Author: Brynne Kelly 5/23/2021
Al Jazeera reported over the weekend that India’s capital New Delhi will start relaxing its strict coronavirus lockdown next week if new cases continue to drop. The South Asian country on Sunday reported 240,842 new infections nationwide over 24 hours – the lowest daily number in more than a month – and 3,741 deaths.
For weeks, India has battled a devastating second wave of COVID-19 that has crippled its health system and led to shortages of oxygen supplies. New Delhi, one of the worst-hit cities, went into lockdown on April 20, but new cases have declined in recent weeks and the test positivity rate has fallen under 2.5 percent, compared with 36 percent last month, Chief Minister Arvind Kejriwal said. “If cases continue to drop for a week, then from May 31 we will start the process of unlocking,” Kejriwal told a news conference.
Much hope has been pinned on a 2nd half of 2021 for demand recovery greater than supply increases/growth. Market participants have continued to roll their optimism forward, placing bets on when this pain point will be realized. Interestingly, open Interest at the CME in the front month WTI contract (July, 2021) was at the highest level seen for a front month contract 'pre-fund roll' this year (as of last Friday's close).
Month after month this year, we have seen outright prices rally against a backdrop of less than stellar spread performance. The front month calendar spread in WTI has been unable to expire and realize backwardation until the expiration of the June/July spread (red line below).
You can see from the chart above that even as front spreads have been expiring weak, the second month spread continues to remain optimistic, trading at a premium until it becomes the front spread on the board and gets overwhelmed by the roll (into next month futures). It's no different this time with the exception of the front spread signaling some strength and expiring above second month futures.
Weaker spreads can be a sign of overall market weakness, but aren't necessarily a sign that overall prices are too high. At some point, it might be reasonable to think that a lack of supply growth might manifest via a carry market (i.e., the future cost of production replacement is greater than the cost to produce today). It's what all markets are grappling with under an inflation narrative. If inflation isn't 'transitory', then at some point market structure is going to 'hold on to' barrels via inventory.
The next OPEC JTC meeting is scheduled for May 31, 2021 and will hopefully provide some insight as to whether the current market structure adequately represents market conditions. As a reminder, in May, OPEC+ production quotas rose a collective 350,000 b/d, with another 350,000 b/d increase scheduled for June and 441,000 b/d in July. At the same time, Saudi Arabia unwound its extra cut by 250,000 b/d in May, 350,000 b/d in June, and 400,000 b/d in July. This gradual increase schedule is one of the reasons for the shape of the spread curve. The spread curve reflects the intersection of the market's expectations for when supply is expected to grow less than demand (or, production cuts are reduced less than demand increases, aka the pain point).
One thing is for sure, crude oil prices and spreads have stalled lately. As with equities, participants are unsure: has a recovery been priced in already or are we on the verge of a super-cycle rally induced by the pandemic?
The lack of evidentiary proof of oil market tightness via strong calendar spread expiration as noted above is becoming a weight, hung around the neck of the overall market. At some point, the market needs a proof of concept.
Viewed through a lens of outright prices, we present the calendar 2022 through 2026 curve shift in the chart below.
We believe that any flattening of the curve will serve to entice hedgers, that have, to date, been less aggressive at hedging future exposure given the level of backwardation. As in, if the front of the market is strong, the motivation to hedge future production at lower levels is not very attractive. Should we see more aggressive selling in the back of the curve, the market might get spooked. This is because all of the selling-to-date in the front of the curve has been met with a lack of selling in the back. Something to keep an eye on.
While the market contemplates outright prices, there has been a lot of movement in product spreads. Like calendar spreads, inter-product spreads have been have been on the move, specifically those in gasoline markets. As the largest component of end-user demand, the structure of the gasoline market has been a key signal for oil prices.
Gasoline
According to Platt's, weekly gasoline imports into the US Atlantic Coast (USAC) declined slightly over the week ended May 16, after reaching a multiyear high the previous week (per the latest Kpler data due to the Colonial Pipeline outage). In the week ended May 16, imports of gasoline products totaled 5.59 million barrels, down from 5.68 million barrels the week prior. Regional imports are expected to reach 5.6 million barrels the week starting May 17, with 15 cargoes expected between May 17-23. The majority of cargoes sailing toward the USAC originated in Europe, with 3.57 million barrels expected the week starting May 17.
