Author: Brynne Kelly 11/13/2022
THE POTENTIAL PROBLEM
Temperatures are dropping across the U.S. and families are looking to the winter with dread as energy costs soar and fuel supplies tighten.
The Department of Energy is projecting sharp price increases for home heating compared with last winter and some worry whether heating assistance programs will be able to make up the difference for struggling families. The situation is even bleaker in Europe, with Russia's continued curtailment of natural gas pushing prices upward and causing painful shortages.
THE BACKDROP
The US Northeast relies heavily on heating oil, which serves as the primary source of heating for 18% of households. According to the Energy Information Administration, residents who rely on home heating oil will spend an average of $2,354 to heat their homes this winter — a 27% increase from the previous winter and the highest price point in more than 25 years.
There is a reason consumers are on edge. US Distillate inventories are worryingly low and the recent pullback in prices (gold line below) led to only a nominal increase in inventory levels (blue line below). We are hearing from trusted sources, high prices are the cause for lower demand for stock ahead of the winter cold.
Industry Restockers may not have been able to BTD fast enough...
In a fragmented supply-side industry that is cash dependent, suppliers will buy less with less consumer demand keeping with a just-in-time inventory management while they hope for lower prices down the road. Therefore the lack of demand trickles ominously up the supply chain as inventories are kept low.
Specifically, most heating oil suppliers in the US Northeast are stating that at least some of their customers are opting for partial tank-fills right now due to high prices with many saying they are not planning to turn on the heat until they absolutely have to. Therefore, they in turn have bought less.
We note with the colder season upon us we find the price retreat was short-lived (chart above), giving storage buyers only a small window to stock up. Distillate inventory is already showing signs of this stress on the verge of making lower lows with the season hardly starting.
NORTHEAST IN CROSS HAIRS OF REGIONAL RISK
It's worth noting that the distillate inventory issue rests largely in PADD 1 (blue line below), which represents the US Northeast Coast. This also includes the New York Harbor which is the delivery point for Nymex HO futures. Lesser supply issues in PADD 3 (orange line below), are of little consequence to the need on the east coast as it relies on foreign imports to fill the supply gap. PADD 3 is used more as a barometer of global demand since the incremental unit of production in that region is exported. However gains in PADD 3 inventory could be a precursor to lack of global demand which would eventually filter back to PADD 1 in the form of cheaper imports, so you can't take your eye off of them completely.
US PADD 1 Distillate Inventory not a direct benefactor of PADD 3 Supply...
GLOBAL DEMAND HURTS REGIONAL SUPPLY
This is specifically why the US is so tied to global supply issues - the US East Coast is heavily reliant on foreign imports to meet demand more than any time in recent history due to lack of local refining capacity. It is completely dependent on foreign imports to meet supply/demand gaps. Probably why a Russian price cap is on the table. A Russian price cap would allow 'non-participating' countries to theoretically supply more refined products to the market at advantaged prices. This caused us to take a closer look at the US demand profile for distillate to orient ourselves as winter begins to set in.
US Distillate demand shows a Seasonal Pattern between Winter and Summer
Monthly ULSD consumption, while highly weather dependent, still displays a level of seasonality. For today's purposes, we zoom in on the winter months (November - March) for a bit more granularity. This is what was noted.
December and February are historically lower demand months...
THE RESTOCK, REPLENISH, TOPOFF CYCLE
The variation in daily average demand (black line above/ below, 5-yr average) by month can be simplified as follows:
November: Demand increases as consumers stock-up ahead of winter,- Restock
January: Demand spikes again in as cold weather sets in and inventory needs to be replenished- Replenish
March: Demand increases as emptied tanks are once again topped off- Topoff
But, this year is anything but average. Prices were high despite being in the trough of seasonal demand.
As stated earlier, retailers and their consumers are not following their usual 'stock up ahead of the season' patterns due to high prices. What could be very different this year is buying patterns. Some of the market is definitely relying on just-in-time purchases to meet their supply shortages. This scenario in which systematic restocking and smooth demand are abandoned, creates not-in-time price vulnerability.
REACTION: SHRINKING ALLOCATIONS AS A FALLBACK
The can has been proverbially kicked down the road, and may work out, but not without some headaches. One example: Without a significant pullback in prices, operational inventories will continue to run low accordingly as demand trickles in 'as needed' rather than all at once. Inventory is simply not being 'held' because its too expensive. Retail suppliers are merely following their customer purchasing patterns and not willing to 'carry' inventory in anticipation of demand. Some wholesalers have even begun allocating smaller amounts of heating fuel to retailers in their home states, who in turn must then ration the amount they can sell to consumers. In this way price spikes may be somewhat mitigated by lesser continuous demand, but exacerbated by "on demand" demand spikes. Either way, it may be necessary, and may work, but is not an easy way to operate a going business concern.
