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"Structure" Trades Dominate Oil Markets

Updated: May 31, 2022

Traders ditching flat price trades in favor of spreads for a couple of reasons

Author: Brynne Kelly 5/29/2022

The amount of time that WTI crude oil has spent above $100 over the last 10 years is minimal. History has shown that at it's extremes, volatility gets amplified. This puts traders on edge as it constantly feels like the rug could be pulled out from underneath the market leading to large daily swings IN EITHER DIRECTION.

This inevitably leads to smaller market positioning and a greater emphasis on spread trading. We can begin to see this in the Commitment of Traders Open Interest data (below).

At first glance, it might not appear as if there is anything significant to look at here regarding open interest. It certainly doesn't register as much of an outlier compared to history. However, it is interesting to note that current open interest data (through 5/24/22) is slightly lower than levels seen the last time WTI was above $100 (circled in black above).

This makes sense for a few reasons:

  • Relative to history, outright prices themselves are in a rarefied area above $100. An area that has proven to be unsustainable historically as demand destruction and profit-seeking producers become a factor.

  • The macro-economic environment is facing a US fed that is in tightening mode. Meaning that 'risk-on' asset trades start to look shaky as players worry the rug could be pulled out from underneath them at any moment.

  • Since the start of the Russia/Ukraine conflict, the correlation between spot markets and futures markets have broken down due to the difficulty in obtaining quality collateral for deals.

  • The bifurcation of available collateral means there isn't enough to justify the open interest that is normally carried in comparative periods in history.

Accordingly, market players are now trading more 'intra' commodity spreads than 'inter' commodity spreads due in part to the favorable margin offsets provided by exchanges for intra commodity spread.

Flat price trading has become a coin-flip. Players are reticent to express outright directional opinions in such volatile, potentially event-driven markets. One cannot scale one's opinions in flat price effectively without facing above average exit risk from uncertain liquidity.

For example, over the weekend, Shanghai authorities announced they will be easing a city-wide lock-down that began some two months ago this Wednesday, and will also introduce policies to support its battered economy. In addition, Beijing city officials announced that two districts can switch from work-from-home to normal mode UNTIL this wave of COVID outbreaks are well under control. The lock-downs in China have been a weight hanging over the markets.

Or how about last week, when in an effort to signal that the US White House was on top of runaway fuel prices they proffer some headlines hinting at legislative actions being considered. Lately, these feel more like plugging holes than solutions. The overall sense is that policy isn't intersecting with reality. As a result, the market SHOWS INITIAL INTEREST but has little follow-through.

The main market-moving headlines last week that DID spook markets lower when they hit the tape were:

  • The White House is considering environmental waivers for all blends of US gasoline in order to lower pump prices - sources

  • House passes Fuel Price-Gouging Bill

  • After a period of silence from Washington on the subject, it appears that the U.S. is going to ease its sanctions on the Latin American oil giant. At the same time that the U.S. is lifting some sanctions, Venezuela is working with Iran to help revive its oil industry. It seems geopolitics has taken a back seat to the global energy crisis as oil prices soar.

Combined, the conditions noted above are driving market players further into spreads rather than outright positioning. However, as we will see below, spreads are now so wide that they are acting like the current conditions are temporary. When a condition is expected to be temporary, structures blow out (i.e. the front of the market takes the brunt of the impact). When a condition is expected to be pervasive structures flatten out as the market normalizes to new levels or new market fundamentals.

As money flows into spreads, they tend to get distorted. Let's take a look at how the spread markets have reacted and ask ourselves if they have gotten ahead of flat price or are a sign of more to come.

Market Impact

With oil prices trading at nosebleed levels, professionals have been more focused on trading 'structure' in the complex rather than outright 'price' levels for obvious reasons. As a result, structural relationships that are normally fairly range bound are providing directional trading opportunities like never before. Even though the spreads themselves have increased in volatility, the dollar moves are generally much smaller than those in the flat price world and therefore have become somewhat of a 'proxy' for market sentiment.

Calendar Spreads

Normally, spreads tend to regress to the mean and professionals trade them IN MORE SIZE at the extremes. Now, post invasion it would seem that spreads are no longer behaving that way. Will this continue as long as there is a war and sanction issues or will they begin to normalize back towards their mean as flat price adjusts to a higher normal level?

Below we take a look at continuous one-month WTI futures spreads. The black line represents the month-1/month-2 spread and the gold line represents the month-2/month-3 spread.

