Author: Brynne Kelly 11/20/2022
RECAP
As we head into the holiday season, both longs and shorts in the petroleum complex have been licking their wounds. Last week was a perplexing one. WTI prices fell almost $10 from their opening week print of $90 finishing out the week barely holding on to the $80 level. This is the magical level at which the US DOE has suggested they would be interested in buying barrels to replenish the historic draw-downs from the Strategic Reserves. Hence why pullbacks have tended to stall and reverse down there.
FRIDAY FOLLOWUP
One key impetus to the selloff late last week was rhetoric out of China regarding it's COVID status. That reason proved prescient given news from the region this weekend with headlines like this on the newswires:
* Beijing Official: The city's COVID control condition is grim.
* Beijing calls for the prevention of community spread danger in key districts.
* China has reported the first COVID death since May 26th.
For two decades China has had an outsized impact on oil prices because it has been the world’s fastest-growing large economy importing most of the oil it uses. So this makes sense, even if it is overblown a little. What doesn't make a lot of sense yet is the internal disconnect between products prices last week in the selloff.
Oil prices, as a proxy for the supply/demand of global energy are sending mixed signals. Prices are lower, but so are inventories across the board. In an attempt to reconcile the marketplace contradictions it is probably best to look at products price action and inventories.
GASOLINE LEAD THE WHOLE COMPLEX LOWER
Refined products are the real indicators of supply and demand imbalances (rather than refiner processing capability) and are still chronically low. Yet price activity last week still took a dive in a big way. Gasoline lead the whole complex lower. RB was the culprit, not HO.
But if this is Heating season, should we even care about RB? Turns out yes we should: Despite it being winter and Heating season, RB continues to have an outsized effect on WTI prices. So everything is lower due to Gasoline getting crushed. To highlight this, we note below the RB/HO continuous spread relative to continuous WTI futures prices.
Historically, weakness in RB/HO is a leading indicator for WTI futures...
That implies this is a Gasoline driven market sometimes even in Heat season. The next logical step is to ask ourselves: Well maybe there was an inflated inflow of RB this week relative to Diesel. Turns out that was not the case either. Because you cannot make one product without making the other one. Gasoline may be the driver in the RB/HO spread as we shall see below; But neither RB nor Diesel inventories budged much at all. Charts for that are near bottom. We will revisit that later on as well.
Gasoline took Oil lower, but we know it was not from an increase in supply. Further confirming this is the fact that, the HO inventories did not move much either. Turns out neither product is yet building despite the now chronically low inventories.
PRICES ARE DOWN IN GASOLINE, BUT SUPPLY IS DOWN IN BOTH
Gasoline is viewed as 'relative weakness' to it's refined product cousin Diesel. Why do we say this? Because for every gallon of diesel (Ultra Low Sulfur Distillate) produced, there are almost 2 gallons of gasoline produced. If you need Heating Oil, you will make roughly twice as much RB in the process.
Therefore, despite the seasonality, the exports to Europe, and the low inventories of HO and Diesel, WTI continues to act like an RB market moved by domestic demand. The chart below also illustrates this. Gasoline took Oil lower, but not from some newly-discovered changing crack refinery ratio either. We still need both resupplied.
For every Barrel of Oil Refined, gasoline output hovers at around twice that of diesel...
Nothing really stands out in the above historical chart except that production ratios seems to be consistent. The fear in the market has been that low diesel inventories need to be rectified and to do that would mean doubling up on gasoline production (because to produce diesel you need to produce gasoline). Neither output ratio is out of sync historically.
WHAT ABOUT FORWARD LOOKING SUPPLY?
So far we have accounted for drivers reflected in current inventories (they're low) and refining capabilities (the ratio is what it is). In neither case can we find corroborating evidence of a reason for the Gasoline selloff taking the complex down so much in price despite low levels on the supply side. As to the demand side; the Fed is talking of possibly backing off its rate hike regime so the worst may seemingly be over there.
Perhaps the relative weakness in Gasoline is due to anticipation of the seasonal winter build. This selloff is quite possibly forward looking with this in mind. The chart below leads us to believe that seasonal builds are imminent (red arrows), and that maybe some are playing that angle.
Gasoline AND Diesel inventories are at similarly low levels but a pattern emerges in RB
The market appears to be anticipating this, only future inventory data will reveal if it was a wise decision. The expectation is that we need a spike in diesel inventory ahead of the winter demand season, which leads to an expectation that gasoline output will follow suit. Typically, gasoline inventory begins its rise in November. We are not seeing that as of yet. And while a recession or slowdown in Chinese demand might be imminent, we are not seeing that play out in gasoline inventory.
