The Lasting Impact of 2020
Updated: Dec 22, 2020
Author: Brynne Kelly (w/Lee Taylor technical levels)
Some may say the most dramatic event for crude oil in 2020 was the day that futures went negative. This was a short-term pain trade for many people and did significant damage to the overall industry. More compelling though, was the dramatic shift lower of the entire futures curve which single-handedly devalued the future production and reserves of energy companies. THIS is where the lasting impact of 2020 will be felt.
Obviously, the move to negative territory was an historic event. That being said, it was only in one futures contract (May-20, red line above), for one day. By the July-20 futures contract expiration the market had recovered and settled slightly above the $40 level (green line above). Preceding this, we were dealing with a market that was already coming unglued. WTI futures had already crashed more than $40 from their opening print at the start of the year thanks to the pandemic and the inability of OPEC+ to reach an agreement. In hindsight, it makes sense that OPEC+ was unable to agree on the simple task of extending their 1.2 million barrel per day cuts beyond March - thanks to a rapidly accelerating oversupply issue. An historic cut of 9.70 million bpd was finally agreed upon beginning May 1, 2020. This left the May-20 futures contract for delivery highly exposed since it expired mid-April, and the market was completely unsure at that time how large the oversupply issue could become. Additionally, the market had lost a bit of faith in OPEC+ compliance.
More dramatic than the front month contract dipping briefly into negative territory in 2020 was the devaluation of the entire forward curve. While spot prices recovered over $60 from their dalliance with negative prices, the fact remains that the $50 level which had served as a 'floor' for longer-dated markets was breached (red and yellow lines below).
Since it's incumbent upon the front of the market to lead, that's exactly what it has done in 2020. Front month prices brought down the entire curve, in the same way that front month prices can pull the entire curve higher. Of note though here is that prior to this year, the only other time that a dip in front-month futures (below $50) had been able to drag the associated 3-year strip below the $50-level for any meaningful amount of time was in 2016 (black line vs purple line below). Without meaningful evidence of tight spot demand, the $50-level we are approaching could prove choppy at best.
We now find ourselves in the unusual situation of backwardation leading the market higher (purple line below, continuous 12-month calendar spread) at a time when spot demand is hampered by knock-on pandemic effects. This is worrisome and could provide a head-wind for outright prices.
To understand the pattern of backwardation vs flat price, we turn to a comparison of month-2 continuous futures (black line) vs 12-month continuous calendar spreads (purple line). Not in recent history has 12-month backwardation crossed the 'zero-line' before WTI futures have crossed the $50-line. Nothing about this year makes it comparable to previous years, but the anomaly is worth noting as we move into year-end thin markets. The question becomes whether or not the current market structure accurately reflects reduced supply now (due to production cuts) vs increased supply later. OR, has the market missed the boat and overvalued a recovery in the short-term? At the moment it appears as though the market likes owning front-month upside.
Year in Review: Futures Curves and Spreads
Considering that oil prices can't be viewed in a vacuum, we compare the curve shift in WTI to curve shifts in the related refined product crack spreads. To examine this, we use the calendar 2021 and 2022 gasoline and distillate crack spread futures to WTI. The shift in the WTI curve as noted earlier is shown on the left and the related crack spreads are shown to the right. In all 3 charts we compare curves at the start of the year (dark purple line) to those seen on May 1 (red line) and current prices as of 12/18/20 futures settlement (yellow line). Notable are distillate cracks (middle chart below) that have been unable to stage a meaningful recovery. By contrast, gasoline cracks have moved higher since May 1 and ironically, winter gasoline cracks are relatively unchanged for the year (right chart below).
Low distillate prices and low demand have also contributed to a tightening of the WTI/Brent spread as lower ULSD prices lead to lower transport costs (marine fuel). The slowing of global demand has also reduced export premiums to the bare minimum.
To highlight current market structure, we zoom-in on the yearly shift in WTI curves since the end of 2017 below. Here we see the aforementioned collapse in future prices (despite the fact that prices have rallied since May).
The shape of the curves above translate to Jan/Dec calendar spreads below for 2021, 2022 & 2023. All of these spreads have rallied from steep contango to moderate backwardation. Into expiration of the January contract however, the Jan/Dec 2021 spread (green line below) is starting to lag, which may be cause for some concern in the overall rally.
Armed with a sense of curve shifts and curve structure, we turn to upside and downside risks as we close out 2020 and move into 2021.
Risks to the Upside
Global unrest will continue to introduce risk to oil markets. As an example, earlier this week a tanker off the port of Jeddah, Saudi Arabia was rammed by another ship loaded with explosives. Saudi Arabia suspects Yemen rebels Houthi, yet no one has claimed responsibility as of yet. No fatalities were reported, but this serves as an example of risk that exists as Saudi Arabia oil facilities have become targets for Iranian-backed Houthi rebels.
