way to even test the gaps left above but it had been so oversold during March and April. Any recovery now is a welcoming sign. Look for July/August to hold -345 to make a move towards the bottom of the gap, however, if it fails, a move back to the -400 level is a sure bet. We repeat this recommendation as this is what transpired since early May.

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