Market Impact
While the above dynamic has kept buyers out of the market in hopes of lower prices, a cold snap will be a strain on those running at minimum inventory levels forcing them to either pay-up as their resources dwindle or go without.
This makes front distillate spreads more vulnerable to weather this year than ever before. Will consumers pay up when they really have to? Will retailers have access to supply when needed or will we see a demand strike when it gets cold as people simply go without?
Where the Heating Oil Rubber meets the road...
The upcoming week will be an interesting test as temperatures across the country are set to drop. The market could be easily disappointed on the upside. Why do we say this? Because while inventories are indeed LOW, the first cold snap may not be enough to spur on a replenishment cycle. This first cold snap could be one where consumers test their 'resolve' as to how comfortably warm they need to keep their homes.
BACKWARDATION BEGETS BACKWARDATION
The assumption has been that spot demand will drive up prices, causing front spreads to rally. Below we see the Dec/Jan futures spread, both past and present (violet line below). There is clearly no comparison to draw from recent history, even with the latest pullback.
HO Dec/Jan reflects inventory dynamic...
If we haven't found storage buyers of any significance at current price levels, its probably too late. Backwardation at these levels is a deterrent to that. Sure we may have some last minute buyers that are forced to pay up and get some 'energy security' in the tank, but its more likely that it will be real spot demand by consumers that would be the catalyst to press this spread higher. A 'buyers' strike however, could really do some damage and send this spread lower. Also, historically demand is lower in December than January, which is why in the past this spread has hugged either side of zero.
Referring again to our earlier demand (bar) profile chart, note the difference between the 5-yr average demand in January versus April. This is one important spread to exploit given inventory levels if that plays out.
HO Jan/Apr highlights seasonal demand patterns to the extreme
In many ways January demand has nothing to do with April, hence why the spread has rallied way beyond historical ranges. Also, January is typically the first real month where home heating tanks need to be refilled after usage in November and December. Spot demand will put upward pressure on January prices if its cold and inventory levels remain low. In that case, there is no upper limit to Jan/Apr this year unless summer buyers show up to grab a relative bargain in futures months to replenish end of season inventories.
Given current inventory levels, summer inventory balances could also become problematic
Over the weekend, Janet Yellen was quoted as saying "Europe's energy crunch will be more difficult next year". This puts more pressure on storage buying this summer. The supply problem keeps rolling along down the seasonal road now. This winter, the supply problem has come down to the rising potential for demand delay ( i.e. hope for lower prices and good weather, not necessarily destruction) and the need for more and better financial risk management to navigate increasing supply chain vulnerabilities. This risk as a byproduct of supply chains and inventory management not being in sync with demand patterns is more commonly called the Bullwhip Effect.
A word about the Bullwhip Effect:
The bullwhip effect is a supply chain phenomenon describing how small fluctuations in demand at the retail level can cause progressively larger fluctuations in demand at the wholesale, distributor, manufacturer and raw material supplier levels.
The effect is named after the physics involved in cracking a whip. And it is manifesting in distillates this season now
Bottom Line
The cold weather is now upon us, and it's time to see how the market reacts. Will consumers pay or will they look to make radical changes in behavior?
Seasonal patterns may be less reliable this year as high prices are changing consumers behavior.
Global events have made this Heat season very regionally focused with the Northeast NY Harbor in the crosshairs.
The high price of distillates beyond seasonality has forced cash sensitive end-users to delay restocking using an even more just-in-time mindset for the wrong reasons.
This lack of demand in turn has trickled up and suppliers have delayed their own restocking purchases hoping to buy a dip that may not have been low enough.
Lower consumer demand (conservation) at higher prices has forced allocation rationing from suppliers to retailers.
This last minute "by necessity" behavior has steepened backwardation (even at the recent lower-ish prices) and serves as a deterrent to stocking up at this point.
The combination of high prices and hope (as opposed to the low supply itself) as made many opt to put off purchases and/or do without for as long as they can. This is all along the supply chain now.
Flat price is now very susceptible to whips in both directions due to supply chain ripples from new found grass roots demand elasticity.
This lack of supply reliability has generated an increased reliance on just-in-time inventory management, putting bullwhip effect risk on the table and possibly ending with suppliers buying high and selling low chopping themselves up a lot. Even if we all survive this winter, the industry may not be the same as higher-cost operating businesses (Mom and Pop) with poor financial management may not do so well.
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EIA Inventory Recap - Week Ending 11/04/2022
Weekly Changes
The EIA reported a total petroleum inventory DRAW of 1.00 for the week ending November 4, 2022. Of this, Commercial inventories posted a weekly BUILD of 4.00 while SPR inventories DREW by (3.60).
YTD Changes
YTD total petroleum EIA inventory changes show a DRAW of (222.10) through the week ending November 4, 2022. The bulk of this is due to drawdowns in SPR inventories.
Inventory Levels
Gasoline and Distillate inventory levels remain decidedly below their 5-year average for this time of year.
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