Author: Brynne Kelly 6/12/2022
The tension between supply and demand can been narrowed down to supply-side unknowns and demand-side uncertainties. Future supply is unknowable at best. All the forecasts in the world are just that, forecasts.
The current environment of chronic war is an archetype that hasn't been completely embraced. This is a result of the short-term nature of supply disruptions that have occurred over the last decade. Quick spikes higher followed by an equally quick retreat once the impact of supply disruptions are defined. Recently however, supply-side issues are the most critical piece of the equation. The 'unknown' unknowns that hinge on forecasts and expectations are yet to solidify themselves into any sort of reliable trend.
On the demand side, we can narrow it down to 3 likely price drivers that can tip the scale. Those are: Fed Policy, Covid, and Price Levels. Of those 3, Covid has been the only one that has the potential to swing markets on a short-term basis. This equates to outsized headline risk.
Even trying to handicap Fed policy or Price-driven demand destruction is, again, reliant on so many moving pieces that the math is dated 24 hours after its done. The input calculus from Fed policy changes almost daily as evidenced by equity market gyrations and conflicting economic data.
The day-to-day actions in response to higher prices have become difficult to prioritize because there are so many evolving variables currently. The noise to signal ratio is so high right now, and the signals are becoming less reliable.
Esoteric tiny risks suddenly become magnified when they need to be unwound. Yet, this doesn't mean that any particular trade is 'crowded'. It just means that with so many factors leaning one way, it only takes one headline to cause a violent move in either direction. The dynamic is a very precariously balanced situation. Any sign of an imbalance can cause extremely exaggerated reactions in price.
Consider that a mere two years ago it was widely accepted that $60 a barrel oil would be the panacea for both producers and consumers. With WTI closing out last week at around $120/bbl, we are a LONG way from home. All of this leads one to ask the question: what is the definition of ' lower STABLE oil prices' these days?? What, exactly, would be a victory here?
With this much tension and uncertainty, it's good to step back and look at the whole canvas here. There is a lack of confidence in relationships and correlations that we could historically at least use as reference points. Meanwhile, the market waits for the true fundamentals to emerge.
What do we know, and what do we not know?
On the supply side, we have a constant moving target regarding growth production. On the demand side, we have the 'hope' that high prices will do their job to erode usage over time. In the meantime, Strategic Petroleum Reserves are being used to fill the void and lend some stability.
For the sake of accuracy, regarding said releases of reserves, we review some detail provided by the Department of Energy on their website.
In accordance with the President’s announcement, 90 million barrels will be released between May and August through two notices of sale totaling 70 million barrels and 20 million barrels from ongoing emergency sales. DOE has been executing on this announcement releasing oil from the Reserve at approximately that rate over the last several weeks.
THE REPORT GOES ON TO DETAIL THE AUGUST THROUGH OCTOBER RELEASES:
The first 90 million barrels will be released between May and mid-August. This includes 20 million barrels already scheduled to be released in May before the President’s March announcement, 30 million barrels noticed for sale on April 1 following the President’s announcement, and the 40 million barrels being released through this notice of sale. The remaining 90 million barrels will be released between August and October.
Finally, most of the promised crude being delivered to the market under this release is sour, as the DOE explains:
"Under this notice of sale, the SPR is offering to release up to 39 million barrels of sour crude oil and 1.1 million barrels of sweet crude oil, totaling 40.1 million barrels."
Thus far, none of this has yet to make an impact on Commercial US crude oil inventory levels (red line below). Which tells us that immediate 'demand' is gobbling up these physical barrels via local refiner demand or export demand (aka, loaded on ships for export). This coincides with continued strength in WTI calendar spreads (black line below = continuous 6-month futures spread).
Staying with the supply side, the latest US EIA Short-Term Energy Outlook issued for June 2022 provided the following forecast:
The US is currently producing right around the fiscal year 2022 forecast average (11.90 million bpd). From here, there is a lot riding on supply growth. In fact, the forecast calls for another 1 million barrels per day of production by the end of next year.
One could argue that we actually already are consuming at that level, it is just being being masked by the 1 million bpd SPR release. It remains to be seen if that can actually happen given current circumstances. Again, this is the projection that is out there AND WHAT WE MUST WORK WITH.
Next, we look at what the weekly EIA data reveals about the current supply/demand balance. The chart below compares US crude oil supply (production plus net imports) with US crude oil demand (weekly crude oil input to refiners). The difference between the two is balanced weekly via inventory injections or draws (blue line above black line = storage draw).
Note that between 2014 and 2020 the 'run rate' of supply and demand spent most of it's time above 16 million barrels per day before collapsing to much lower levels during the pandemic. Recently, however, demand has once again entered historical 'run rate' territory (shaded green area above). Supply however, has not. Whether or not this trend reverses remains to be seen and, as yet it has not provided any sort of trend to rely on.
On that note, let's review the current production trend in the US:
Doesn't seem like a big uptick in production given where prices are, does it? Are we on a precipice of explosive supply growth? To answer that, let's look at divergent narratives out there. Here are just a few recent examples:
Biden: Oil companies such as Exxon are not making new investments. Corporations should be required to pay taxes on share buybacks.
