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Event Risk is Back, The Return of Cushing, Supply and Demand Out of Sync, Beware the Contango


Author: Brynne Kelly 1/29/2023


We have a blockbuster week as far as scheduled events go which includes: the FOMC meeting, a key OPEC gathering (February 1), and a flurry of heavyweight earnings reports. The Federal Reserve is largely anticipated to fire off a 25-point rate hike to take the federal funds rate between 4.50% and 4.75%. The consensus view is that the Fed will continue with its tightening policy and signal more rate hikes are still in the mix. Assume if they hike 50 bps, that would likely cause a dip in all risk assets including Oil.


Investors are monitoring the impact of EU sanctions on Russia’s seaborne shipments of petroleum products early next month, which some warn could be more disruptive than past restrictions. Analysts at JP Morgan Chase & Co in a note Friday said that the profit margin for turning oil into products such as diesel is soaring and supportive of further crude demand.


The economic backdrop has kept WTI futures in a tight range the last few weeks between $79-$82 as traders try to handicap which narrative will dominate going forward. Basically, the call on flat price at the moment isn't really getting any traction.


Short-Dated WTI Futures Remain in a Tight Range...

Despite the slight weakness in the front of the market, the structure remains predominantly in backwardation, suggesting the risk premium still exists past the immediate time horizon.


SPR Drawdowns: Large Exports, Tiny Imports

But, beneath the economic narratives are some interesting facts in oil markets. Specifically, US oil exports are on their highs, net imports are at their lows and Cushing inventory builds have begun and could accelerate.


Weekly US EIA Crude Oil Exports Soar...


US exports had grown in tandem with the unprecedented release of Strategic Petroleum Reserves corroborating other data that the Oil drawn down was largely not for domestic consumption during the last few months. This also served to tamp down global oil prices as supply met demand in the EU. Since global oil prices are linked, lower global prices reflexively instigated local prices eventually.


The second most direct impact of the SPR release can be seen via US Net crude oil imports. As US exports grew, US net imports have fallen to their lowest level for this time of year EVER in history.


US Net Imports of Crude Oil Fall to All-Time Low in January...


That SPR Oil Was for European Use

Large exports and low imports in combination indicate the usual sell 10 and buy 9 flows of oil in and out of the US was not happening and is consistent with low domestic energy use. Demand isn't coming from the US lately.


US oil demand is thus not growing, which reduces the import demand even while the exports are rising. Taken together this places US producers squarely and increasingly as net incremental suppliers to world markets.


Cushing Starts to Refill

While the US was busy supplying oil to the world (Not you Russia!), local inventories at Cushing had remained below their historical norms. But, using the latest EIA inventory report, we are finally starting to see builds, moving Cushing inventory off worrisome lows.


Weekly EIA Cushing Inventories: Off the lows steeply, but a-ways to go yet...

Last week we discussed US SPR inventory levels and potential future actions in the report titled "American Skepticism, Chinese Optimism and the SPR Question". This week we turn our attention to commercial crude oil inventory to get a better view of the whole picture.


US EIA Commercial Crude Oil Inventory by Year...


No Commercial Sympathy Action Yet

What was noticed: the build at Cushing is not translating to higher commercial inventory yet

Despite Cushing inventory rising, Commercial inventory changes have been fairly flat. It remains to be seen if barrels continue to pile up at Cushing and spill over or if exports will continue to keep things flat on the commercial side.


WTI calendar spreads moved into 'storage' contango the end of last year (red line below) and have remained so as far out as the May/June spread (green line below). This is consistent with builds at Cushing.


WTI 1-Month Calendar Spreads Encourage Storage...

The regional dynamic in the US is beginning to filter down to global oil spreads, such as WTI and Brent. With supply fears moving to the back burner this year, the relative value of global oil benchmarks are taking center stage.


WTI/Brent Spread


The single most widely traded spread in the global oil complex is the WTI/Brent spread and the change in the relationships between these two global marker crude oils has implications to both crude oil and refined products on a global basis.


However, crude oil, long seen as a global fungible commodity is now becoming more regional and the disparate nature of global recoveries/recessions is being reflected in this spread.


If the world were uniformly slowing down, you would be more apt to see Brent decrease in value relative to WTI. (Brent is a high beta version of WTI). We are not seeing that in the near-term.


The US is in an interest rate hiking cycle, actively trying to keep energy prices lower while other parts of the world are actively subsidizing consumers with payouts to offset higher energy costs.


Perhaps as a result of the increased split in global economies, we are now witnessing China re-opening and likely coming out of a recession while the US is unsure if they are entering a recession or will avoid one.


Meanwhile Europe appears to be in stagflationary mode, with demand bolstered by geopolitical events due to the Russia/Ukraine conflict. In addition, 'post-Covid' global economies don't appear to be on the same page economically anymore.


