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From The Abyss to Exonerated: Now What?

Author: Brynne Kelly 7/25/2021

There are a handful of conditions that can truly propel oil markets away from their mean. We witnessed one of these conditions last year as we dove into the unknown abyss of global lockdowns and the subsequent re-opening of economies. This was a fairly short-lived cycle characterized by a swift move lower of the entire curve and then a sharp V-shaped recovery in one year's time. It seems as though oil has exonerated itself of the pandemic!

The previous peak to trough cycle from 2014-2015 has yet to be fully exonerated.

That move was initiated by the build-up of capacity ahead of the US lifting it's oil export ban in 2016. Unlike the selloff in 2020, the recovery towards even the longer-term mean of $60 took almost 3 years. Quite a difference when a meaningful drop in prices is led by supply growth rather than a 'transitory loss of demand'. In 2020, the drop in demand due to the pandemic caught producers and refiners with their pants down. Demand became unpredictable for several months, However, the underlying fundamentals and logistics did not change, so the rebound was entirely based off a rise in demand in the face of production cuts.

Which brings us to last week when, surprisingly, oil markets had a bit of a scare after OPEC+ agreed to progressively raise production, at a pace of around 400,000 barrels per day per month going forward. This led to a quick $5/bbl drop in prices across the entire curve and threatened the validity of it's exoneration. It turned out to be one of many short-term pullbacks that don't last. By the end of the week, the pullback was all but erased (5-day WTI futures curve shift below).

The real noise last week came from gasoline markets when Russia stated that it is ready to introduce a ban on gasoline exports as soon as next week amid record-high wholesale prices on the exchange. In fact, we heard similar themes out of both China and India last week. In China's case, they intend to cut oil product exports to 1.07 mil mt in August amid tight quotas, sources with knowledge of the matter told S&P Global Platt’s on July 23.

This all comes at a time when gasoline demand in the US typically hits it's peak (typically in August). Appropriately, gasoline futures rebounded towards 3-year highs.

US Gasoline Demand Profile

Peak US summer gasoline demand usually takes place between May and September. This is depicted in the chart below, which shows US gasoline demand by month, along with the 5-year average (black line below = 5 yr avg.).

US gasoline demand has fallen short of it's 5-year average for the last 16 months through June, 2020. It wasn't until this month(July) that weekly gasoline demand numbers began to normalize towards their 5-year average (green bars above). We are now headed into August, which historically rivals June as the highest gasoline demand month of the year.

It's no surprise then that calendar spreads strengthened by the end of the week. After all, we are less than 7 days away from August - the historical peak demand month. We saw this play out in the Aug-21/Sep-21 calendar spread, which showed the most strength (lime green line below). This spread could be volatile into expiration if the countries noted earlier do, in fact, limit their gasoline exports since the US east coast relies on gasoline imports either via the Colonial Pipeline from the South or foreign imports via ship into the New York Harbor.

This is also a clever way for Russia to play the production cut game. Either put barrels back on the market and potentially drive the entire complex lower OR keep refined products 'in house' therefore tightening supplies and keeping a bid under gasoline prices.

Missing from the above chart are the Sep/Oct (shown below) and Mar/Apr calendar spreads. These two spreads are generally significantly wider than the rest of the curve given that they reflect the change from summer to winter spec gasoline and vice versa.

Again we see the same pattern of a spread moving outside it's historical trading range into expiration but, respecting it's average trading range until then. There is still time for Sep/Oct in 2021 to challenge 2019 levels. A rally from current levels though is highly dependent on the marginal difference between blending components like butane versus gasoline as we switch over to winter spec gasoline, as well as positioning and inventory levels into spread expiration.

US Distillate Demand Profile

Unlike gasoline, US ULSD demand began to surpass it's 5-yr average in April of this year and continued to do so through June, before falling back below the 5-yr average this month (green bars vs black line below).

Typically, the summer months are used to build distillate inventory ahead of the winter heating season. Storage capacity helps smooth out the seasonality somewhat during the shoulder months. However, there hasn't been much incentive to store distillate barrels this summer given that calendar spreads have been hugging the flat line flipping between backwardation and contango (below). This could lead to a tighter market this fall. Consequently, distillate spreads for September through the end of the year are experiencing a slow move higher into further backwardation.

In order to sustain the levels we are currently seeing in both gasoline and distillate prices and spreads, we would need to see monthly demand come in at least around the 5-year average for the rest of the year. Keep in mind, however, that summer is the time of the year when refiners are apt to chase profits regardless of what supply and demand numbers tell them

Crack Spreads

As outright oil prices have been running in to resistance above the $75 level, the bulls can point to stability in refined products crack spreads, which held up relatively well during the July 19 selloff, reflecting some optimism on the gasoline and diesel demand front. This can be seen via fourth quarter gasoline and distillate crack spreads versus WTI.

Definitely an impressive recovery over the last 15 months in refining margins, however, when looking at the above chart, note that only the gasoline cracks in Q4 have surpassed pre-Covid levels. Distillate cracks have not. Instead, the two are just converging within the $15 - $20 range. It would be nice to see the distillate cracks take the lead here as we move away from summer driving season and in to winter heating.

With seasonality in mind, we look at how the summer-22 strip (April - Oct gasoline cracks) is performing relative to history.

The $20 - $25 range has been the aspirational target and we are now comfortably within that range in the summer 2022 strip. This provides some cover for oil prices to move around without pulling the strip outside of the range. Yet, definitely something to watch should we break out either way.

They say if you stare too long at the abyss, the abyss stares back at you. This happened in 2020, we saw what the edge of reasoning looks like and survived. Fundamentals look good for the foreseeable future and relative values have mean reverted for the most part. It's time for gasoline and distillate markets to lead the next journey outside the mean.


EIA Inventory Statistics Recap

Weekly Changes

The EIA reported a total petroleum inventory BUILD of 0.70 million barrels for the week ending July16, 2021 (vs a draw of 3.30 million barrels last week).

YTD Changes

Year-to-date cumulative changes in inventory for 2021 are DOWN by 84.60 million barrels (vs down 85.30 million last week).

Inventory Levels

Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years are have gone from way above historical levels to slightly below historical levels and should continue to draw as long as backwardation in the market persists.


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