U.S. President Joe Biden on Friday said he was working with U.S. oil companies to boost output to record levels next year, while accusing the industry of capitalizing on a supply shortage to fatten profits. U.S. consumer inflation accelerated in May as gasoline prices hit a record high and the cost of food soared, leading to the largest annual increase in four decades. Biden, who came into office vowing to reduce U.S. dependence on fossil fuels, said on Friday he was hoping to speed up oil production, which is expected to hit record highs in the U.S. next year.
The European Commission is currently reviewing and assessing a proposal from the European Chemicals Agency (ECHA) to classify lithium carbonate, lithium chloride, and lithium hydroxide as substances hazardous to human health. An EU committee is meeting early next month to discuss the proposal, while a final decision on the issue is expected toward the end of this year or early next year. If the EU decides to include the lithium chemicals in the hazardous category, it would deal a blow to its own goals of becoming self-sufficient in batteries this decade. The decision would change the way lithium producers and processors work and will add costs to their operations.
The German auto industry is protesting a decision by EU parliament to ban the sale of cars that run on petrol and diesel by 2035, describing it as detrimental to the market and consumers.
The New Zealand government announced a draft plan where farmers will have to pay fines for their animals’ emissions starting in 2025. According to the Washington Post last week, "New Zealand has more sheep than people, by a factor of about five. Now those sheep and other livestock could be taxed for incessant belching — a major source of greenhouse gases for the Pacific island nation. The government Wednesday announced a draft plan to charge farmers for their livestock emissions, in what would be the first effort of its kind. The plan is part of a larger emissions reduction initiative proposed by the Ministry of Environment, which includes plans for its energy, transportation, waste and job sectors beginning in 2025."
Waste of energy: why Japan’s gamble on power since Fukushima could mean a hot summer, rolling blackouts, and the restart of nuclear plants.
There is simply nothing one can really sink their teeth in to. Confidence in any of the above band-aids making any sort of impact in the short-term is minimal.
One trend worth noting on the supply side, is the increase in oil rig counts. Last week, the oil and gas rig count, an early indicator of future output, rose six to 733 in the week to June 10, its highest since March 2020, energy services firm Baker Hughes Co said in its closely followed report on Friday. Baker Hughes said that puts the total rig count up 272 rigs, or 59%, over this time last year. U.S. oil rigs rose six to 580 this week, their highest since March 2020, while gas rigs were unchanged at 151 for a third week in a row.
Given the backdrop of a hot summer, hurricane season and infrastructure failures as a result of non-stop use and an increase in rig counts feels minimal at the moment. It's not a reliable trend yet.
Market Impact
There are so many potential drivers of this market, it's extremely difficult to identify the appropriate lever to drill down into.
What we do know is that there are a limited number of things that can bring down demand at this point. They are: Policy (driven by the fed), Covid outbreaks, and Price. Normally, it's easy to find which of these drivers is the most crucial and position accordingly.
But, with flat price and spreads coiling near their highs, the big drivers are not as easy to see.
Therefore, we continue to keep an eye on spreads (calendar, cracks and arbs) each week as we try to handicap the importance of each.
Calendar Spreads
Butterflies have become a go-to trade in the current environment. They trade within smaller ranges than flat price does, offering a more appealing risk profile. Below we profile the Dec/Jun/Dec butterfly in Brent.
Historically, they appear to be trading near the top end of the range at the moment (light green line above).
Continuous 1-Month spreads have a tendency to react with much more rigor to abrupt disruptions in the supply/demand equation (below).
The trend is decidedly higher, not currently appearing to want to give up any ground. But, still at such high levels that confidence in shorting them is low while at the same time confidence in buying them is low. Everyone wants to buy a pullback when they are rallying, but is afraid of pullbacks when they appear. Another sign that fundamentals are difficult to handicap and everything is an emerging trend.
Crack Spreads
There is no denying that the refining sector is a pain point in today's market environment. In last week's report, we discussed the myriad of daily refinery hiccups that are relentless, which is lifting refining cracks into the stratosphere.
These factors haven't changed. Especially in distillate markets. As a result, there has been no material pullback in HO/Brent spreads. In fact, not only are spot market distillate refining cracks strong, but it is spilling over into the calendar 2023 market (dark blue line above).
Crude Arbs
Since the US lifted the crude oil export ban several years ago, traders have been attempting to measure the 'arb' between US WTI and European Brent markets. Factoring in transport costs, insurance, etc. in order to determine if the spreads were too wide or too narrow (meaning too much of an arb or too little).
Recently, this spread has become somewhat of a proxy for war sentiment and a vote as to which region of the world will be relatively in more dire straits.
I think the jury is still out on that. After all, it's not easy to handicap global monetary policy positions via the crude oil market. What we do know, however, is that oil is in demand and any relative 'cheap seat' will be bought.
Bottom Line
Supply is the 'news' right now. A hand grenade that may or may not go off, wholly governed by event risk. Demand is wholly governed by policy right now as a function of the Fed.
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EIA Inventory Recap - Week Ending 6/03/2022
Weekly Changes
The EIA reported a total petroleum inventory DRAW of 3.40 for the week ending June 3, 2022. However, commercial inventories rose by 2.10.
YTD Changes
YTD total petroleum EIA inventory changes show a DRAW of 107.80 through the week ending June 3, 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 draw as long as backwardation in the market persists.
