Looking for Cracks in the Oil Rally: Location Spreads & Convenience Yields
Author: Brynne Kelly 4/25/2021
The long-term price of WTI has cleared the $50 mark and held. The persistence of the back of the curve towards mean reversion has opened the door for the front of the curve to react to short-term fundamentals with some reckless abandon. Long-term price stabilization means that the market is no longer in free-fall and that the industry as a whole is moving on from the chaos of 2020.
In the chart above, we see the steady shift higher in the long-term WTI price curve since the beginning of the year (gold line = 4/23/21 settle, dashed purple line = 12/01/20 settle). This leaves the front of the market to deal with the push/pull of output cuts vs demand recovery.
Examples of this push/pull can be seen in recent data points:
According to GasBuddy data, US gasoline demand has fallen for the third straight week, down 1.7% Sun-Sat. It's the weakest weekly demand since the week ending 3/20. Demand fell WoW on Friday by 0.4% and Saturday by 5.3%.
The combined consumption of diesel and gasoline in India this month is poised to plunge by as much as 20% from March, as streets in major cities such as New Delhi and Mumbai become eerily quiet (Bloomberg).
The International Energy Agency (IEA) predicts that energy demand will grow by 4.6 percent in 2021 as economies across the globe recover from the COVID pandemic. The agency noted that this growth in demand would more than make up for the 4-percent contraction in global energy demand last year. The majority of the anticipated energy demand growth – some 70 percent – will come from Asia.
Ministers are due to hold their next monthly meeting later this week. When they met at the start of the month, they agreed to a schedule for relaxing some of their output cuts in May, June and July. Those plans might have to be revised before they’re brought into effect.
One way this push/pull is being played out is in the calendar spreads for crude oil, gasoline and distillate markets (12-month calendar spread futures between month-2 and month-14 below).
The data reveals that even in the beleaguered distillate markets, the front has finally moved above the back (blue line above). Across the board, markets are placing an outright premium on the front of the curve - owning a barrel today vs a barrel in the future.
It's not the same story when you look at the ULSD crack spread curve vs WTI for the next 2 years (2022-2024). In this case, shorter-dated crack spreads are trading at a discount to future months (yellow line = 4/23/21 settlement). An unusual curve shape considering the global growth anticipated in refining capacity, and its notable that the shape of this curve suggests there is no technology or efficiency gains in refining going forward.
Outright prices and time spreads are consolidating at higher levels (as discussed in previous analysis). How does this compare to other market dynamics such as location spreads and yields? Are there any cracks in those relationships?
The spreads between crude oils of similar quality should have only three components: the difference in quality produced by different oil fields, the difference in shipping distance, and the discounted delivery time. The underlying product for both Brent and WTI futures market are light and low-sulfur crude oil, and the quality of oil is similar.
While not overly volatile in 2021, the main trend in WTI/Brent spreads has been one of weakening (yellow line vs dashed purple line). This is good since a narrow spread typically makes U.S.-crude linked coastal grades less attractive to international buyers compared to Brent-linked grades.
However, before getting too excited about the move lower in the WTI/Brent spread this year, taken in context relative to where we were a little over a year ago, the spread has strengthened significantly (cyan line = 1/02/2020). Because Europe is connected to the Middle East and Asia on the mainland, the geopolitical situation in the Middle East and Europe, and the actual consumption needs of Asian countries such as China and Japan have a direct impact on the oil price in the London futures market. Therefore, the Brent futures price index system still reflects the real-time fluctuations of the world crude oil market. A tighter spread suggests a competitive global market. Gone are the days of a discounted random bottlenecked barrel of WTI escaping the USGC for a significant arbitrage overseas. There simply isn't enough global competition at the margin. A widening of the spread going forward would suggest that the US is approaching it's max export capacity in the face of growing world demand (absent a demand-side shock like we had with Covid).
The North Sea oil field is a world-famous oil producing area, and its output includes the sum of crude oil production in five countries including Britain, Norway, Germany, the Netherlands, and Denmark. Cushing is located in Penn County, north-central Oklahoma, USA, where there are many intersecting pipelines and storage facilities, and the physical facilities are an important hub, so its inventory is a key variable. Crude oil production in the North Sea oil field has declined significantly in recent years and was overtaken by the US shale oil production in January 2014. The direct consequences of the depletion of the North Sea oil field include:
The loss of self-sufficiency in European crude oil. Britain as a traditional crude oil-exporting country became a net importer of crude oil in 2005;
The crude oil trade in European countries is more closely related to the world market. With its convenient shipping conditions, the crude oil produced in the North Sea oil field is mostly traded in real time and there is no huge oil storage facility. The theory is that significantly different storage facilities may create a gap between prices of one market versus the other.
