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Playing With Matches

If you are going to do something which is potentially dangerous, don't be surprised if you get hurt.....

Author: Brynne Kelly 1/31/2022

The intense battle between Russia, the U.S. and Europe is yet again driving the fear of war, and perhaps even invasion. The Ukraine is a front to both the East and West, which means that a country, a nation could be deplorably sacrificed. Russia, which invaded Crimea, and annexed eastern Ukraine, is trying to solidify its position in the Black Sea and Eastern Europe. Meanwhile, the U.S. and the West are trying to ensure their own security by manipulating the fate of other countries. They are using Ukraine as a front against “the threat from the East.”

This narrative led to an endless stream of geopolitical headlines that are colliding with reduced production, low inventories and frigid temperatures and driving markets to new highs. The tinder is dry and extremely vulnerable to the spark of fire. This led to an exciting, volatile week for energy markets, specifically natural gas and crude oil.

But, when a child starts playing with matches, it's time to have a calm, serious talk about the rules and consequences of this behavior. Oil markets are reflecting the consequences of the global game that is being played out. The stakes are always higher when natural resources are deemed to be tight. This creates leverage. Leverage is best applied at the extremes. It is believed that we are at an extreme when it comes to oil inventories, production and demand. The graph below highlights the relative low level of current US petroleum inventories versus prior years. Only took us 8 years to work our way back down to pre-shale 2014 inventory levels!

Let's be real here......going forward do we expect there will be another time in the modern history of US oil production growth like the one we witnessed from 2014 - 2020? Is another 'Shale Revolution' on the horizon? History has shown that rapid production growth crushes the market for years to come without a similar expectation of rapid demand growth.

The upcoming OPEC meeting on February 2 should deliver the expected 400k bpd of production increases, which might seem benign on the surface. However, we should ask ourselves: when does everyone quit looking for a production handout and start focusing on individual accountability? Remember the bygone days of exponential US shale production growth? When chasing the dream of participating in the world theater of energy through exports would reduce the US international trade deficit? Producers were willing to endure significant periods of losses while chasing the dream of future nirvana.

Fast forward to today and you would be hard-pressed to find a producer that isn't disillusioned and unsure about the future landscape of energy demand. Pledges to climate change initiatives that promised lofty deliverables decades in the future are now coming due making it more difficult for energy majors to commit capital. In the midst of 'pivoting' away from fossil fuels they are suddenly getting the 'side-eye' wondering why they are not growing their fossil fuel production.

We are now in what feels like a dry forest where any spark could set off the proverbial forest fire. Before we dive in to this week's market analysis, let's review some of the key news headlines last week that contributed to upside momentum.

The Events That Shaped Last Week


Last week, The U.S. Department of Energy announced another loan of 13.4 million barrels of crude oil from its strategic reserve as part of a renewed effort by the Biden administration to contain oil prices that have surged to their highest level since 2014. The awards to seven companies -- part of a previously announced move -- mark the second-largest exchange of oil from the Strategic Petroleum Reserve ever, and bring the total amount of oil released from the cache to nearly 40 million barrels, according to the Energy Department.


Last Monday, meteorologists began tweeting about a possible nor'easter impacting the Mid-Atlantic and Northeast from Friday Night to Saturday. The system, named Winter Storm Kenan by The Weather Channel, brought blizzard conditions to areas including Boston's Logan Airport and the New Jersey coast as well as parts of New York, Connecticut, Delaware and Maine.


Near-record food prices risk elevation as soaring crude oil increases the appeal of turning more agricultural commodities into biofuels. Benchmark palm oil futures traded near a record, raw sugar hovered around a 2-week high, while soybeans, soybean oil and corn climbed.


More Chinese are joining the great travel rush back to their home towns for the Lunar New Year holiday despite the spread of omicron, unleashing pent-up demand and providing a bump to oil consumption. The surge in journeys will aid oil demand just as crude prices soared to the highest level in seven years on stronger than expected consumption and shrinking stockpiles. That’s prompted a raft of banks including Goldman Sachs Group Inc. to predict a return to $100 oil this year.


Kremlin: Present tensions are reminiscent of the Cold War.

BBC: Pres Biden warned there was a distinct possibility Russia might invade Ukraine next month, reaffirmed in call with Ukraine Pres Zelensky the readiness of the US to respond decisively if Russia further invades Ukraine. US: has called for a UN Security Council meeting for Monday to discuss build of Russian troops on Ukraine border. Biden also told Ukraine’s Pres. Zelensky: The US is looking into additional macroeconomic assistance for Ukraine.


Iran nuclear talks are entering a critical stage. Whether a deal can be reached in the coming weeks or months from Iran's nuclear talks will affect forecasts for the supply-demand balance in the oil market, as Iran could increase its oil exports by 1 million barrels a day in the first year of sanctions-free exports. A full resumption of the deal and the lifting of U.S. sanctions would push oil prices lower as the glut of oil on the market would increase. The longer the nuclear talks drag on, the longer it will take for Iran to start increasing oil exports with a deal. Western countries and the United States in the JCPOA fear that a further delay in talks would allow Iran to advance its nuclear weapons activities. Oil prices will be very bullish if the talks in Vienna break down, with market balances expected to tighten in 2023 and 2024, and the standoff between the US and Iran could further fuel tensions in the Middle East.


