Author: Brynne Kelly 3/21/2021
Over the last several weeks we have been talking about the rally in oil spreads. At every turn, spreads were at or close to historical highs. Last week, markets continued to hold firm through inventory stats. That is until Thursday, when oil markets got absently crushed and ended the day down 7%. There wasn't any singular headline that prompted such a selloff, rather a lack of a new catalyst to propel markets higher. By Friday's session markets had stabilized and WTI closed the day up 2.4% (blue dot below).
Were there any signs?
March definitely came in like a lion as outright oil prices continued to make new 14-month highs. Underneath the surface though, the front of the market started losing value relative to the back of the market. To highlight this, we use a rolling spread comparison between the front 6-month spread (month-1 vs month-6) and the back 6-month spread (month-7 vs month-12). For a brief period between February 23 and March 4, the front vs back spread moved into backwardation, reaching it's peak on February 26 at +$0.41.
This move stands out because in the last 5 years, there have only really been two other times that the front 6 month spread (blue line below) has decidedly traded at a premium to the back 6 month spread (green line below).
Does this have any correlation to outright prices? Loosely, it seems. Comparing the above spreads with front month futures, the data reveals that short-term spikes in the front spread above the back spread have been followed by a new high in front month futures (red line below) and then a steep selloff. The inability of a rally in the front-6-month spread to hold relative to the back is met with skepticism and a belief that the fundamental story is over. Are we getting a similar signal this time or is it different?
One area of the market provides a glimmer of hope and that is the front calendar spread. Not since last August (2020) has a one-month calendar spread in WTI expired in backwardation (pink line below). Tomorrow (2/22), marks the expiration of the April-21 WTI contract and with it the Apr-21/May-21 calendar spread (green line below). Surprisingly, this was NOT the weakest link in last week's selloff. In fact, the front spread held up fairly well considering the 7% selloff last Thursday in outright prices. Brent markets have routinely seen the front calendar spread expire in backwardation. Yet Brent futures are largely financial in nature while WTI futures are largely rooted in physical expiration.
That being said, there is only so long that the market can tolerate front calendar spreads expiring weak before it begins to permeate the entire curve. Is last week's action in the Apr/May spread finally pointing to some of the cyclical strength that is typical ahead of summer driving season? That would be a big help to overall market sentiment. Coupled with the tenuous nature of OPEC+ production cuts, it would be reasonable to finally expect the front calendar spread in WTI to expire with some strength given the size of existing production cuts.
We know that at the last OPEC+ meeting, the Ministers approved a continuation of the production levels of March for the month of April, with the exception of Russia and Kazakhstan, which will be allowed to increase production by 130 and 20 thousand barrels per day respectively, due to continued seasonal consumption patterns. However, we do not know whether those cuts will continue. The next meetings of the JMMC and OPEC and non-OPEC Ministers are scheduled for 31 March and 1 April 2021, respectively.
To round out the calendar spread picture, we turn to continuous 12-month calendar spread futures in both Brent and WTI. Even here we see the front of the market losing steam relative to the back. The concern here is that persistent strength in calendar spreads has led the overall market higher. Rolling length from the front of the market to the back in hopes of future strength will dampen this overall bullish sentiment. This could lead to a lack of appetite to buy spread dips ahead of the next OPEC+ meeting absent another catalyst. Inventory data could be one new catalyst next week as could global political risk.
Cyclical Tailwinds
In our last report we pointed out some of the cyclical tailwinds that were being used to underpin market strength including:
Inventory levels & Seasonality
Demand Recovery vs Production
At the time, both were presenting as supportive to prices. Since then new data has emerged regarding a lengthier vaccine campaign in Europe (due to delays and increased hesitancy). According to Rystad Energy, this could delay the recovery of 1 mb/d of oil demand this year. As we saw in the one-month calendar spread chart above, these continued blows to demand recovery have led to weak front-month expirations in WTI.