The US Government announced this week that many of it's agencies were hacked, including the Department of Energy (DOE) and the Federal Energy Regulatory Commission (FERC). Of particular concern is the electric grid information housed within the FERC systems. As of now, no critical infrastructure was reported to have been harmed, however it will take a few weeks to fully understand what data was compromised. These attacks by bad actors, whether state sponsored or ideologues, could expose the US and World energy complex to nefarious sabotage attempts, to what extent is yet to be seen.
Risks to the Downside
The surprise build in crude inventory for week ending December 4 has pushed US commercial crude oil inventory levels back in to warning territory. This trend would be worrisome if it continues.
OPEC+ is set to gradually raise production by 500k barrels per day each month, starting January 1, 2021. US production is still reflecting a supply glut, but it remains to be seen what that will look like if prices get above $50 in WTI.
Utilization Rates and Product Supplied by Refiners
Refiners are running at minimal utilization rates (left chart below), choosing to balance any supply/demand deficit via imports/exports. Reduced operating rates lead to lower production of refined products (right chart below). This continues to be a delicate balance of weeding out the least efficient suppliers in the market with local supply. Any misstep by refiners or producers could derail this balance.
As noted earlier, distillate cracks are depressed. This is a big reversal from last year-end when IMO 2020 dominated the headlines. That all seems like distant history at this point proving how quickly a narrative disappears.
This year has potentially changed oil markets for years to come, a realization of how fleeting demand can be. That being said, markets seem to be dusting themselves off and looking forward. We may have reset the entire curve to lower levels which could make 2021 a year of competition in production costs (by refiners and oil producers) and locational optimization. At the moment, oil curves have returned to the backward structure it's been so familiar with, a time when the supply/demand balance was such that upside risks due from geopolitical issues garnered more premium than downside risks.
EIA Inventory Statistics
The EIA reported a total petroleum inventory DRAW of 1.90 million barrels for the week ending December 11, 2020 (vs a build of 24.60 last week).
Year-to-date, total inventory additions stand at a BUILD of 71.70 million barrels for the week ending December 11, 2020 (vs 73.60 last week). Thwarting any thoughts that last week's build would be reversed.
Commercial Inventory levels of Crude Oil (ex-SPR) Gasoline and Distillate compared to prior years remain above the 5-year average for commercial crude oil and gasoline inventories and just slightly below the 5-year average for distillate.
Lee Taylor - Technical Levels
Resistance: 53.11 / 55.88 / 58.00
Support: 51.06 / 49.80 / 46.06
The Brent market is more overbought than the WTI market, but I am not sure if that will matter much, perhaps move the market sideways for a few days. The first major level of resistance is 53.11, an old low on the weekly chart. The targets are set with 46.52 as major support below on the weekly charts and from 55.88 to 56.15 as major resistance on the same chart. I am leery of this market having a major retracement at the beginning of the new year.
Resistance: 49.50 / 52.24 / 53.58
Support: 47.87 / 46.80 / 43.51
January Crude Oil goes off the board tomorrow so the focus will shift to February. Will the market to rally in the last two weeks of the calendar year? Can the USD go lower amid the next round of stimulus package? Can the energy market continue to rally in spite of the fact that it is clearly overbought and has been for a solid week? I think the answer to all three is yes! There is trendline support at 47.87 which will be our first key sign – if the market is to maintain the year-end rally it will need to hold this trendline. My biggest concern is the high level with regards to the RSI.
Resistance: 1.4100 / 1.4358 / 1.4480
Support: 1.3574 / 1.3412 / 1.2964
January RBOB broke through a significant level of 1.3840 basis of the weekly chart last week. In my opinion, both products will follow the lead of WTI and Brent and rally into the year end close. It appears to me that every fundamental story has a bullish sentiment lately. For example, the closing of London yesterday led to massive congestion as traffic built up leaving the city. The list goes on and on. Spreads remain strong and looking at April/May RBOB, we expect a test of -92 before one sees a pullback to -117.
Resistance: 1.5283 / 1.5456 / 1.5735
Support: 1.5021 / 1.4877 / 1.4268
The strength of heating oil since mid-November has been impressive. As I have written about the other two commodities, the only thing that keeps me from locking in higher prices is how overbought this market is. I am beginning to believe that it won’t matter much at all since the weakened dollar has little chance of recovering any time soon. Any pullback in spreads should be considered. For instance, look at March/May heating oil and a potential pullback to -16.