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Crude Oil: American Skepticism, Chinese Optimism and the SPR Question

Author: Brynne Kelly 1/22/2023


SO FAR 2023 oil markets have been trapped between a rock and a hard place. The inclination to put the narratives of the past few years is strong and the Chinese Lunar New Year has furnished markets with something positive to pivot towards. Something to build upon. At the same time, economic recovery is uncertain and increasingly domestic in nature based on differences in government intervention policies.

In the US, the Federal Reserve is trying to exit their stimulus-friendly Covid policies without causing a market sell-off. Some believe this is possible, others believe this will result in a recessionary environment.

Two Macro Economic Drivers

As a result, oil prices have been caught between AMERICAN SKEPTICISM and Chinese OPTIMISM.

These are the two major economic drivers in opposition: Restoring China's demand to pre-pandemic levels, versus fighting G7 recession pain brought on by aggressive rate hikes these past months. Caught in the crosshairs is crude oil. And while these are separated opposing forces, they can also effect each other in a reactionary way.

Too much demand growth from China could push oil markets higher which in turn would necessitate more inflation-fighting monetary policy from the West. US Fed's Waller said as much last week when he stated "If inflation 'pops back up', rate hikes will not stop".

Separately, last week saw weak U.S. consumer data rekindling global recession worries. So the Fed is leaning towards easing off the economic brakes for sure now, but only if China doesn't get too hot too quickly.

On the more optimistic side, we have the Chinese Lunar New Year and the easing of Covid restrictions auguring in new optimism Ahead of the New Year celebrations, there are brightening economic prospects for China and thus expectations of a boost to fuel demand in the world's second-biggest economy.

Regarding Covid, or more specifically China's attitude towards it now-- according to the South China Morning Post: China is unlikely to see a second wave of Covid cases any time soon because most people have already been infected. At~80% already infected there is little possibility of large-scale epidemic rebound due to 'herd immunity' they believe. Their Zero-Covid policy is dead. Therefore, for all intents and purposes, unless a more deadly strain of the disease emerges, the Oil market is over it.

This push/pull between these two narratives can be seen in the oil market structure itself now.

WTI: Recession Weighs on Front of Market, Re-bound in Demand Emerges in the Back of the Market...

Both OPEC and the IEA weighed-in last week with the release of their monthly oil reports. Highlights from each can be found below. We note both organizations continue to emphasize China's key role in their forecasts. These will either be born out or not, but based on the complex's reaction post the China reopening news, it seems the markets believe they will. Here are the salient points from each.

OPEC Monthly Oil Market Report Highlights:

  • OPEC sees oil demand rising in China by 500k bpd this year.

  • China's larger oil import quotas are a good sign.

  • OPEC are also eyeing potential for a slowdown in Europe, US.

  • OPEC has to balance a growing Asia against a slowing West.

  • OPEC+ will do whatever it takes to keep the oil market stable.

  • OPEC now has greater spare production capacity.

  • OPEC are waiting to see what happens after China's New Year holiday.

  • OPEC are cautiously optimistic about global economy.

IEA World Energy Outlook:

  • Oil Market Faces Bigger Surplus Even As China Reopens

  • Global Oil Demand to Add 1.9M B/D to Record 101.7M In '23

  • Raises 2023 Oil Demand Growth Estimate by 80K B/D

  • Lowers 2022 Oil Demand Growth Est. By 70K B/D to 2.2M B/D

  • China to Account for Almost Half of 2023's Oil Demand Gain

  • Global Oil Supply Grew 4.7M B/D in 2022, Led By OPEC+

  • Global Oil Supply Growth to Slow To 1M B/D In 2023

  • Global Oil Supply to Grow To Record 101.1M B/D In 2023

  • Non-OPEC+ Oil Supply to Grow 1.9M B/D This Year

  • OPEC+ '23 Oil Supply to fall 870K B/D on Russian Cutback

Neither narratives are likely to come to 100% fruition in the short-term. But it is becoming apparent that Oil is now fully focused on China demand rebounding while continuing to discount the good-news/ bad-news risks of US economic data and Fed behavior. That pretty much covers it for what is known and how that is currently being handicapped.

Beneath the surface however is the SPR refill narrative. Traders now seek to handicap the effect of how the refilling of it will it be, and *if* it will be a refilled to anywhere near what it was before. This is something worth revisiting now. Better than waiting for the narrative to start taking hold again on the heels of some cold snap or refinery fire.

The SPR Question

The 'refill' of the Strategic Petroleum Reserve (SPR) is an open issue that has sparked a lot of debate. If the SPR can be viewed as a policy insuring against war or calamity; then last year the US definitely made a claim against it to keep a lid on prices after our post-covid re-opening outpaced production recovery. Will 'premiums' go up as a result?

Analogies aside there are several key questions being asked all assuming there will be a refill in the not too distant future. We would add: Does our government even feel it needs to replace that which we have withdrawn? And if they do, what is their price sensitivity (limit to buy below)? If they do not, what is their pain point (buy-stop above)?

Let's take a look at the administration's track record since this draw down started.

