Author: Brynne Kelly
Market uncertainty theory argues that in an efficient market the “unknown information set” is not and cannot be reflected in market prices. The notion that markets are always right in their present discounting of the future state of affairs is only correct with reference to the “known information set”. In a market economy there is always an element of uncertainty that the “known information set” could change substantially, or to put it differently, that the “unknown information set” may contain some substantial information, knowledge, or experience that could in the future significantly alter the “known information set”. Thus, the “unknown information set” conceptually represents the uncertainty of the correctness of efficient market prices.
As 2020 has unfolded, it could be argued that the degree of uncertainty in the 'known information set' has never been greater. Available information, available knowledge, and available experience relative to the circumstances we have faced and are facing are limited.
The degrees of uncertainty can be divided into 5 levels:
Predictable
everything is pretty much perfectly predictable. You can plan for the longer term with relative ease as the future is well known and next year will very likely be similar to this year.
Exploitable
there is moderate change -- something equivalent to a light wind. It is, with reasonable intelligence, quite easy to predict what will happen
Problematic
The ability to respond to external forces is not guaranteed
Turbulent
things are becoming distinctly dangerous as external forces demand immediate action and serious restructuring may be needed.
Chaotic
A number of dimensions of uncertainty interact to create an environment that is virtually impossible to predict
Energy markets have moved swiftly from Predictable to Chaotic in the last 6 months. Prior to 2020, the predictable pattern in the oil complex was to buy weakness in calendar spreads and sell strength. In fact, this had almost become an exploitable pattern towards the end of 2019 as markets began to face headline risk that led to price spikes in the front of the market. Things became problematic in January when the Chinese New Year collided with news of the coronavirus in Wuhan as well as the unwind of IMO 2020 positioning. By late February / early March, OPEC failed to agree on production cuts. Additionally, as the coronavirus rolled across the globe, markets became increasingly turbulent, which culminated in negative prices for May WTI crude oil futures the day before they expired.
OPEC+ countries finally agreed on significant production cuts and by the time we got to the end of April/beginning of May, oil markets firmed up and it appeared as though we would stop at 'Turbulence' and the level of uncertainty we were facing might ease. However, over the weekend as riots began to escalate beyond Minnesota, it is reasonable to question whether or not 'Turbulence' may turn to 'Chaos'. As noted above, in chaotic markets a number of dimensions of uncertainty interact to create an environment that is virtually impossible to predict.
The Unknown information set that continues to get more "Unknown":
Inventory levels and the amount of offshore and unreported inventory around the world
The size and timing of demand recovery
Refinery Utilization
The reaction of production to price levels (OPEC+ is set to discuss a short extension of its current output cuts, according to a delegate, as the cartel considers bringing forward its next meeting a few days to June 4.)
One of the common business strategies for chaotic times involves investments in flexibility. Towards that end, we take a look at where one might find opportunities to gain exposure to multiple outcomes in oil markets.
First, its important to set the backdrop of overall market positioning. Net money-manager open interest is often seen as a reflection of market bias, or at the very least what needs to be liquidated. Net money-manager long open interest in WTI futures is approaching levels not seen since 2018 (blue line below vs WTI continuous futures, black line). It's reasonable to think that this position won't be stressed to liquidate unless WTI prices fall below $20. There is a price level though at which they reduce length which will put pressure on the market.
Keeping that in mind, and seeing the response of WTI futures prices to significant changes to said open interest, the next leg higher in WTI prices could be met with profit-taking selling pressure. Flat price is the front-line of chaos and dependent on momentum, relative prices of other oil products and not the best place to invest in chaotic times since price swings can be significant and difficult to manage.
As an alternative, we highlight spread relationships that might currently be over-influenced by current uncertainty and provide lower risk exposure to changes in current conditions.
Exposure to global demand recovery and higher shipping costs
Cushing inventory levels have been loosely correlated to the US oil export 'arb' expressed via the spread between WTI and Brent crude oil. In the last few weeks, EIA inventory reports have shown draws at Cushing. This would suggest barrels are once again able to move to the US Gulf Coast. We recognize that this could simply mean that barrels are moving out of Cushing into the US Strategic Petroleum Reserve and therefore NOT an actual reflection of demand. But, there is an anomaly here relative to prior year Cushing inventory levels. The chart below shows Cushing inventory levels vs the Month 6 continuous WTI/Brent futures spread. Should Cushing inventory levels continue to draw, and tanker rates from the US to Europe increase as global demand for increases, this spread could decline.
