Crude Oil: The Rise of Uncertainty
Author: Brynne Kelly 10/09/2022
Last week was eventful to say the least as far as energy is concerned. However, two major developments stand out and have raised uncertainty going forward. They are:
A huge blast early Saturday damaged the only bridge connecting annexed Crimea to the Russian Mainland
OPEC+'s made the unprecedented decision to approve production cuts of 2 million bpd on October 5.
Both events have heightened uncertainty not just about supply-side calculus, but also: how the involved parties may retaliate, what their response will be, and energy market implications going forward.
Prior to this week the market had 'settled' into a rhythm of prioritizing increasing risk factors that were at least somewhat known and definable. Most of those risks can be put into 3 categories: Economic, Geopolitical, and War Events.
Economically, the demand side risk has become increasingly defined by recession fears.
The Geopolitical risks (mainly the Biden/OPEC side-show), and Ukraine War events have been main drivers affecting supply replenishment potential.
The pendulum has swung back and forth depending on which risk factor took center stage on which day.
Weather is and continues to be the other wild card in all of this. First from hurricanes and then from winter weather. While hurricane season is not yet behind us, we have made it through the unknowns brought on by landfall of IAN last week. Fortunately, neither US production nor US refining capacity were impacted.
Enter the key developments over the past week. Together they threaten to exacerbate weather fears and the effect of potential frigid temperatures. What concerns us presently is the retaliation potential that could arise from either development given the disturbing lack of "cooler heads" lately.
Cooler Heads and Lack of Restraint
Restraint in war (geopolitical or real war) had been common practice until recently. Top of everyone's mind now however, is which event or combination of events may finally succeed in weakening that cooler head restraint we counted on. This past week's events may have given us the answers to that question.
The OPEC+ cutback and the likely missile attack on the Russian bridge are viewed as possible disruptors of whatever balance we had established these past few months. That rhythm we had settled into is all but gone, and the restraint may be gone with it.
Before we move to the main event(s) it is also worth mentioning: it's a light start to the week in the US with the Columbus Day semi-holiday, but the Asia-Pacific calendar has some demand side info. China is returning from a week of holidays and has issued it's first batch of crude oil import quotas for 2023, mainly to independent refiners.
Moving on to the the Ukraine War and OPEC+ news.
Blast on Crimean Bridge
Over the weekend, there was a blast that damaged the Kerch Strait Bridge (otherwise known as the Crimean Bridge), a 12-mile piece of critical infrastructure between the Russian Mainland and the annexed Crimea Peninsula completed in 2018. Since the Ukraine invasion began, it has been identified as one of Russia's biggest vulnerabilities in the region.
Why? The Crimean Bridge is the main artery for human and material movement between the Russian Mainland and the annexed Crimean Peninsula. It is so vital that Russia was more than happy to invest the more than $3.6 billion in the project because it is a critical piece in retaining Crimea as a Russian physical possession.
Any impediment to traffic on the bridge could also affect Russia’s ability to wage war in southern Ukraine, where Ukraine’s forces have been fighting an increasingly effective counteroffensive.
The blast occurred early Saturday morning. By Sunday October 10, it was announced that cars were able to cross on the remaining one lane and trains would also resume later that evening. The bridge may only be damaged, but it is said that Putin's ego is dented. "The situation is manageable - it's unpleasant, but not fatal," Crimea's Russian governor, Sergei Aksyonov, told reporters. "Of course, emotions have been triggered and there is a healthy desire to seek revenge."
According to the head of the national Investigative Committee, Aleksandr Bastrykin, the attack was organized by the Ukrainian security services, which were “aided” by some Russian and foreign nationals.
Kiev hasn't officially taken responsibility for the Kerch incident, although it commemorated the explosion within hours with a new postage stamp and Zelenskiy's aide, Mikhail Podoliak, posted on Twitter saying the explosion is “the beginning.”
The implied significance of this lies not just on who is responsible, but also in the tacit uncertainty it creates. The present damage from the bombing is known, but now the future is more uncertain. Will this escalate war activities further and affect oil prices? This is what the energy markets will likely be focused on: The potential retaliatory response to this attack.
One of the great paradoxes of war is that once you have destroyed something, you can no longer use it as leverage against your opponent, because it already happened. Leaving it to linger in the back of the mind of the opponent. It may provoke or weaken an opponent, but the potential for escalation is now larger.