The Constantly Moving Refill Price

When President Biden first pledged 1 million barrels a day of oil from the SPR last year to combat high oil prices, he initially stated that reserves would be repurchased below $100. Once the market dipped below $100, however, there was no buying around. Ok, to be fair, he didn't say how much below $100 it would be. Instead, the DOE continued releasing barrels from the SPR.

In September Biden again commented on the SPR buy back price calling at "around $80 per barrel". After $80 came and went, the price to buy back came back between $67 and $72 according to the administration.

Yet, in early January 2023 - the US DOE's first attempt to replenish stockpiles - the Biden administration stated that it was delaying the replenishment of the nation’s emergency oil reserve after deciding the offers it received were either too expensive or didn’t meet the required specifications, according to people familiar with the matter.

This was our first taste of their sense of urgency. The message: We don't feel an urgency to replenish stockpiles at these price levels. This lead traders to wonder "If you don't buy when the market comes your way, are you ever going to buy?"

The answer isn't so simple. It requires us to understand the 'lessons' the DOE has learned since 2020.

Cure Low Supply by Crushing Demand

Simply put, they now understand the 'optionality' or 'levers' they can pull BESIDES owning reserves. The pandemic taught them much about the control they have over the demand-side of the equation. This may seem hard to believe, but there is precedent that this writer remembers very clearly from the late 1990's power de-regulation speculative plays that disappointed many bulls then. During this time, the government got smarter, more arrogant, and lucky in their "risk management", if you can call it that. Here's what happened then.

The Lessons of History

In the late 1990's when electricity markets were de-regulating, wholesale electricity futures went from long-historical highs of around $30/MWhr to $3,000+/MWhr as previously regulated utilities scrambled to meet customer demand.

What the utilities learned from this debacle was to better control the demand-side options where they could. And it turns out they could control demand a lot. Suddenly, utilities were more astute when it came to 'curtailing' demand rather than 'supplying' demand. They began to focus on 'Demand Response' as an asset.

They would offer slight discounts on their rates in return for the ability to cut off supply when prices were high. Forcing consumers to place a value on 24/7 access to electricity. Some consumers gambled and accepted lower rates going forward in return for the chance of having no electricity when supply was tight/prices were high. This trade-off is still wrestling with valuation today.

That was pretty extreme. But power markets can do that to a player. And it worked. Fast forward to present day oil, which in our opinion is easier to "manage" risk in and has many more options in which to do that.

Oil Gets the Power Treatment

In the past 2 years in the petroleum complex rather than suppliers feeling all the heat, the demand side (consumers) began to feel the heat too as regulations were used as a means of zeroing out demand. They figured out that you cold offset supply shortfalls by using demand side throttling. Who said the gov't doesn't understand supply/demand economics?! They are pretty good at it when the risk is borne by the tax payer... but we digress.

For the first time in this most recent cycle, neither the SPR nor commercial inventories were seen as the end-all, be-all for balancing the supply/demand equation. Lack of investment, lack of reserves, lack of infrastructure are now all events that aren't exclusively solved by supply. The Covid aftermath gave them a dry run on how to solve the equation by regulating demand.

Because, after all, the Fed can't 'print' oil, but they can make us use less of it. By simply making it unavailable. And making the reason it is unavailable politically acceptable to the consumer.

Lower Demand by Not Raising Commodity Supply

The crazy thing is that typically, when there is a large position or bet in the market, it can usually sniff that out and get ahead of it. The 'large position' in this case is the perceived SPR short. This 'short' exists if you believe that there is an upper price level that will cause the DOE to panic and cover.

Due to the demand-side levers at their disposal described above, this 'price risk' is less straight-forward. The market is trying to figure out if it can 'get ahead' of future purchases given the reduced SPR levels. It might not be able to so easily.

Here's the secret part. The pain trade is felt by the consumer, not the SPR "risk manager". If oil goes to $150 that's life. You get less oil, more expensive oil or a combination of the two. And you get higher tax rates on the back end to pay for it. Finally, if it gets really bad, you get a stimulus check. This was all proven to work last year. The election results basically confirmed it was not a failure. And oil doesn't vote.

The lesson the Fed learned is clear: They can use their tools to manage demand, manage price, and manage out of pocket expense for consumers in a jam. Government also has a habit of taking successful emergency measures and making them permanent features of their risk management. Once something works, they will do it again and again. Almost every standing permanent facility the Fed uses has roots in an emergency measure at one time. You can add Oil to that as well now. And they did it seemingly without the cooperation of Big Oil.

The supply-side is no longer the only option. Regulations (emergency or otherwise) can change the slope of the demand line in an instant. Climate goals can now intertwine with regulation with more immediate impacts. Examples include Electric Vehicle goals, carbon regulations and global movements of oil.

Lower Demand by Using Financial Means

In fact, if prices WERE to surge above $100 again, we know that the Federal Reserve is standing ready to 'fight inflation' with more interest rate hikes. Their ability to manage the demand side of the equation for short to medium periods of time has only emboldened them to kick the can down the road. If anything, the DOE would probably be sellers of more reserves if oil were to make new highs, rather than act like a traditional short futures player that is stopped out due to margin. of course they could be buyers up there, but you would nit know it. For that would be economic suicide for. And...lets not forget about the ability to short paper oil for periods of time that are not delivered.

