Author: Brynne Kelly 6/20/2022
In last week's post, we stated that the 'Tension between supply and demand has never been higher'. This week we give that tension a timeline.
Over the weekend, OPEC Secretary-General Barkindo said that "9.7 million barrels per day of oil will be back by August". This prompted us to pull up a chart made in 2020 just after OPEC announced they would be taking 9.7 million barrels per day *off* the market in response to the demand drop caused by the pandemic.
The chart shows continuous 1-month WTI calendar spreads, narrated by OPEC actions leading up to their announcement.
As we now know, things got quite a bit worse from there as the cutout below shows the full 'before and after' picture of the spreads' reactions.
Some Background Detail:
In July 2021, OPEC held a pivotal meeting in which they outlined how and when they would begin to bring oil back to the market.
We reported on this in our July 18, 2021 weekly analysis. In it we featured the results of this meeting which are summarized as follows.
OPEC agrees to:
Increase overall production by 0.4 mb/d on a monthly basis starting August 2021 until phasing out the 5.8 mb/d (million barrels per day) production adjustment, and in December 2021 assess market developments and Participating Countries’ performance,
Adjust the Reference Production baseline for certain members , effective 1st of May 2022,
Extend the existing Declaration of Cooperation agreement through the end of December 2022, and
Endeavor to end production adjustments by the end of September 2022, subject to market conditions.
For additional reference, the original OPEC+ supply cut agreement by country is shown below, including revisions made to time frames and Reference Output adjustments made along the way.
Now let's come back to present time, to what we now know. We know that in OPEC's latest meeting (held June 2, 2022), the group agreed to a larger increase in supply than planned. As we outlined earlier, the 'plan' was 400,000 bpd each month of the contract period. In fact, the group said it would raise production by 648,000 barrels a day in July and then again in August. Effectively, this compresses 3 months worth of increases into two. Hence, reaching pre-pandemic reference targets a month ahead of schedule and the announcement over the weekend confirmed this.
Skeptics question whether or not OPEC Plus member countries are capable of generating that output when the time comes. It's been noted that many of the producers have already run out of additional production capacity. It's believed that only Saudi Arabia, the United Arab Emirates and one or two other countries have reliable capacity to bring to market with such short notice.
Some analysts say the fact that OPEC Plus was willing to depart from its previous routine could be the beginning of a breakthrough, leading to more cooperation from Saudi Arabia and other countries like the United Arab Emirates as sanctions reduce Russian output. This all remains to be seen.
We also know that in the US, the DOE continues with their planned release of 1 million barrels per day for six months. This brings us through the end of September, 2022.
Given the above, by this fall OPEC is expected to have fully restored production to pre-pandemic levels while the US Strategic Petroleum Reserve are scheduled to end their drawdown under the existing mandate. Although anything could happen to either variable above, they do serve as a focal point going forward. Where the rubber could meet the proverbial road this fall.
With that in mind, let's revisit where continuous 1-month WTI spreads were as of last Friday. Notice that spreads have begun to buckle a bit under the weight of added production and reserves.
This temporary onslaught of 'supply' however, is set to end by the fall. The release of US strategic reserves is merely a stopgap. The SPR is buying us time while we get viable longer-term supply sources nailed down. Those new supplies will come from mostly three overlapping areas:
US Production: Domestic output needs to get caught up
Government Policy: Implementation of new policies to kick in and do as promised
Reconstructed(?) Supply Chains: new commercial relationships and supply routes need to be developed, mature, etc.
All three are important, but the linchpin is the US Production.
Why do we need US production to catch up? Because more often than not lately, refiner demand for crude oil has exceeded supply. One way to visualize this is to look at the difference between weekly US oil supply (US production plus net imports) and weekly US oil demand (crude oil input to refiners) as reported by the EIA.