The 45th Meeting of the Joint Ministerial Monitoring Committee (JMMC) and the 33rd OPEC and non-OPEC Ministerial Meeting took place in person at the OPEC Secretariat in Vienna, Austria, on Wednesday, 5 October 2022. The most notable outcome from this meeting was the decision to:
Adjust downward the overall production by 2 mbd from the August 2022 required production levels, starting November 2022 for OPEC and non-OPEC Participating Countries as per the attached table.
On Sunday October 9, the Kremlin:
Praised the 'balanced and thoughtful' work of OPEC+ for agreeing to production cuts that would successfully counter the "mayhem" shown by the United States in global energy markets. This has further strained already tense relations between President Joe Biden's White House and Saudi Arabia's royal family.
Saudi Energy Minister Abdulaziz bin Salman did say the real supply cut would be about 1 million to 1.1 million bpd. Saudi Arabia's share of the cut is about 500,000 bpd.
Following the OPEC+ decision, Goldman Sachs raised its 2022 Brent forecast to $104 per barrel from $99, and its 2023 forecast to $110 from $108 (hardly significant especially in context of previous GS projections from lesser war activity), but it did serve to curb downside price action.
The White House said it would consult with Congress on additional paths to reduce OPEC and its allies' control over energy prices in an apparent reference to legislation that could expose members of the group to antitrust lawsuits. Retaliatory rhetoric for this event is already starting to gain momentum.
The US Senate replied with an intention to amend the National Defense Authorization Act with a retaliatory clause:
"We are looking at all the legislative tools to best deal with this appalling and deeply cynical action, including the No Oil Producing and Exporting Cartels (NOPEC) bill," Senate Majority Leader Chuck Schumer said in that statement. Senator Chuck Grassley, a Republican who co-sponsored NOPEC, said he intends to attach the measure as an amendment to the forthcoming National Defense Authorization Act.
Whatever your opinion on sanctions, that should be your opinion on NOPEC which is effectively more sanctioning. On a typical day, political jawboning is merely for the home voting crowd. But in this new environment, it has potentially far-reaching effects and OPEC will almost certainly react. They have not been quiet lately and will likely not hesitate to levy their own criticisms.
For example, on Sunday the Kremlin out of Russia stated that "The US is trying to manipulate with its oil reserves. Such a game won't yield any good outcome." This is not your normal OPEC acting up, this is them willfully challenging Western superiority with some not so silent partners in their corner. Truly an OPEC "plus"
SPR Refill Update
Separately, on October 6 White House energy advisor Amos Hochstein said that the United States is still planning on replenishing the nation’s crude oil emergency stockpiles when the price of oil goes down. The White House energy advisor’s comments come as a million barrels of crude oil continue to leave the nation’s Strategic Petroleum Reserves every day.
It certainly doesn't feel like cooler heads are as 'in charge' as we would like to believe they are. This appears to be outside the bounds of normal OPEC push-back.
Tensions are ratcheting up and fears are increasing that the war may escalate from here. As a result there is less certainty in the next market move.
While the OPEC news may seem to have been a primary driver of the rebound in prices last week, there had been significant buying near the $80 level in WTI recently before these events. It is possible Oil was due anyway given the deteriorating supply fundamentals in the last few months after the war was factored in.
Specifically, we are experiencing a tighter overall supply/demand balance now versus where we were at when the the Russia/Ukraine war began. Oil prices after the announced OPEC+ cuts are still nowhere near the $130 level seen when Russia first attacked Ukraine. Make of that what you will, but lower prices have done little to replenish supply or deteriorating fundamentals on . Oil prices have been dampened by demand reduction, not supply increases at all.
This dampening of oil prices has come at a cost though. That cost is the depletion of US SPR reserves which is not actual 'production'. This form of 'supply' has limits. In fact, the path we are on - one of using SPR as a replacement for production growth - could develop into a much larger problem if OPEC+ doesn't give in and increase supply.
Ironically, we may need a much bigger recession to get OPEC+ to change course if nothing else changes.
The SPR Cost and Effect
To date in 2022, the US has released a total of 177.4 million barrels from the SPR through September 30. Since the announcement of President Biden's 'one million barrels per day for six months' SPR release on March 31, 2022 the US has released 149.2 million barrels (out of a total commitment of 180 million barrels) from it's reserves. That leaves 30 million barrels still to be released.