On Sunday, RBC stated that China's reopening is 'Far from priced into oil markets' and that 'Oil's low for the year may already be in'. If the Fed does decide we've had enough rate hikes, and China has no further setbacks, that could very well be the case. The most likely case between the China/US diad is China is a newly born demand-bull now, while the US is a midlife demand-bear.


Given that these two economies are currently out of sync, it makes more sense that there has been notable weakness in WTI futures relative to Brent so far this year. The gap between the two leading crude oil benchmarks has widened significantly, with March WTI futures closing $7 Below Brent last Friday.


March WTI/Brent spread Weakest in over a year...

Next up is the shape of that term structure shown above, which struck us a little oddly.


The Contango Long Jump

What we see here is a curve shape that has a very steep falloff before returning to a more stable nature mid-year. The steepness of the contango curve is not natural. To have such a steep contango of over $1.60 for the first 5 months to then resolve at flat in month 6 seems a little too slope-ish. If the market were truly in balance and efficient, one would think this was in the process of being 'arb-ed' into a more normative monthly differential carry slope right?


Brent WTI Trader on Vacation...


If this persists, there is at least one possible explanation to justify it. The spread curve is perhaps reflecting the inventory/supply dynamics discussed above, with a focus on a short-lived US recession relative to other parts of the world.


The Fed is also within 50 bps of allegedly stopping their hiking. Should that be the case -- meaning the curve is correct and the US doesn't come out of its demand-recession until August--then we may be waiting a while for a catalyst to normalize the curve to what we are used to looking at.


Zoom Out and Things Look More Normal

Looking further out on the curve, the spread is more normalized and trading in the middle of it's yearly range (gold line below).


On balance, there seems to be a consensus that oil markets will experience a more significant loss of Russian oil this year than in 2022 but estimates still vary. While OPEC, for instance, expects the loss to be around 850,000 barrels per day, the IEA set that figure to nearly 1.5 million barrels a day (mb/d).


Calendar 2024 - 2026 WTI/Brent Spread Futures Weak, but have come Full Circle...

Shifting Supply & Demand Dynamics

US Supply: Since the US has been an incremental 'supplier' to the world, yet WTI remains relatively lower than it's global benchmark Brent, one could conclude that a weak WTI/Brent spread is indicative of how strong the demand is at the moment for 'incremental barrels'.


Russian Supply: So far, Russia’s oil production has remained essentially unchanged. According to the latest IEA estimates, Russian oil output is just 200,000 barrels per day below pre-invasion levels. However, things might be different this year as the sanctions bite harder.


China Demand: According to the World Bank, nearly half of the growth in oil consumption in 2023 is expected to come from China. Bank of America argued that as that country reopens, more than a billion people will start traveling and spending, increasing demand for energy and other commodities. Goldman Sachs estimates that China’s reopening will add 1 mb/d to global demand (or around 1 percent of world consumption), putting an extra $5 a barrel to oil prices.


But, can we rely on this data to lift global oil markets as is the usual case? Since Covid, the economic cycles between regions don't match as much as they used to. As noted above, China is coming out of recession while the US by many measures is going into one. Perhaps this out-of-sync global economy problem will continue as a symptom of the de-globalization process we're witnessing.


Thinking out loud: If the above is correct: What would collapse the WTI/Brent spread? China doesn't come out of recession (sell Brent)... Europe worsens economically (sell Brent)... The US has a soft landing and immediately takes off again? (Buy WTI)


Yet The IMF Says Global Demand To Get Much Worse

According to the (very objective) IMF, a third of world economies will enter a recession this year, including China, the EU and the U.S., which together account for nearly half of world oil consumption. “The worst is yet to come,” the fund has warned. The World Bank issued a similar warning in its latest Global Economic Prospects report. “Global growth is slowing sharply in the face of elevated inflation, higher interest rates, reduced investment, and disruptions caused by Russia’s invasion of Ukraine,” the report stated.


This doesn't line up with the 'China recovery' story, that's for sure. Somebody is wrong and there is a trade in there based on the economics of it all. China bulls may end up against Powell and his money shredder on the bear side. Chose your fighter.


Bottom Line: Event Risk is Back

Vacation is over. Oil may start getting interesting again as OPEC steps back on the stage and global economies reach opposite inflection points. Not to mention the FOMC rate announcement

  1. This coming week has a lot of events to focus on and gauge how Oil digests their outcomes

  2. US Exports are at the high end of the range,

  3. US Net Imports are at the lowest they've EVER been

  4. Cushing is refilling, but Commercials are not yet, which is possibly due to the large export flows

  5. Futures Curves 6 months out seem to be focused on US recession and recovery timetables

Plenty of opportunity for news headlines to whipsaw the market this week.










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EIA Inventory Recap - Week Ending 1/20/2023



Weekly Changes

The EIA reported a total petroleum inventory BUILD of 1.70 for the week ending January 20, 2023. Of this, Commercial inventories posted a small weekly BUILD of 0.50 while SPR inventories were flat on the week.


YTD Changes

YTD total petroleum EIA inventory changes show a BUILD of 32.90 through the week ending January 20, 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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