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US Selling, China Buying: Return of Contango

Updated: Nov 30, 2022

Author: Brynne Kelly 11/27/2022

The US continues to take steps to downsize its oil supply, while deferring on the SPR restocking many think will come. China, a key to the demand side, continues to struggle to get out of Covid lockdowns despite hopes to the contrary. Thus, prices took a dive last week. That is not new. So what happened?

There were a couple of news items which related to the above comments, and may have triggered an alarm for bulls to exit. Before we get to those, it's how the market sold off that concerns us. That is what was different.

Last week, we saw contango develop in oil markets during the selloff. This was markedly different than other recent flat-price drops. Prior to last week's plunge, calendar spreads held support remaining in backwardation even as outright prices moved lower, a reflection of scarcity and seasonal refined product demand fears. Last week however, the oil contango returned in prompt months signaling: the SPR isn't a problem, the supply (of oil at least) isn't a concern, and the Chinese demand drop is a problem.

WTI Futures Curve Shift over the last 10 days...

The market is telling us that the demand for the incremental barrel of US production is not as crucial to the equation as it was earlier this month, or even earlier this year.


The demand side is pretty cut and dried. Over the first 10 months of the year, China added about 690,000 bpd to inventories, largely because refinery processing was weak in the first half of the year amid soft domestic fuel demand as the economy was crunched by a series of lockdowns as part of Beijing's strict zero-COVID policy. COVID fears are ramping up again before they have even had a chance at a proper demand recovery. This time, however, China is more 'stocked up' than it was before.


The supply side has been ruled by SPR sales supplying incremental barrels to the market. Total US crude inventories are down by around 550,000 bpd this year thanks to SPR sales. The market seemed to care a bit as the SPR was drawn down earlier on. Now it seems to be focusing on the Biden administration's lack of urgency in refilling that oil , and not caring.

Maybe the administration doesn't feel the need to buy it back. Maybe the Administration sees the drawdown as an advance withdraw on the plan, the plan it already had in place to drain the SPR going back a couple years.

As far back as 2016, the Department of Energy realized that the SPR was not practical anymore and had planned to sell oil slowly into the market to generate the capital to modernize the whole SPR system. The Ukraine war has allowed this to accelerate.

In some ways the Russian invasion of Ukraine has done the SPR a favor. It has allowed them to reduce the size of the reserves that was increasingly look[ing] like a stranded asset. The reports states that the average purchase price of SPR oil is USD 30 a barrel. The SPR sell down would have generated a USD 10bn profit so far.

They are monetizing the oil ahead of schedule. Add to that the fact that Biden approved an export project last week and you get a strong signal that the SPR isn't going to be refilled any time soon.

As reported in the Texas Tribune:

The Sea Port Oil Terminal will expand a Houston-area terminal operated by Enterprise and connect it to a new 140-acre onshore facility near Freeport with 4.8 million barrels of storage capacity. From there, two 36-inch underwater pipelines will run to the new deepwater port, 30 miles offshore, where two 24-inch floating crude hoses will load it onto the world’s largest class of crude tankers.

The facility will process more oil than the largest U.S. export terminal currently operating, Moda Ingleside Crude Export Terminal, owned by Enbridge in Texas, which moves up to 1.6 million barrels per day at the Port of Corpus Christi, the nation’s top port for oil exports. It is slated to start operations in 2025.

We have cleared out what the DOE considers 'excess' strategic inventories and have green-lighted a major export project. Taken together, although nothing has changed incrementally on the supply side in the US, it seems pretty clear that future oil produced in the US is intended for export, not US consumption. Or at least that is what they are signaling.

Whether this news was a factor in driving oil prices lower is not a given, but it did not help. The futures curve is now flashing signs of contango. The convenience yield of holding physical barrels is disappearing. In fact, in this latest futures roll cycle, it appears as if the market has "rolled and sold" as one participant noted, perhaps exacerbated by EOY position squaring.


While the overall structure of the market is still in backwardation, there is no denying that the market has begun to abandon its short-term oil supply fears. For the first time in a while, flat price selloffs in oil are not being buoyed by strength in calendar spreads.

Strength in calendar spreads when outright oil prices are being sold has been a bellwether this year until last week. This time around, not only are outright prices moving lower, but backwardation disappeared in the front of the market.