It appears as though our negotiating position with OPEC+ has deteriorated. We spent SPR oil ostensibly to give us time to 'fix' the 'high oil price' problem. While some demand has been squashed by recessionary forces brought on by inflation, issues continue to arise that threaten to outpace this. It is becoming clear in the face of the recent OPEC+ tone and actions that our negotiating position is reduced even while our SPR is drained.
One month calendar spreads in WTI have been unable to recover the peak highs seen at the outset of the Russia/Ukraine war. Ostensibly because this is no longer viewed as a short-term event. In fact, recent events like those noted above suggest that the cumulative impacts could have an even bigger impact 3 months from now than they do today. Therefore, the near future is not being as discounted to the front-month contract as it had been.
The market realizes that things are not going to turn on a dime, unless the war ends. And even if it ended tomorrow, we still have to replenish. So where can we see these potential pain points manifest? For that we have to do some more detective chart work. Below are three charts for review: Flat price, one-month spreads, and seasonal butterflies.
WTI Flat Price is off its lows, but nothing crazy...
The first two charts (above and below) seem almost normal. Flat price and one-month spreads aren't manifesting much of a story. Sure, we have bounced off of recent lows, but nothing of significance to write home about.
Similarly, one month spreads are a little perky, but nothing crazy yet...
However, when looking at seasonal spreads it's clear that this market is still all about winter weather. In other words, seasonal risk continues to be front-loaded in a big way. This is evident in the WTI Dec/June/Dec butterfly as an example (lime green line below = prompt WTI Dec/June/Dec butterfly) which continues to challenge recent highs.
But when you look at Seasonal butterflies, the problem is evident...
Seasonal Pain Point Risk
THIS chart above represents an underlying pain point in the market. It is also a contributing factor to the 'perkiness' in one-month calendar spreads. This seasonal problem is not going away until we are in a surplus - driven by either a warmer than normal winter or a rate-induced bigger recession.
One reasonable way to play a market like this (if you don't want to go long at new butterfly spread highs) is to buy the Dec/June CSO put. You will pay through the nose for it, but should the market fail you will be handsomely rewarded. OR, one could buy the CSO call above and hedge by selling the spread outright.
However, if the seasonal spread is going to fail, it is likely going to fail more reliably in serial fashion one calendar spread at a time. The risk/reward on a 6 month spread is probably more than the some of its one month component spreads Why? Exit risk.
On a monthly basis we get the rolls giving some liquidity (usually at least) even in a panic. The real point here is the fundamental product fear/problem is not going away until the supply side is handled or the weather fear subsides. And even then, its back to Gasoline season spreads most likely Until the supply side seems on its way to being handled, the convenience spread may (or may not) trump the risk of not having the product handy.
For a couple months we had "enjoyed" what almost passes for normalcy having handicapped supply risks according to Geopolitical, Economic, and War type effects. We survived Biden/OPEC 1.0, navigated the recessionary effect of Fed rate hikes, and stomached Ukrainian War developments on the whole. Last week however our "grind" was ended and tables turned over once again.
Uncertainty was injected into things with Geopolitical risks as manifested with OPEC+ push back. Second, the War took a very potentially ugly turn with Russia viewing the bridge attack as a war escalation.
The events are a big enough source of price uncertainty. That should be enough. But these are not one-and-done events. These events increase uncertainty. They do not resolve open ends at all. They come with implied retaliation and escalation by the other sides in each occurrence.
The uncertainty is growing again as to the reactions of players involved. That pause in volatility we had for a month or two may be over as round two of problems start and impede our ability to secure supplies again.
While SPR releases have dampened oil prices, they have not dampened refining margins.
Distillate cracks make new highs....
Additionally, the combination of SPR releases on US oil markets and supply chain disruptions in Europe caused by the war have weakened WTI relative to Brent.
WTI/Brent under pressure
EIA Inventory Recap - Week Ending 10/09/2022
The EIA reported a total petroleum inventory DRAW of 10.10 for the week ending September 30, 2022. Commercial inventories however, posted a small weekly DRAW of (0.20) while SPR inventories DREW by (4.60).
YTD total petroleum EIA inventory changes show a DRAW of (191.40) through the week ending September 30, 2022. The bulk of this is due to drawdowns in SPR inventories.
Gasoline and Distillate inventory levels are now both decidedly below their 5-year average for this time of year.