Author: Brynne Kelly 12/11/2022
The Bull Market is very sick. It's been sick before. Every time price got hit these past few months, the side effects never really spread past flat price. Other parts of the market structure remained healthy despite price drops. Calendar spreads held. Backwardation held. Cracks, WTI/Brent and regional spreads like Midland/ WTI also remained bullish. It seems that every time the market got whacked, these other fundamentally driven parts held strong. This oil bull would then shake it off and get back up after a few days rest. But something is different this time.
For the past six months or so, this market successfully fought recession rumors, monthly rollovers, SPR drawdowns and a whole slew of political rhetoric only to reassert itself time and again. The aforementioned fundamentals made sure that whatever illness was attacking, it never got past flat-price. But again, something is different this time.
Our patient now suffers from prolonged exposure to all those little illnesses mentioned above with a couple new ones; Year-end rolls, 2023 asset reallocations, and a new more virulent strain of recession.
Contango Contagion: WTI Prices End the Week on 10-day lows...
The problem isn't just in the flat price anymore. The side-effects of prolonged exposure to this cocktail of illnesses is taking its toll on everything else too.
The Side Effects
This time, when flat price dropped, the problem spread to those previously strong parts of the market structure. The contango last week we noted did not disappear like it had before. The curve did not snap back post roll. And this time, when oil dropped 10%, it took all those healthy fundamentals with it. All of them turned bearish (or at least not bullish) this time markedly.
These were the things keeping the bull healthy and enabling dips to be bought with confidence. This time it was too much. Lets look at each.
WTI/Brent: Signals Global Demand Recession
The single most widely traded spread in the global oil complex is the WTI/Brent spread and the change in the relationships between these two global marker crude oils has implications to both crude oil and refined products on a global basis.
It is also the most important spread in setting all of the various pricing interrelationships among the many different crude oil grades as well as for refined products inside and outside the United States. Brent (North Sea crude oil) and WTI (US indigenous crude oil) are the industry’s two main benchmark crude oils which the majority all of the crude oils around the world are priced against.
Last week, we got some headlines directly relevant to the global supply/demand narrative from US banks. For example:
Citi's CEO Fraser: A US recession is probable in the second half of 2023
Citi's CEO Fraser: We are in a period of rolling country recessions.
Recession timing is now all the rage and the WTI/Brent spread is being used as a gauge of this. A weak spread suggests stronger demand across the pond for oil than relative to the US. A strong spread suggests weak relative global demand. This is important because the US is not where marginal demand growth is expected.
WTI/Brent Spread Rallies - Easing the European Bull Narrative...
Traders had been correctly positioned for tight global markets relative to the US due to the Russia/Ukraine war effects. That is no longer the case.
The rally in the WTI/Brent spread reflects that global oil prices have fallen relative to those in the US. The impact of the G7 price caps weren't as bullish as expected. This global spread caved to falling oil prices. A crack in the bull narrative.
Midland/WTI: Export Pressures Subside
Strength in the Midland/WTI spread is seen as a signal of interest in US barrels worldwide. Midland Oil demand increasing relative to WTI is justifiably seen as a sign of offshore buyers surfacing.
Midland/WTI Spread Collapses
A widening spread is taken as fact that people are paying up for export barrels relative to US Cushing barrels. This spread collapsed, especially in the front of the market. Again, reinforcing flat price weakness.
Crack Spreads: Low Supply meets Lower Demand
But wait, product inventories are still low which should be supportive, right? Yet, another side-effect of last week's oil price selloff was refined product cracks. RB Gasoline vs WTI Spread closed last week near its lows.
Gasoline Demand is projected to back off and Cracks reflected that...
Heating Oil cracks fared just as bad with everybody focusing on the lack of heat/degree days thus far, and ignoring the supply side
Distillate cracks (HO/WTI) also Reflect Oil Price Demand Weakness...
Calendar Spreads: No more Panic
One of the bellwether spreads in the oil bull market narrative has been the strength in calendar spreads. In fact, earlier this year, we saw the 12-month Dec/Dec spread exceed $17/bbl (lime green line below).
WTI 12-Month Spread Collapses
Now? The 'prompt' 12-month Dec/Dec spread (Dec-23/Dec-24) settled below $2.50 on Friday. And it still may have room to drop if the supply side is not the focus.
Bottom Line: Bed Rest
For the past year this market priced the lack of supply in Oil and seasonal products. On balance it worried more about potential shortfalls from weather, sanctioned oil and chronic war than the potential loss from recession. All that changed over the last two weeks or so. As far as illness goes, the bull is suffering from a prolonged exposure to recessionary demand now.
Speaking of demand recession: Last week a couple things happened on the financial side that warned of an even worse recession. One of the most most important (in our opinion) was yield curve inversion increasing to levels as bad as it has ever been all the way back to 1981. Combine that with what we already know and you have all the makings of a market shifting focus to demand fundamentals. Supply isn't fixed at all. But market participants are now taking seriously a global recession in the pipeline. Throw in an EOY rollover, reallocation, and mild weather and most have forgotten about the lack of supply... at least for now.
As far as recession's go The FOMC makes their rate announcement next week with many on the equity side thinking that if Powell raises rates only 50 bps, that is a sign of what they are calling a pivot-lite. This is a long way off from easing to get the economy started, but it is something on the demand side that may be a factor next week.
To finish our medical analogy. No autopsy is needed yet. We think the patient has to let the problem work its way through the system. But barring an unforeseen shock to the supply side, this market needs to stay in bed and try again in 2023.
Ad Valorem Taxes: Something to think about...
At the end of December each year, parts of Texas and Louisiana, where significant volumes of crude oil are stored, assess ad valorem taxes (meaning, according to value) on end-of-year crude oil inventories. These taxes, along with the generally accepted accounting practice of last-in, first-out (LIFO) method used to value the assets, create an incentive to draw down crude stocks in the region at the end of the year in order to reduce the tax bill. If oil prices have risen during the year, this accounting practice gives companies stronger incentive to reduce inventory because doing so will further limit their tax exposure. Conversely, if oil prices have fallen throughout the year, companies have less incentive to reduce crude held in storage.
EIA Inventory Recap - Week Ending 12/02/2022
The EIA reported a total petroleum inventory BUILD of 4.20 for the week ending December 2, 2022. Of this, Commercial inventories posted a weekly DRAW of 5.20 while SPR inventories DREW by 2.10.
YTD total petroleum EIA inventory changes show a DRAW of (232.30) through the week ending December 2, 2022. The bulk of this is due to drawdowns in SPR inventories.
Both Distillate and Gasoline inventory levels hover at the low end of their 5-year average for this time of year while US Commercial Crude inventories slide below its 5-year average.