It's as if the market has reassessed the supply issue and determined that unless there is a weather problem, there is no hurry to replenish oil. The high price energy shock has also ushered in a slew of conservation measures and government subsidies to combat overzealous demand. In other words, the Fed's plan to dampen demand has done a good part of the work for them like it or not. That may come back to haunt them, but not right now.

On a historical basis, we see the movement of curve structure over the last 2 years. Notable is the fact that the 'curve' tends to flatten out around the $50 level. Implications for this are: above that area and the curve purposefully moves into backwardation. Below it, and you get contango pricing.

Rarely do you see contango manifest with oil above $70 at all much less for short periods in the prompt part of the curve.

WTI Curve flattens out around $50

It's important to note that this selloff started with the gasoline selloff a couple weeks ago. Now it has moved to Oil with a worrisome contango accompanying it. Even deferred heat cracks are getting hit. But no one is selling prompt Distillate yet. That isn't a license to be bullish. It is merely a logical progression of the whole complex getting hit at its most vulnerable points. Being short in-season heat is not on the menu yet.

More comfortable selling the 2024 crack rather than the 2023?...

One reason these might be getting sold is they were dragged higher by the front spread's insane performance. Even just being dragged higher, they currently represent a differential of $20 more than at the start of the year (yellow line vs red line below). So on a risk adjusted basis, even factoring in the smaller liquidity, those might attract more selling next given the weather is a ways off.

Still a lot of meat left on the bone in Distillate Cracks...

A couple weeks ago, we had a warning shot across the bow with the Gasoline-lead selloff. But even then the backwardation mostly held. Later that week, oil once again popped back up despite many of us doubting it should. But this time around was different. Spreads didn't hold. Fear is receding for now, manifesting first in crude oil's term structure. If this continues, prompt distillate will begrudgingly follow suit, at least until weather makes its final stand.

Flat price is now almost entirely focused on commercial inventories and not concerned with the urgency (if any exists) in refilling the SPR. That's the reality. Low (relative) SPR levels are a known, but not one that represents front month market tightness. The tightness remains, but the fear is only manifested in crack spreads for now.

Meanwhile, commercial inventory is also above start of year levels and much higher than in 2014

COMMERCIAL inventory levels hold the key. SPR is now 'noise'......


A couple speculative points to make. Looking at the incipient contango one has to be careful as this is now a curve in transition. Still, it is very enticing to look at the current inefficiency of that structure as potential opportunity. What are we saying? If you are bullish, given how the crude oil market is normally efficient you'd be buying the contango parts. If you were bearish, you might be tempted to sell the bump (in the curve). Butterfly types would want to do both. But this is a curve most definitely in transition. And after a year of crazy backwardation, there may be extended delays in it normalizing as positions square up. Something to think about


The other part came up in our search into previous futures curves looking for contango clues. On November 22nd or thereabouts last year, a couple of banks reiterated supersized aggressive calls to be long oil when it had dropped down to sub $70 levels. One called for a move to $85 back then. The market proceeded to move higher in a solid fashion soon thereafter for weeks touching $90 even before the war broke out. Pretty impressive. Back then, the backwardation also more or less held. This time it has not, with oil just under $80 (Biden's first "buy level"). More interestingly none of those banks have come out and made their bull case again just yet. In fact two that we know of lowered their targets as of a week ago. Something to think about.

Bottom Line

Nothing has changed. Oil supply is at multi-year lows when accounting for the SPR draws. Nobody is getting permits to drill for domestic use. The Chinese demand outlook is where it was a week ago when they were also debating reopening just as they are now. Supply of distillates seems dangerously low. Diesel rationing is being thrown around.

Yet oil is down and the futures curve is teasing a very big backwardation well above its historical norm of around $50 before it usually flips. Something may have changed. We will see soon enough.


EIA Inventory Recap - Week Ending 11/18/2022

Weekly Changes

The EIA reported a total petroleum inventory DRAW of 0.50 for the week ending November 18, 2022. Of this, Commercial inventories posted a weekly DRAW of 3.70 while SPR inventories DREW by 1.60.

YTD Changes

YTD total petroleum EIA inventory changes show a DRAW of (228.80) through the week ending November 18, 2022. The bulk of this is due to drawdowns in SPR inventories.

Inventory Levels

Distillate inventory levels remain decidedly below their 5-year average for this time of year.


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