At a high level, a negative value indicates an imbalance that results in a storage draw. A positive value indicates an imbalance that results in a deposit in to storage. Notice the number of weeks that this difference has been negative. Indicating that 'organic' supply has been short by around 1 million barrels per day for a while now. That gap is essentially being filled by the SPR sales (of, not coincidentally 1 million barrels per day).
While US production *has* been on the increase back to pre-pandemic levels since early this year, it is still 1 million barrels per day below where it needs to be.
Which brings us to the title of this submission: Tension Has a Timeline Now. The focal point of that timeline is Fall 2022. By this Fall OPEC is expected to have restored production fully while US production will have hopefully fully recovered just as the SPR releases end. These events are expected to converge before next winter. Allegedly, we have to say.
This puts US production center-stage as the linchpin in this scenario. The linchpin is therefore also the wild card that could save or derail all of it. Not only does the above imply that the complex NEEDS production to increase to meet daily demand once the release of reserve barrels ends, but also to restock all the inventory draw-downs.
As far as crude oil demand is concerned, we may also get a respite early fall as refiners enter maintenance and demand less crude allowing it to flow in to inventory. This also does not bode well however for refined product inventory and our ability to restock inventories before the upcoming winter heating season.
Speaking of wild cards, it has been suggested that the US could ban exports of either crude oil or refined products as a price-fighting tool. While anything is possible, this doesn't seem to have a high probability of happening. For one, our European partners need it and the US appears to be doing all they can right now to 'pitch in' on the energy front. For another, we don't have the infrastructure in place to re-route exported barrels within the country. Trade routes and the logistics that support them take years to develop and are enormously expensive. In the short-term we are going to see a massive increase in costs due to the need for significant capital investments.
The battle to attract capital is a tough one. Investors are aware of the fact that countries have a long-term drive to move away from fossil fuels while at the same time also are experiencing short term supply shortages. Right now, the market is just biding it's time and will invariably react to current conditions such as weather, refinery outages and headlines.
One of the short-term issues that has been increasingly on the rise is the stability of power grids across the globe. This helps illustrate well our long-term climate aspirations being disrupted by the reality of the need for fossil fuels today.
According to the Financial Times, on Thursday, June 16:
Chris Bowen, the Energy Minister of Australia — the world’s biggest exporter of coal and Liquified Natural Gas — asked the residents of its most populous state New South Wales (NSW), to conserve power as much as possible during the peak demand hours of 6 pm to 8 pm to prevent blackouts. Mr. Bowen added, however, that he was confident that the government could avoid blackouts.
This came just a day after the Australian Energy Market Operator (AEMO), in an unprecedented move amid the ongoing power crisis, suspended the wholesale electricity market for the East Coast, which includes five of Australia’s six states. AEMO cited that the power market had become “impossible to operate” while ensuring reliable and secure electricity supply to Australian households and businesses.
Australian authorities have given themselves the power to block coal exports if the resource is needed to ease the country’s crippling power crisis in the latest measure taken to avert the risk of blackouts.
Rising coal and gas prices, coupled with outages at ageing coal-fired power stations, have plunged the market into turmoil this week, forcing the Australian Energy Market Operator to take control of the wholesale market to ensure reliable supply of electricity to eastern states.
The government of New South Wales invoked emergency powers on Friday to oblige miners operating in the state to redirect coal heading overseas to local generators. The precautionary move was taken to strengthen energy security on the advice of AEMO.
Over the past few years, we have seen the impact the loss of electricity has had in the US in both the summer and winter due to either hurricanes or freezing temperatures. Specifically, weather impacts along the US Gulf Coast are extremely disruptive to the producing and refining complex. We saw how damaging hurricane Harvey (2017) and winter storm Uri (2021) were to the complex. We also know that we don't have a lot of wiggle room at the moment to accommodate another hit to the complex.
As stated earlier, however, these are the type of events that are of immediate concern when the arise. That aside, tensions between supply and demand and how that equates to market prices have never been higher. We also now have a focal point with which to measure progress towards.
