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Is The US Market Structure Sending the Wrong Signal?

Author: Brynne Kelly (w/Lee Taylor technical levels)

Strength in crude oil markets given the fundamental backdrop of 2020 are causing people to look for a new narrative to provide direction going forward. The dramatic build in US commercial crude oil inventories last week seemed to come as a surprise, as market participants held their breath waiting for another sell-off in response. However, flat price maintained its rally ending the week at just shy of 10-day highs.

There are four major themes at play here:

  1. Inventory Changes

  2. Calendar Spreads

  3. Export Arbs

  4. Refining Margins

We think a build in US crude oil inventories was an appropriate response to the other 3 items on the list. It shows how thin margins are and how important every dime is to margin-seeking physical players.

US Inventory Changes

Since the start of 2014, the US has added a total of 176.46 million barrels of commercial crude oil to inventory (green bars below). During that same time period, a total of 57.87 million barrels were withdrawn from the US Strategic Petroleum Reserves (gray bars below).

2017 and 2019 were the only 2 years that commercial inventories ended the year lower than where they began.

With US crude oil production unchanged last week, the large build in commercial crude inventory build was, in theory, foreign crude.

This increase in inventory via imports makes sense given the structure of calendar spread futures.

Calendar Spreads

The front of the WTI market is still in contango until the May-21 contract as of Friday's close (blue line) while the front of the Brent curve is in backwardation (red line). The market structure for crude oil in Houston (green line) is still displaying slight contango in the front, but moves into backwardation one month earlier than WTI, again as of Friday's close.

US market for light, sweet crude is one of the few out there that is still paying producers to store crude oil even as outright prices rally. With markets as loose as they are, it's more attractive to keep barrels in the US and let them appreciate in the short-run rather than export them. If last week's large build in inventory is not an anomaly due to timing, either front WTI spreads need to move towards backwardation in the front, export arbs need to widen-out or refining margins need to increase in order to remove the incentive to build inventory in the US.

Crude Oil Export Arbs

Speaking of export arbs widening out, the spread between WTI and Brent had already been widening even before the EIA inventory report. This weakening/widening of spreads is seen through a bit of a different lens when flat price is rallying. While it doesn't necessarily point to relative WTI weakness, it does point to storage incentives and right now, that incentive is in the US. The market is saying that at current export spreads, it would rather hang on to barrels than send them out for export.

Refining Margins

The US has the lowest amount of refining capacity in operation since mid-2016 (left chart below). Over the last six months, the EIA has reduced the total reported operable refining capacity by roughly 600,000 bpd from the high of almost 19 million bpd made earlier this year. In this market environment, the least efficient refiners have been forced to finally retire. We only mention this because as a result, utilization rates ticked higher last week (right chart below).

The removal of the refining capacity from both the east and west coasts could eventually lead to the need for product imports while the US Gulf Coast continues to refine and export. Its unlikely this trend will change in the near future.

Now we look at WTI crack spread futures for both gasoline (left chart) and distillate (right chart) below. Both crack spreads have moved higher in the last 10 days. Distillate cracks are ever-so-slightly trying to move into backwardation in the front.

Regardless, both crack spreads point to higher margins in the future relative to today. Another reason to hold on to barrels. Are US markets sending the wrong signal to producers/refiners? Do we really want to provide market incentives through flat price and spreads to build more inventory?

While the recent move higher in distillate cracks has been viewed as a tailwind to the market, when looking at the shift in distillate cracks since the beginning of the year we see how weak the front of the curve has gotten relative to the back. The year began with the calendar 2021 & 2022 spread curve being in a relatively flat structure (right chart below) and are currently sitting not far from their lows in a contango structure.

Things look much different in WTI where the term structure has recovered much of it's backward structure between calendar 2021 and 2022, albeit at a lower flat price.

With the refining complex not only losing operable capacity, but also operating at less than 80%, and with the steep contango developing in US distillate cracks, the market is saying that in the short-term that it prefers crude oil over refined products, as oil has more outlets at the moment (i.e. storage, foreign refineries).

EIA Inventory Statistics

Weekly Changes

The EIA reported an astonishing total petroleum inventory BUILD of 24.60 million barrels for the week ending December 4, 2020.

YTD Changes

Year-to-date, total inventory additions stand at a BUILD of 73.60 million barrels for the week ending December 4, 2020 (vs 49.00 last week).

Inventory Levels

Commercial Inventory levels of Crude Oil (ex-SPR) Gasoline and Distillate compared to prior years are once again above the 5-year average for commercial crude oil and gasoline inventories and just slightly below the 5-year average for distillate.


Lee Taylor - Technical Levels

(To return next week....)

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