With a reduction in global demand, US marginal production is competing with the rest of the world for a home. A widening of the spread from here would need to be driven by higher transport costs or an increase in US inventories relative to global inventories.
Midland vs WTI
The prevalence of backwardation across the curve in the WTI market is somewhat offset by the contango in the Midland/WTI spread. The chart on the left shows the shift and the shape of the futures spread for Midland vs WTI. The chart on the right shows the same for WTI futures. As WTI futures decline into the future, the spread between Midland and WTI at Cushing increases.
This increase in USGC premiums leads to a wider WTI/Brent spread because as USGC barrels gain in value, the WTI/Brent spread needs to widen out to accommodate.
Slight backwardation or contango in oil markets are normal. Wide backwardation is a sign of more severe short term supply issues. The market is currently near or above recent all-time highs in backwardation. How do we rectify this with the perceived supply overhang? Enter convenience yield.
A convenience yield is an implied return on holding inventories. It is an adjustment to the cost of carry in the non-arbitrage pricing formula for forward prices in markets with trading constraints. The convenience yield can be thought of as the interest rate paid in barrels of oil for borrowing one barrel of oil.
While convenience yields are not directly observable, they can be synthetically replicated by taking simultaneous positions in money, crude oil spot and futures markets. The premise is that the lender must be compensated for forgoing the benefit associated with holding the barrel of oil. In equilibrium, this requirement links the convenience yield to the price of storage.
The 1-yr convenience yield in WTI currently stands at around 16% (right chart below). Implying there IS value to holding oil in this market. We are almost back to 2019 levels when 12-month calendar spreads were also on the rise (left chart below). The difference between the current spread rally and that of 2019 is that in 2019 convenience yields were falling as backwardation was increasing. Contrast that to 2021 when convenience yields have risen as backwardation increased.
Everyone who owns inventory has the choice between consumption today and investment for the future. A rational investor will choose the outcome that is best for herself. While the convenience yield is often tied to inventory levels, in current times inventory levels take a backseat to production cuts. In many way, today's OPEC+ production being withheld from the market can be classified as 'inventory'. If speculation leads to a build-up of inventory, this should be reflected in a decline in convenience yield.
Since crude oil is a storable commodity, stocks link current demand and supply to expectations of future demand and supplies. Inventories play a fundamental role in the formation of a commodity price because holding stocks is intrinsically valuable given the operational flexibility they provide. For example, owing to technological constraints, an oil refinery has the incentive to hold stocks to optimize its output of petroleum products, reducing the costs of changing production and helping them to avoid stock-outs. Consequently, the optimal levels of production and inventories are jointly determined given the spot price of oil and the price of storage.
Convenience yields tend to exist when the costs associated with physical storage, such as warehousing, insurance, security, etc., are relatively low. Convenience yield behaves like an American call option, which suggests that the information content of convenience yield is volatility behavior. The convenience yield is also an implied return on inventories.
Bottom line, we are seeing convenience yields rise as inventory draws down. Some argue that speculative length in the market is creating a synthetic build up of crude oil inventories. The convenience yield suggests otherwise.
Reminder - Annual SPR Sales
The U.S. Department of Energy’s (DOE) Office of Fossil Energy (FE) announced earlier this month a Notice of Sale of crude oil from the Strategic Petroleum Reserve (SPR). DOE intends to sell up to nine million barrels of crude oil from the SPR. This notice of sale is to fulfill requirements for Section 404 of the Bipartisan Budget Act of 2015, part of a notice of intent first announced January 14 regarding the timing of Fiscal Year 2021 SPR crude oil sales.
The Notice of Sale announced today includes a price-competitive sale of up to nine million barrels of SPR sour crude oil. The sale will be conducted from the following SPR sites:
Up to 3 million barrels from West Hackberry
Up to 3 million barrels from Bryan Mound
Up to 3 million barrels from Big Hill
DOE must receive bids no later than 10 a.m. CDT on Tuesday, April 27, 2021, and will award contracts to successful offerors no later than May 6, 2021. Deliveries will take place in June 2021, with early deliveries available in May 2021.
This is the equivalent of roughly 300,000 bpd. As a result, the front month spread is weakening relating to the second month spread and so on in order to absorb this additional supply. Last week, the US EIA reported a draw of 800,000 barrels.
EIA Inventory Statistics Recap
The EIA reported a total petroleum inventory DRAW of 1.20 million barrels for the week ending April 16, 2021 (vs a draw of 5.90 million barrels last week).
Year-to-date total inventories in 2021 are DOWN by 7.00 million barrels (vs 7.60 million last week).
Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years reflect progress that has been made in reducing excess inventory levels.