Exposure to demand recovery and lack of investment in supply growth
Twelve month calendar spreads as shown via year-on-year Dec/Dec spreads below are reflective of the impact of headline risk on the front of the market versus the back. Prior to 2020 this headline risk was weighted to the supply-side as seen via spikes in backwardation. This quickly moved to contango as headline risk became focused on the demand-side.
Since the entire market tends to move in tandem, the 2021 vs 2022 and 2022 vs 2023 spreads followed the move in the prompt 2020 vs 2021 spread. This year is highly uncertain and full of chaos, and even with the significant recovery in flat price, spreads remain backwardated. An uncertainty going forward is whether or not the announced lack of investment in supply growth going forward might lead to demand recovering faster than supply. On the other hand, a slower recovery in demand could lead to further contango, in the front of the market, especially if the market length mentioned earlier begins to liquidate. A lower-risk investment on an eventual recovery would be to go long the Dec-22/Dec-23 spread (blue line above).
Gasoline Demand Recovery
There is no doubt that gasoline demand has taken a huge hit as the US and the rest of the world has abided by stay-at-home orders. It's expected that prompt gasoline crack spreads would take a hit as gasoline has backed-up in the system and inventories rose (black line), and assume that current conditions will exist in summer 2022 (orange line). Over the last 2 weeks however, there has been a disconnect between the front spreads and the back. If there is another leg lower in front gasoline cracks that puts pressure on future crack spreads, this might provide an opportunity for 'investment'.
Bottom line, future spreads have fallen in tandem with the front of the market. Take advantage of the chaos and invest in lower-risk investments in future spreads.
Inventory Recap
US inventory levels by PADD vs total storage capacity by PADD:
Weekly Stats
The EIA reported a total inventory BUILD of 7.90 million barrels for the week ending May 22, 2020. Once again, Cushing inventories posted a draw that was partially offset by increases in the US Strategic Petroleum Reserve.
Year-to-date, this bring us to a Total Inventory BUILD of a record 140.80 million barrels. This surpasses all previous year to date builds in total.
Inventory levels are shown below, compared to prior year levels for the same week ending as well as against total storage capacity. Cushing inventory levels are the only outlier here as the only one below previous-year highs (likely due to re-direction to the SPR).
Lee Taylor - Technical Levels
BRENT
Resistance: 38.85/ 39.63 / 41.89
Support: 36.63 / 33.99 / 32.19
39.63 - 39.70 is the bottom of the gap for the Brent market and again will appear at Mt. Everest for the energy market. The Brent market now seems to be the first commodity in the energy complex to try at the gaps above. Aug/Sep Brent filled the gap last week and now will use -.38 as support for a move back to flat. Flat price will need to rally to see these spreads continue their upward rise.
WTI
Resistance: 36.35 / 37.64 / 41.05
Support: 33.75/ 29.82 / 27.53
Last week seemed like the longest four-day week in history! I think the market was exhausted as were traders. The gap persists above the market in July WTI and every rally will be short-lived until it can break through the gaps left from March’s debacle. The focus will be on the upside technical levels as traders focus on the buy stops above. We will need important economic numbers to arise for a retracement in the market. We think the market is geared to test the bottom of the gaps again, but it may trade sideways for a bit as the RSI’s are quite toppy.
RBOB
Resistance: 1.0819 / 1.0999 / 1.1124
Support: 1.0262 / .9881 / .9275
July RBOB seems to be overdone to the upside technically, however if it can hold 1.0262 early in the week it may be able to stabilize and drift higher. The products both tried to rally but seem stuck in the mud. I honestly believe that gasoline is the commodity to lead the energy complex to the upside, but it may need another week to gather more momentum. Many of the RBOB spreads seem over-priced as well. Look for July/Sep to retest -237 and Sep/Oct to test -800.
HEATING OIL
Resistance: 1.0611 / 1.1159 / 1.1384
Support: .9878 / .9708 / .9368
July Heating Oil is lagging the rest of the complex from a technical standpoint. It still needs to break above some key technical levels prior to making a run at the gaps left in March. Look for July/August to hold -345 to make a move towards the bottom of the gap. However, if it fails, a move back to the -400 level is a sure bet. We repeat this recommendation as this is what transpired last week.