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The Oil Market's Widow-Maker: Volatility Explodes in a Traditional Energy Spread

Author: Brynne Kelly 8/29/2022

The recent instability in a traditional relationship between US energy products is wreaking havoc on the direction of crude oil markets. What relationship are we talking about? RB gasoline vs ULSD futures, more commonly known as the RB/HO spread. It's unique ability to capture the different seasonal demand profiles between the two also makes this spread extremely vulnerable to short-term weather surprises and disappointments. Historically this spread relationship had a more 'local' flavor to it. US seasonality was it's largest driver, apart from any regulatory changes that produce a one-time effect. Increasingly however, global influences are becoming more of factor in this once 'local' spread.

Last week we took a look at the relationship between US distillate prices and global LNG prices. We pointed out that the ability to easily replace one energy source for another in power generation is reaching operational capacity. This week, we turn inward and look at the oft volatile, yet seasonally predictable spread between US gasoline and US ULSD prices.

Evidence suggests either: there's a real shift in demand for US Heating Oil Distillates to Europe as a function of the larger globalized demand pull of a usually regional energy product (EU demand for US LNG being a prime example), or this is a fear-induced hoarding panic that may or may not be warranted.

Lets start with the price relationship between RB and HO

RB/HO volatility has dwarfed WTI Vol so far in 2022 underlining the uncertainty of price drivers....

The red triangles in the graph above show the RB/HO spread's volatility is much bigger than WTI's recently. Whereas historically that spread is usually less volatile than the outright. We are used to the volatility embedded into this spread that comes with seasonal demand, but the uncertainty reflected in price action in 2022 is well beyond that in both directions. As the graph above shows, the relationship in price between RB and HO has seemingly broken down. But, how can that be, given the expected yield ratios for a barrel of crude? Is this price action warranted given what we know about the product ratios?

How Volatile is the Spread now? Going back to 2015 the spread remained on average in a $0.50/gallon range until the end of 2020 which included Covid. In the last 5 months alone however, the same spread has had almost a $2.00 range, a 400% increase.

The RB/HO Spread, a usually reliable indicator of seasonal leadership in WTI price action has become less reliable...

RB versus Distillate Yields Are Stable

Now lets look at the less volatile product yields from a barrel of oil. As the graph below shows, the ratio of gasoline and diesel output as a percentage of total products supplied by refining a barrel of oil in the US is fixed, with HISTORICALLY small seasonal variability.

Refined Product yields from a barrel of oil are far less erratic (volatile) than their recent price action has been...

Refining oil produces a level of diesel as a percentage of output which structurally can’t be easily increased. We know that if a refiner wants to produce more distillate, it inevitability will produce more gasoline. This is how refiners are configured. Nothing in the short-term can change this.

So, if gasoline prices are down, and oil prices are down, and a barrel of oil yields a relatively fixed ratio of gasoline to diesel, what is driving the divergence of heating oil distillates right now?

The Widow-Maker

The relationship between gasoline and distillate prices (often called the widow-maker due to its propensity to swing rapidly on seasonal factors) has become increasingly even more unstable well beyond its seasonal volatility this year. Low inventory levels and increased exports are on a path to collide with storm risk and refiner maintenance. All of which have created a tension in the relationship between supply and demand. In addition, policy decisions continue to focus on reducing prices for the retail consumer and are unpredictable at best.

The RB/HO spread has added some unseasonal volatility in both directions of late...

More Political Event Risk

Speaking of policy, President Joe Biden's administration is pressing US refiners to rebuild inventories of gasoline and diesel as the production-disrupting Atlantic hurricane season heats up, rather than increasing record-high volumes of product exports. According to an article by Argus:

US energy secretary Jennifer Granholm said, If companies do not proactively address the shortages, the "... administration will need to consider additional federal requirements and other emergency measures,"

Meanwhile, Oil officials voiced their own concerns:

Oil industry officials have said they appreciate the discussions with administration officials on inventories and tight energy markets, but they worry any potential emergency measures focused on domestic stocks would end up restricting exports.

The issue in contention is this:

US exports of gasoline, diesel and other products hit a record four-week average of nearly 6.4mn b/d in the week ending 19 August, an increase of more than 1mn b/d from a year ago, according to the US Energy Information Administration (EIA). Latin America in particular has been a major destination for US products.

Add this to the growing list of 'Event Risks' commodity markets around the world are facing.

Possible Federal Actions

On the list of possible new federal interventions would be minimum gasoline and diesel stockholding obligations, according to a senior official at the US Energy Department, although the immediate priority is to engage with industry and state officials on emergency preparedness to avoid a situation where a weather driven crisis leaves the US "scrambling" for supply. This comes at a time when inventories should be building faster than they currently are.

Distillate inventories usually increase during the third quarter as refineries boost crude processing to make more gasoline for the summer driving season. So far this year, inventories have failed to rise.

Distillate supply inventories have barely started to seasonally build thus far...

The reality remains that whatever the government decides to do, enforce-ability is a problem, especially if a real-time crisis is concurrent with any new federal stockholding mandates.