Note the fairly normalized range trading that existed in calendar spreads before Russia invaded Ukraine. This all changed once the war began. The initial shock of the news sent spreads to record highs until quickly retreating after the US announced another major release of Strategic Petroleum Reserves. Since then, however, spreads have begun to once again move up as they are now being used as proxies for expressing market sentiment.

The move in the chart above is confirmed by the increased volatility of front month spread versus the continuous futures (below, purple line = M1/M2 spread, black line = continuous M1 futures).

When it comes to trading spreads as a proxy for market sentiment, each market has it's own 'darling' that it uses to express that. In crude oil that is the 12-month Dec/Dec spread. The home of producer flow hedging and directional speculators. In natural gas it is the infamous March/April spread, where levered speculators love to play.

Crude oil Dec/Dec Spread History:

Natural Gas March/April Spread History:

These two spreads have more in common that one might think. They are more volatile than most other spreads in their respective complexes and they attract a lot of capital. They are also both known to ultimately conform to market fundamentals as expiration nears. They also both attract a disproportionate amount of speculative length.

So far it seems as though there is no stopping either of them. But, we are keeping our eye on them for sure for signs that they have potentially gotten too far ahead of flat price moves.

Crude Arbs

Growing threats of increased international sanctions on Russian grades have seen European buyers shun medium sour Urals, redirecting flows of the crude toward price-sensitive Asian buyers such as India and China, sources said. This has thrown global relationships between benchmark crudes into turmoil as new norms going forward are defined.

Since 2013, Brent has been the more expensive crude blend thanks to its status as the global oil benchmark and a better indicator of global oil prices. However, WTI has lately been gaining prominence thanks to Europe's move to impose a formal embargo on oil from Russia, which is pushing countries in the bloc to race to secure supplies from other markets. At the same time, U.S. refiners are trying to ramp up activity to meet demand, which is also squeezing WTI higher.

Currently, Europe receives about 2.2 million barrels per day (bpd), or half of Russia's total crude oil and petroleum product exports and 1.2 million bpd of petroleum products.

What's interesting is that initially, after the US announced it's massive SPR release, it was assumed that WTI would weaken relative to Brent. One key reason this hasn't played out that way is due to macro economics. Bottom line, the US economy is doing better so far during this recovery than the European Union. The US Fed is midway through a tightening phase well ahead of the EU, implying that they will also exit this cycle earlier than the EU.

At the moment these two benchmarks SEEM barely related. There is so much going on that could derail a trade like this. For one, as mentioned earlier, a crisis of good collateral to express such cross market spreads exists. For another, this trade is highly susceptible to differing margin and exchange regulations.

Bottom line, good ideas can get crowded really fast because of a potential exit LIQUIDITY problem. Realizing any of these moves for size is becoming an issue. Note the move in the WTI/Brent spread over the last 10 days. Somewhat counter-intuitively the spread has tightened.

If we zoom out and look at the curve shift over a longer period of time (since the beginning of 2021) we note that while the relationship between the two products has deteriorated since the start of the war, it's beginning to work its way back to 'normal'.

The question now becomes whether or not this will continue.

Crack Spreads

Following the decision to stop importing Russian oil, there has been a number of cascading effects. The loss of distillates, gasoline, and gasoline ingredients has refiners scrambling to make up a deficit. Most of the imports coming from Russia were finished products. The U.S. imported some gasoline, but it was primarily distillates (e.g., diesel), and unfinished oils like naphtha that are used by refineries to make gasoline.

The net result is that inventories of both distillates and gasoline are well below the normal range for this time of year, while refiners are running at over 90% operable capacity. There isn’t a lot of room for additional production.

But, when looking at the move in both gasoline and distillate crack spreads relative to WTI, they continue to remain elevated but nothing new really stands out.

Distillate Cracks:

Gasoline Cracks:

Product markets are thin and in distress. We don't expect that to change until inventories reach a more comfortable level.

Bottom Line

Volatility in crude oil prices, supply chain disruptions, and global inflation remain key risks to outright price levels. Lack of quality collateral, elevated margin rates and speculative positioning are pushing traders into spreads as a last resort to express market sentiment. There is some concern that spreads may be getting ahead of themselves.


EIA Inventory Recap - Week Ending 5/20/2022

Weekly Changes

The EIA reported a total petroleum inventory DRAW of 5.90 for the week ending May 20, 2022.

YTD Changes

YTD total petroleum EIA inventory changes show a DRAW of 92.70 through the week ending May 20, 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.


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