The Colonial outage has opened up the arbitrage for waterborne imports from Europe because the USAC is heavily dependent on the pipeline for supply. The outage caused a shift in refined products trade flows, as cargoes were fixed for import to fill a spot market shortage on the USAC, and as cargoes were shipped from the USGC to alleviate a surplus of stranded barrels. This dynamic has led to an incredible rally of the spread between USAC prices and those in Northwest Europe (NWE).
It's not just the front spread that is signaling strength as a result of the pipeline outage, but also the back of the market. There has been a significant rally in 'gasoline arbs' across the board this year (US vs NWE).
While this looks bullish on it's face, much of the rally in the gasoline 'arb' (between the US and NWE) can be attributed to renewable fuels blending requirements in the US.
The $10/bbl locational gasoline spread (left chart above) is met with a $10/bbl spread between ethanol and gasoline (right chart above). Every imported barrel of gasoline must either be physically blended with ethanol or an ethanol RIN credit must be acquired. So, we have a $10 'arb' met with a $10 ethanol to gasoline premium. This could be worrisome as the USAC grows more heavily dependent on imports to meet demand. The ethanol to gasoline premium could overwhelm the import incentive.
Gasoline Cracks
The current pain point in gasoline supplies lies on the US East Coast due to the pipeline outage and the fact that the USAC accounts for less than 5% of US refining capacity. Incremental demand must be met by imports (via Colonial or abroad). One measure of US demand for gasoline in the heavily populated USAC is the refinery crack between NYH gasoline and imported Brent prices.
Gasoline refining cracks versus Brent crude oil in the US have recovered much more than those in Europe (purple lines vs gold lines below). In fact, the front month RB crack is at levels not seen since 2015. It's no doubt that the Colonial Pipeline outage helped support margins in Europe as exports to the US picked up, however the real winner was a mythical US Atlantic coast refiner (since the USAC accounts for less than 5% of US refining capacity). Without barrels flowing into the USAC from Colonial, there was little to 'check' refining margins in the region except for imports.
It would be reasonable to assume that the strength in the front of the market due to short-term fundamental issues would not filter through to the back of the curve. However, looking at 10-month strip prices, we see the continued strength in USAC gasoline crack spreads relative to NWE (purple line vs gold line below).
This is a bit of underlying strength that cannot be ignored. Global gasoline arbs have moved enough to cover renewable costs across the curve. This suggests that US reliance on imports will continue.
USGC Versus USAC Gasoline
Expectedly, the spread between USGC and NYH gasoline has weakened in the front due to all the Colonial pipeline issues over the last month (April 1 = black line, May 21 = green line below). Meaning that the constrained region has moved to price at the cost to import supply in the short-term.
What's more interesting is the rally further out on the curve (in the September through December spread) where USGC prices are trading OVER NYH prices. This suggests that US demand is no longer on the margin towards the end of the year. In fact, it suggests a more normal spread based on the refinery outage load between regions. It's reasonable to price the relative refinery outages in the fall between the two based on their relative difference in refining capacity (USAC = 4.52%, USGC = 53.70%), meaning maintenance season in USGC is more impactful on overall US supply.
So, how has all of this affected US gasoline inventory levels?
Gasoline Inventory
Given the events of the past months, gasoline inventories have moved from being potentially problematic to potentially optimistic. This makes every inventory number going forward crucial, but there isn't much room for error.
As India presumes to 'turn the corner' with the pandemic, demand is showing signs of rebounding worldwide. It will be a welcome respite as its been a weight on markets. Spreads have paused as a result, but overall are still supportive. All eyes will now be on the OPEC+ meeting.
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EIA Inventory Statistics Recap
Weekly Changes
The EIA reported a total petroleum inventory DRAW of 4.90 million barrels for the week ending May 14, 2021 (vs a draw of 3.20 million barrels last week).
YTD Changes
Year-to-date cumulative changes in inventory for 2021 are DOWN by 40.60 million barrels (vs down 35.70 million last week).
Inventory Levels
Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years are actually - believe it or not, at the point of becoming too low should the pattern of withdrawals continue!