And as we all know, even if an action were to happen, the market would sort out the price change in typically efficient fashion. Historically, enforcement penalties can be factored in as a 'cost of doing business' if there are margins to still be made and inelastic demand.

Europe Demand Slows US Build

We know what the administration is doing to combat high retail gasoline prices. What we don't know is what will they POSSIBLY do during the winter to combat high diesel prices IF NEEDED. THAT is a big unknown.

We can see what is being done in Europe: Price caps and Inventory hoarding. End of summer inventory goals are causing EU energy providers to stockpile inventory at almost any cost. The knock-on effect in the US has been higher heating oil prices. And as we noted earlier, US inventory balances are not rising. Rather, the US is supplying product to the rest of the world so they can build their own winter inventory balances.

This behavior can explain the bigger disconnect than usual between HO futures and the rest of the complex.

RB and WTI Remain in Lockstep while HO Goes its Own Way...

Price Differentials Are Beyond The Norm

Looking at the upcoming seasonal spreads in terms of past relationships for the Widow-Maker, it's clear that we aren't in Kansas anymore. If you are looking for historical relationships to bail you out, you'll be hard-pressed to find respite here.

Q4 2022 RB/HO is nowhere near historical levels, now Q4 2023 tracks that path too...

US heating oil futures are trading at greater than a $50/bbl discount to US gasoline prices in Q4 2022 (green line above). Why are we at historical lows in this spread?

The demand equation for US heating oil has changed this season. The world is de-globalizing while energy prices are becoming increasingly globalized. The energy crisis in Europe is being borne, in part by, US distillate. In the short-term, there isn't much that can be done to combat that other than wait for winter weather to either materialize or not materialize.

Whether there is a longer term overseas demand-pull for US heating oil remains to be seen. Prices for now are suggesting that possibility exists.

Lasting Demand Shift or Short Term Panic

Even the Q4 2023 has breached historical lows (gold line above). This suggests that either the fundamentals of supply and demand have explicitly changed, OR there is a 'toilet paper' panic akin to what we saw at the start of the Covid pandemic. If so, it would be reasonable to expect future spreads like the Q4 2023 to eventually mean-revert. That is if prices are decoupling for invalid long-term reasons.

No one seems to have a time horizon on this crisis, therefore longer-dated winter futures are moving in sympathy with a high correlation to the current trend in the front in part because there is no real volume trading that far out. Will this be a recurring seasonal demand shift phenomenon or a one-time panic problem?

If this is a fundamental shift, then the marking-down in sympathy is probably warranted somewhat. But if it is a seasonal panic in 2022-23 driven by the insane alignment of events spanning the globe, then perhaps the next winter season RB/HO is being unfairly punished.

Additionally, non-rhetorically speaking, how long can this acute 'hoarding premium' effect last before innovation steps in and eventually crushes it?

In Q1 this tracking phenomena continues as well...

If we shift our focus to the second half of winter seasonality we see the deferred quarterly spread being dragged down by prompt Q1 2023 futures and also making new lows. The perception is spreading across multiple winter seasons now.

In the current state of de-globalization, US gasoline is looking more and more like a 'local' product while heating fuels are becoming more global. Considering where RB/HO spreads are trading even a year or more out from today, it appears at this moment the market believes this could be the case for longer than just 'one winter'.

Bottom Line

  1. It has been painfully interesting to track the current season's RB/HO volatility as it undermines itself of WTI price action. What is normally a predictable anchor for WTI to tether to, has become a relatively unstable friend.

  2. Whether the changes witnessed are more a function of the shifting global demand construct for US distillates fundamentally or a one-time seasonal hoarding panic as an echo of the supply chain problems ( or something else) remains to be seen.

  3. The evidence that a fundamental change in HO demand construct is in play and is becoming present in how deferred seasonal RB/HO spreads are tracking this years insanity. But that evidence needs more data.

  4. The evidence that this winter's instability in the RB/HO spread is a one time problem is borne out by everything else that has transpired of late. Buyers of Oil, then Gasoline all were forced to secure supply and suffer through paying higher convenience spreads than usual due to war, sanctions, and broken supply chains. Now Natural Gas and HO are in play. Who is to say this isn't yet another example of a (warranted) short term panic for operators to stock up once again? This time its winter products.

  5. The event risk of government intervention and OPEC policy changes make things remain on edge shorter term as well. Caps, subsidies, mandates and output changes are all on the table like never before.

  6. Finally how much the industry can increase distillate output is unclear, but it does appear that given natural gas prices and the potential for switching, the world is going to need that number to rise and prices are creating an incentive to make as much as possible. At least for now and perhaps next year.


EIA Inventory Recap - Week Ending 8/19/2022

Weekly Changes

The EIA reported a total petroleum inventory DRAW of (12.20) for the week ending August 19, 2022. Commercial inventories however, posted a weekly DRAW of 3.30.

YTD Changes

YTD total petroleum EIA inventory changes show a DRAW of 1569.20 through the week ending August 19, 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 flounder while backwardation in the market persists. The real 'worrisome' figure is distillate inventory levels.


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