RACE TO THE BOTTOM
The global supply of oil appears to be falling, but many oil traders think that demand is heading down even faster. That’s because economic growth is slowing or turning negative in many countries, and use of oil and petroleum products usually plummets in recessions.
The drop in oil prices has helped bring down U.S. gasoline prices, which will be welcome news to many people hitting the road for the Thanksgiving holiday next week. The national average price for gas was $3.71 a gallon on Friday, according to AAA, down from $3.87 a month earlier.
In fact, gasoline prices are only slightly higher than where they were when Russia invaded Ukraine in February. In Texas and some other Southern states, gas is now selling for close to $3 a gallon, roughly matching the price from a year earlier.
FURTHER COMMENT ON USING INVENTORY SUPPLY AS DEMAND PROXY
A good proxy for end user product demand (absent large inventory builds/draws) is the weekly EIA 'product supplied by refiners' data. Diesel inventories are always a bit low in the spring and fall, during agricultural planting and harvesting seasons, but this fall supplies are at their lowest level since 1982, when the government began reporting data on the fuel.
Product Supplied by Refiners is a good Proxy for demand and remarkably efficient
Both figures are trending lower this year. Regardless, as noted earlier, inventory is not filling up.
Yet, the market continues to tell us that there is a supply issue and premiums are assigned to winter diesel as noted in Q1 RB/HO futures spreads below. Not only is gasoline trading at a big discount to diesel in Q1 2023 (lime green line below) but there is also a spillover effect into the Q1 2024 spread as well.
Gasoline in Q1 is trading at historical discounts to Diesel/Heating Oil
Refining margins currently reside on diesel. Yet diesel production does not make up the lion's share of refiner production. Hence why diesel prices alone are not leading oil prices higher.
In fact, Fitch Ratings expect US refiners’ crack spreads to fall in 2023 from record setting levels, resulting in an approximate 40% decline in median sector EBITDA and median leverage increasing to slightly over 2.0x. Weaker than expected global economic growth next year and sharply higher inventories due to other oil product market factors are key downside risks to our EBITDA forecasts. They expect US refiners’ ratings to remain stable even with weaker-than-expected profitability absent large, debt-funded acquisitions or shareholder friendly activities that exceed companies’ financial policies.
This is obvious when looking at full year crack spreads in both diesel and gasoline.
Diesel/Brent Crack spread calendar strips
RB Gasoline/Brent Crack spread calendar strips
Gasoline margins have been on the decline since May 2022 while diesel cracks have increased. This strength in diesel markets was enough to lift oil prices higher this summer while gasoline demand was in play. Now that summer driving season has come to an end and gasoline margins have retreated, oil prices have come under pressure.
All eyes are on gasoline inventory levels for now. There is an expectation that they will rise as they have, seasonally, in the past which is leading to selling in gasoline cracks and prices.
Beware the trend, as inventories have yet to signal its repetition.
Bottom Line
Last week's selloff was driven by wilting Gasoline that drove WTI lower as opposed to speculators liquidating Oil longs. In fact, given the changes in open interest, it is quite likely that speculators of some sort may be positioning themselves for a rather robust winter Gasoline build season. The data bears this out. Fundamentally, there is no current new supply hitting storage. Economically on the demand side, China continues to be a problem driving both upward spikes and downward swoons on Covid rumors. Domestically, demand seems lower, but the Fed is seemingly slated to back off its aggressive rate hike regime.
Therefore, unless the Administration has discovered that RB futures can be sold instead of CL futures to make their point, this has all the earmarkings of a bet on RB build season and/or a residual fear of shorting HO in season. Otherwise the RB/HO spread held better than expected.
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EIA Inventory Recap - Week Ending 11/11/2022
Weekly Changes
The EIA reported a total petroleum inventory DRAW of 6.20 for the week ending November 11, 2022. Of this, Commercial inventories posted a weekly DRAW of 5.40 while SPR inventories DREW by 4.10.
YTD Changes
YTD total petroleum EIA inventory changes show a DRAW of (228.30) through the week ending November 11, 2022. The bulk of this is due to drawdowns in SPR inventories.
Inventory Levels
Gasoline and Distillate inventory levels remain decidedly below their 5-year average for this time of year.