A U.S. judge on Thursday revoked 80 million acres of Gulf of Mexico oil and gas leases for underestimating the climate impact and risks, Earthjustice, which filed the law suit, said. A federal judge on Thursday invalidated a massive oil and gas lease sale for 80 million acres in the Gulf of Mexico after a coalition of environmental groups sued the Biden administration to stop it. The ruling cancels 1.7 million acres of oil and gas leases from that sale, according to data from the Bureau of Ocean Energy Management. The administration tried in its first days in office to put a stop to new oil and gas drilling. On January 27, 2021, Biden signed an executive order that paused new permits and directed the Department of the Interior to launch a "rigorous review" of existing programs related to fossil fuel development.


Last week, Goldman Sachs downgraded US financials from overweight to neutral. Concurrently, they upgraded US energy stocks from neutral to overweight.

Once again, last week delivered another endless supply of bullish chatter that propelled prices higher. Is this just the beginning? Let's look underneath the hood a bit to gauge what is happening.


Commodity markets are vulnerable to short-term disruptions in supply or demand that can translate quickly to front-month futures prices. Weather events, unplanned outages and sudden shifts in producer/consumer behavior are the usual culprits and historically fairly short-lived. Every so often though, events come along that permeate the entire curve by dragging longer-dated futures along for the ride. The type of move that causes either producers or consumers to significantly revalue their business.

These moves tend to be more extreme when either side of the supply/demand balance is off-sides. In 2020, the market was 'off-sides' with too little demand. This was followed by an extreme accumulation of inventory (right chart below).

Refiners, as a whole, attempt to balance weekly crude oil supply and demand. Any mismatch shows up in weekly changes in oil and oil product inventories. With excess inventory eliminated from the equation by 2022, the focus has shifted to production and demand. The above chart on the left highlights how the total supply of crude oil for refiners (black line, production plus net imports) has increased to meet refiner demand (blue line, weekly US crude oil input to refiners) despite the fact that US oil production has remained stagnate.

Holding on to Winter

Energy products like gasoline, heating oil and natural gas have a distinct seasonality about them. Some are winter peaking (natural gas and heating oil) and others are summer peaking (gasoline). In general, 'winter' is defined as the five month period from November through March and 'summer' is defined as the seven month period from April through October. With March being the prompt futures contract on the board, we are in the last month of the traditional winter season.

At the moment, 'winter' fundamentals are in the driver's seat for the Northern hemisphere which includes the United States and China. As we know, these two nations are the greatest oil consumers worldwide. The long-anticipated frigid winter temperatures have finally arrived and are doing their best to deplete inventories. Both driven by heating demand.

Relatively speaking, both crude oil and natural gas are moving higher, with the move in oil outpacing natural gas. This can be see in the chart below (the heat-content adjusted spread between US crude oil and US natural gas benchmark futures).

Basically, as inventories are depleting, the marginal unit is becoming more valuable.

But, will we have a smooth handoff between winter and summer fundamentals? Since gasoline is the bellwether of summer demand, we take a look at the build in inventories this winter is going in preparation for the upcoming driving season.

Given all the focus on the recent weekly builds in gasoline inventories as a potential pain point, the chart above suggests that we might be falling behind (purple line above). The next several EIA inventory reports will be key as we have not yet approached the pre-summer inventory levels seen in prior years. Distillate inventories on the other hand have continued to wane as frigid temperatures and robust diesel demand (for trucking) have reduced inventory levels towards seasonal lows.

As a result, we are starting to see gasoline spreads begin to take the lead via the 'summer versus winter' spread (June vs December) in the chart below (blue line = gasoline).

While the seasonal spreads within the gasoline complex are showing some signs of leadership, gasoline cracks are stalling a bit as they approach the $20 level on a calendar strip basis.

It is fairly imperative that gasoline markets gain some leadership and we begin to transition from winter fundamentals to summer fundamentals.

Bottom Line

It feels like we are playing with matches. One strike could set the whole thing on fire. Even if the global headline tensions surrounding the Ukraine and Russia subside without incident, the underlying fundamentals are still supportive. But, absent aggravating circumstances may not have the power to move higher from here.

Of Note Over the Weekend

  • North Korea confirms it tested Hwasong-12 missile and took pictures from space

  • Japan's Chief Cabinet Sec. Matsuno: We believe that a subsidy program for oil wholesalers will gradually slow the rise in gas retail prices.


EIA Inventory Recap

Weekly Changes

The EIA reported a total petroleum inventory BUILD of 5.70 for the week ending January 21, 2022 (vs a net BUILD of 3.60 last week). However, inventories at Cushing continue to draw.

YTD Changes

YTD total petroleum EIA inventory changes show a BUILD of 20.00 through the week ending January 21, 2022 (vs a net BUILD of 20.30 last week).

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.


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