So, what about the point at which the short player cries uncle. The Gov't *is* short right?

Where are The Stop-Loss Levels?

The pain trade higher is a price we do not know. We assume that price is actually above the average short price. We assume that with their newly tested ability to throttle demand they will do everything in their power to keep it down if things get hairy again. They'd do it as was done in power in the 90's, with rationing, and optionality used to tradeoff risk. They'd also opt for rolling power-outs where possible.

They'd probably sell more if need be. And if that all was a problem, they'd paper the commodity risk over by using stimulus to "fight inflation", tell people to buy electric space heaters (regardless of how unhelpful that was) and manage the markets using rehypothecation if need be.

Meanwhile, the Fed would be raising rates again. if that all failed, and we weren't at war for our very existence, then they might panic buy.... They may not be able to print oil, but they can certainly print money for half the world to buy oil.

The Stop loss price certainly exists, but imagine what would happen if they publicly admitted buying strength. They'd invade Venezuela first.. Ok maybe not, but they would definitely consider nationalizing oil companies "temporarily" or (heaven forbid) actually start new drilling.

Is this bearish. No. That depends on your price. In any market, if it senses a weak short it will rotate higher to fish for that stop price. And if the market rallies, expect the news to start banging the drum on the SPR refill. But, unless they've exhausted their new found "tools" don't expect panic Fed buying of Oil, unless of course an election is coming up maybe and politicians want to signal they are responsible again for the polls.

Will They Buy the Dip?

That leaves us to observe what they will do with market weakness. Will they step in and buy materially below $70? Or will that be another false floor? Bottom line, the federal government does not view the level of SPR inventory as dire as the market does. They view it as a financial risk, not a commodity risk. One which they can paper over with stimulus checks or curtailment of demand. And they feel like with their new ESG energy policies, they are long the Oil put. We're not saying they are right. But we bet that is how they feel now.

The 'Claim' Against SPR Inventory

Distinct from the SPR drawdown is US commercial crude oil inventories (blue line above). The inventory used to back the day-to-day operational needs of the US complex are in recovery. They are now 'backed' by less 'insurance' but, aren't worrisome in and of themselves.

WTI Calendar Strip Futures

Rising prices have come under pressure despite war, despite global supply issues and despite a recovery in equities. The forces that kept prices at bay still exist.

Crude Spreads Trying to Time Recession vs Optimism

Still, despite the muddied waters that fed intervention has brought to oil markets, calendar spreads are trying to 'time' a demand recovery. Market structure can exist independent of 'price levels'. Even though the front few spreads in oil are trading in contango, deferred spreads are still pricing in a recovery.

WTI June/December Spread Remains in Backwardation

This signifies that the market still believes that medium-term supply issues can get ahead of Fed policy. That feels like a fair conclusion, independent of price.

Price Range Trap and Bottom Line

As a result of the above dynamic, WTI futures this year have been trapped in a $10 range. So far. But the year is young. On the current path it seems like the upside has room now. Event risk may be bearish on the financial side if Powell starts getting nervous. Oil feels like a tech stock these last few weeks, and in many ways has underperformed its other commodity brethren (Copper, Iron, Silver.. even Gold) in the bounce since late October. Maybe it is due for a nice rally.

But knowing what we know now about demand-side levers we view the charts above and below below through a slightly different lens.

WTI Futures Rangebound in 2023

Oil should go up and probably will given the two main known drivers in the market now.

  1. China is almost certainly reopening.

  2. Secondly, unless China's reopening accelerates too fast, the Fed is poised to reduce its rate hike regime taking its foot off western demand.

The SPR refill question is the thing many are focused on now trying to handicap DOE behavior in their pursuing a refill. What we do not know but believe to be true is given the success by their measures of their newfound ability to control demand in a pinch means they will be less likely to buy the dips aggressively, and more likely to let losses run against them while utilizing their new levers.

Finally, like any freshman trader who hits a homerun, the DOE will get greedy, miss their opportunity to buy on the lows, and get punished for it higher. But they won't get fired for mismanaging risk. Therefore, we think it best to not use the SPR refill as a reason to do anything and trade as we normally do. If we're long and the market starts to run, we fully expect the SPR noise to start getting louder once again. But we will not let that get us too excited. It is business as usual for oil traders.


EIA Inventory Recap - Week Ending 1/13/2023

Weekly Changes

The EIA reported a total petroleum inventory BUILD of 10.20 for the week ending January 13, 2023. Of this, Commercial inventories posted a weekly BUILD of 8.60 while SPR inventories were flat on the week.

YTD Changes

YTD total petroleum EIA inventory changes show a BUILD of 31.20 through the week ending January 13, 2023.

Inventory Levels

Both Distillate and Gasoline inventory levels hover at the low end of their 5-year average for this time of year while US Commercial Crude inventories slide below its 5-year average.


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