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The Forensics of an Oil Rally

Updated: Mar 16, 2021

Author: Brynne Kelly 3/14/2021

For the last several months, the market has been churning the same data over and over (OPEC, demand recovery, refinery utilization rates) in order to find the next vulnerability that will move markets out of their current range. One such vulnerability arose via the winter storm in Texas and the surrounding area. This, coupled with OPEC+ agreeing to extend production cuts for another month, threw the system out of balance and confirmed that there was more upside risk to prices than downside. What ensued as a result has been a consistent march higher in the outright price curve (below, 36-month rolling futures curve shift over the last 30 days).

This is a trend that has been emerging for a while. The shift in the static WTI calendars 2022 & 2023 futures curves over the last 6 months highlights this concept further. It's in this chart that we can see the structural progress the market had made since the start of the winter season (November-March, red line vs gold line below). By February of this year (teal line below) the front of the calendar 2022 strip had moved about $10 higher, closing above the $50 level.

The combination of severe cold weather and the extension of the OPEC+ production cuts after that were enough to move the front of the calendar 2022 strip higher by another $10, with the front of the strip closing above the $60 level.

The lens through which the market has been viewing data points is colored with a contextual bullish bias. What are some of these biases and are they warranted?

Crude Oil Inventory Levels vs Price

It is often subtly suggested that inventory levels should equate to market prices. However, if you juxtapose US commercial crude oil inventory levels against the rolling 12-month futures strip price in WTI, it becomes clear that inventory levels themselves don't correlate well to actual price levels (blue line vs black line below). Although trends in inventory levels DO tend to correlate with trends in prices.

Breaking from the macro trend, the rise in US oil inventories over the last 2 weeks has been met with a continued rise in oil prices. Yet, looking back, US commercial crude oil inventories are about where they were this time last year. Prices for the 12-month futures strip are $30 higher than year-ago levels. The main difference being the outlook from here. A year ago we were staring at catastrophic losses in demand and fears of overfilled storage tanks. Today, all eyes are on a return to normal demand.

This suggests the market is not concerned with which side of the ledger inventory draws come from, rather that the trend in total is lower.

The expectation of a rapid return to normal consumption is giving the market a 'pass' when viewing outright inventory levels. Never have future inventory reports held more weight in determining whether or not this actually plays out.

Crude Oil Production Will Lag Demand

The primary demand for crude oil comes from refiners. The mismatch between US oil supply (production plus net imports, right chart below) and demand (crude oil input to refiners, left chart below) as reported by the EIA last week was roughly 1.7 million barrels per day. Taken over a 7-day reporting period this would imply an oil inventory build of 11.90 million barrels. This is fairly in-line with the 13.80 million barrel crude oil inventory build reported by the EIA. The fear is that going forward, increases in refinery utilization will outpace increases in production. But, in all fairness, refiners and producers have managed to fall into a bit of a cadence with each other since the initial demand shock last year.

This cadence is apparent over the last 4 weeks. Comparable data from the previous 2 years reflect similar net inventory changes. The only real difference is that the gross numbers are larger this year.

Given this relative parity of total inventory changes over the last 4 weeks, we zoom out a bit in order to find some validation for the continued rally in prices and spreads. Using the 18-week 'winter' inventory changes (November-March), the comparison reveals a different dynamic this year vs the prior two winter seasons.

First of all, using an 18-week history, this year's inventory changes look much more supportive of prices than the previous 2. This is where the market believes that production is falling behind and has helped underpin a move of the curve into backwardation.

In fact, since November 2020, one-year calendar spreads in WTI have rallied almost $11 in the front (from $4.00 contango to $7.00 backwardation, left chart above). Calendar average strip prices have also rallied since November of last year (right chart, above). The selling pressure that the back of the market faced from producer hedging above the $50 level doesn't appear to be giving the front of the curve much pressure.

OPEC+ Production Cuts Will Impact the Front of the Market More than the Back

One common theme this year has been a weakening of WTI front month calendar spreads into expiration. So far this year, bullish bets related to a gradual reduction of OPEC+ supply cuts have been focused on a 2nd half of 2021 recovery. As a result the June-21/Dec-21 calendar spread has continued to rally. However, weakness in front spreads last week appeared to change the composition of the June/Dec spread. Namely that June-21/Sep-21 spread fell below the Sep-21/Dec-21 spread (gold line vs blue line below).

The only outcome so far of weaker front spreads has been that bullish bets are being pushed further out along the curve, not that the entire curve has moved lower. The popular Dec-21/Dec-22 spread in WTI closed above the $5.00 level last week. This is certainly not an historic high, but it does rival highs seen back in 2016 (blue line) and 2019 (red line).

Weakness in front spreads has caused temporary pullbacks across the curve, but each time the market manages to fight back and make new highs.

Product Inventories are in Trouble

Calendar spreads aren't the only ones making new highs. The same shift higher that we saw over the last 6 months in WTI has been echoed in gasoline and distillate cracks (red vs gold lines below).

Reduced output from refiners has had a significant impact on refined product inventories. Will an increase in oil demand from refiners going forward result in a collapse in crack spreads? When will the next marginal barrel of refined product be enough to tip the scale and put pressure on margins? For now, a rising tide is lifting all boats and until refinery output increases significantly, crack spreads face almost no headwinds.

Gasoline vs Distillate

Beyond crack spreads we have the relationship between gasoline and distillate. Except for a brief period in 2020, the 12-month RB gasoline futures strip has not been above the 12-month ULSD futures strip since 2017. We got close last week.

Reduced output by refiners due to the winter weather in Texas last month diminished refining capacity and led to big draws in gasoline inventory. Clearly, we were not producing enough to meet demand. The question going forward is whether or not the storage deficit created over the last 4 weeks in gasoline can be made up before summer driving season really takes off. If not, we see the gasoline strip moving higher relative to the ULSD strip.

On a monthly basis, only the summer gasoline to distillate spreads are in favor of gasoline. Winter spreads are still seasonally in favor of distillate. This could be a bubble waiting to burst if summer gasoline demand doesn't show up as expected.

Products vs Blending Components

The consumption of refined products in the US creates a renewable fuel obligation. Against the backdrop of lower US product consumption, renewable fuels used for meeting blending obligations have continued to rally.

Distillate vs Soybean Oil

Soybean oil futures can be used as a proxy for biodiesel blending economics since soybean oil is currently a major feedstock for production of biodiesel. Biodiesel prices are rising (right chart, below) along with soybean oil futures (left chart, below).

Gasoline vs Ethanol

Mandates for ethanol blending into the gasoline pool continue to grow. Ethanol prices have been depressed for years and have only recently began to break out to the upside. The days of cheap blending components may be coming to a temporary end this year.

When the market rallies to new highs within 12 months of making record lows, it's good to pause and look at the data. We have gone from max bearish sentiment to max bullish sentiment in the span of less than a year. Reflecting on the data above, there are items that are supportive of prices at these levels, specifically those coming from the refined product markets. There are also signs that calendar spreads have reached outsized levels and are vulnerable to disappointing data going forward. Respect the arsenal of production capacity waiting in the wings until it's proven that it isn't.


EIA Inventory Statistics Recap

Weekly Changes

The EIA reported a total petroleum inventory DRAW of 3.60 million barrels for the week ending March 5, 2021 (vs a draw of 1.70 million barrels last week).

YTD Changes

Year-to-date total inventories in 2021 are DOWN by 17.70 million barrels. Another unprecedented decline for this time of year.

Inventory Levels

Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years are looking rather bullish.


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