Some of this can be attributed to the disruption caused by the winter weather in Texas last month. Finally, though, last week we started to see the refinery complex resume operations. This is another cyclical tailwind. In normal times, a ramp up in refinery utilization ahead of summer would lend support to crude oil prices as refiners begin to exit turnaround season and consume more crude oil. However, even after last week's increase utilization rates are still well below their 5-year average. Contrast this with last year when the pandemic hit, the severe drop in refiner utilization led to a massive selloff in oil prices. This year the story is a completely different picture. The expectation is that refiners will continue to resume operations, and this return towards historical average operating levels by refiners will inevitably be met with increased oil output. As long as this can happen without overwhelming inventory balances, oil prices could remain supported.
For reference we compare the combined US oil and product inventories to prior years and the 5-year average. We currently sit modestly above 5-year average levels with a seasonal (cyclical) decline in inventory levels on the horizon. The slight uptick in overall levels last week is not worrisome unless it becomes a trend.
Overall last weeks EIA changes were fairly flat. Absent a new catalyst to provide continued headwinds to futures prices, the market got spooked by potential demand weakness brought on by new covid-19 restrictions in Europe. Cyclical strength fell victim to the broader sector weakness.
Sector Headwinds
The traditional energy complex as a whole is facing sector weakness buoyed by ESG preferences and the anticipation of stricter climate-related restrictions from the Biden administration.
According to the Financial times, "the US Securities and Exchange Commission has directed two of America’s biggest oil companies to hold shareholder votes on far-reaching new emissions targets, as the regulator adopts a tougher approach to climate under the Biden administration. The SEC denied requests from both Conoco Phillips and Occidental Petroleum to throw out shareholder motions that would force them to lay out detailed plans for cutting their so-called “Scope 3” emissions — those from the burning of their products by customers."
For oil and natural gas exploration and production companies, scope 3 emissions fall primarily into the “use of sold products” category. As production goes up, so generally do a producers scope 3 emissions. One issue with scope 3 emissions is that they are someone else’s scope 1 or 2 emissions. For example, the scope 3 emissions from refining produced oil are a refiner’s scope 1 emissions. The combustion of that oil in the form of a finished product such as gasoline are also scope 3 emissions for the producer of the oil, the refiner and the marketer. This leads to double counting throughout the economy.
This cuts to the very heart of how to meet a return to normal demand in the face of growing regulations meant to address climate change. Will producers and refiners be hesitant to ramp up their production of traditional fuels knowing that they face increased regulatory costs?
Historically low oil prices along with low demand this past year have potentially masked the increasing burden of regulatory compliance. For example, even with a slight pullback last week, overall the cost of RIN's have continued to post new highs throughout the pandemic.
It seems inevitable that without higher oil prices and refining margins, the marginal cost to produce will continue to increase in the foreseeable future as a result of regulatory burden. For now, as of last Friday's close, the average 3-year continuous futures strip price was still above $55.00. This is the upper-end of it's range, absent 2018.
Oil has long been the engine of the world's economy, and even today—as the search for alternative energy sources gains ground—life without crude oil is hard to imagine. Carbon-based fuels are used in heavy and light manufacturing, in the production process (chemicals, textiles, detergents, and medicines), and in every sector of our transportation industries. Will a 3-year average strip price above $55.00 be enough to entice production growth given the regulatory burdens noted earlier, or will a failure at that level lead to another round of producer selling before the price recovery slips through their fingers?
The cyclical tailwinds that have pushed markets higher over the last year now have to deal with the uncertainty created by sector headwinds, caused by regulatory restrictions and demand uncertainty. Cyclical strength needs to prove itself as the winner.
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EIA Inventory Statistics Recap
Weekly Changes
The EIA reported a total petroleum inventory BUILD of 3.10 million barrels for the week ending March 12, 2021 (vs a draw of 3.60 million barrels last week).
YTD Changes
Year-to-date total inventories in 2021 are DOWN by 14.60 million barrels (vs 17.70 million barrels last week).
Inventory Levels
Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years reflect the imbalance between oil and refined product production created by the winter weather in Texas.