Market Impact
Next month, before the Fall, President Biden is scheduled to meet with Saudi Arabia. This is most likely to finalize anything that they have already discussed. The Saudis are seen as one of the few producers remaining out there with significant additional production capacity as mentioned earlier. They are also trying to improve their relationship with the Biden administration. But Riyadh also does not seem to want to break its five-year alliance on oil matters with Moscow, which is a co-leader of OPEC Plus.
Is Biden trying to hedge against a lack of US production growth from current levels? Something to keep an eye on now that we know where the focal point is.
Calendar Spreads
Front spreads are being contained at the moment by the supply additions noted earlier. However, the supply coming from the US strategic reserves is manufactured supply. It is filling a gap. Considering it is looking to hand the baton off to real production increases, its value in the mean time can be measured in badly needed US commercial crude oil inventory builds. Eventually, the DOE will become a buyer in the market as well, instead of a supplier as they replenish what they have released.
Some have even suggested they are looking to begin repurchasing some of these barrels as early as the end of this year. Combine that with the need for real production growth or alternative supply source to appear. Absent a shock to demand, that is.
As a result, calendar spreads are near their highs and volatile. Any collapse in spreads seems to be more about spot market fundamentals than longer-dated selling.
Prices have dropped but the need for prompt versus deferred oil seems to be sticker than usual so far. Could this be that even as speculative bulls exit, fundamentals are not fixed yet?
The extreme backwardation in calendar spreads like the 12-month Dec/Dec reflects extreme event risk. It's trading at spike-high levels as if the event is, or has already occurred. The problem with this is that the even HASN'T occurred. Rather, the expectation of the event is out there. Violent swings in either direction are alarming and can shake one's confidence while waiting for the expected reality, especially when trending too early.
Going back to our focal point of this fall, the same holds true for calendar spreads. They will continue to be victims of headlines and sentiment until we reach the event window.
Crack Spreads
Given all that we have discussed so far, it's no surprise that US heating oil crack spreads continue to remain strong for this upcoming winter. In fact, the January 2023 HO/WTI crack spread settled above $60 last Friday, marking the second time that happened last week.
This is an inventory play that highlights the real fear out there that there simply isn't enough time or capacity to restock for the upcoming winter. But, the steep backwardation of the futures curve also suggests a significant change in expectations beyond that. Again, pointing to how crucial the market views our actions to prepare are this fall.
Crude Arbs
The crude oil 'Arb', or rather the WTI/Brent futures spread has been decidedly undecided. We noted earlier that there are many trade routes and supply contracts in flux at the moment. This is being translated into the Arb against competing global headlines on a daily basis. What once was a more stable long-term relationship is now in question. How will the chips fall as the Russia/Ukraine war wages on?
That being said, when supply is tight buyers will take what they can get at the cheapest price possible. This leaves little room in the short-term for WTI to sustain any real discount to its European counterpart, Brent.
Bottom Line
What we can say confidently is the following: Over the last two months it has been hard to determine what to prioritize as most important and deserving of our focus in assessing future oil price equilibrium. The best we could hope to do was organize drivers into supply versus demand factors. The noise to signal ratio has been very high during this time as well. But this past week's events have given us something real on which to focus. Deadlines are now out there.
The scheduled events of Saudi production, SPR sales ending, and expected ramp up in US production are all converging in the fall. All (not?) coincidentally while maintenance season starts. So to the extent that the Saudis play well in the sandbox that will go smoother. But most importantly, US production has to catch up or the other pieces do not come together
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EIA Inventory Recap - Week Ending 6/10/2022
Weekly Changes
The EIA reported a total petroleum inventory DRAW of 5.80 for the week ending June 10, 2022. However, commercial inventories rose again for a second week by 1.90.
YTD Changes
YTD total petroleum EIA inventory changes show a DRAW of 113.60 through the week ending June 10, 2022.
Inventory Levels
Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years are have gone from way above historical levels to surprisingly below historical levels and should continue to flounder while backwardation in the market persists.
