by Brynne Kelly
May 26, 2017
This week the market had to contend not only with weekly inventories, but also with an OPEC meeting and decision. There was much anticipation and positioning before and immediately after, specifically in the term structure of the curve. The chart below of the WTI futures curve from May 10 to May 25 highlights this well:
Leading up to the OPEC decision, the curve was decidedly moving into a backward structure starting from around the Dec-17 contract. The backwardation was at its widest on the 24th (and early the 25th) before news of the meeting hit the wires, but was cut in half after the news was out.
What does this mean and what should you look for in the coming weeks?
Historically there has been a general understanding of what backwardation and contango mean in commodity markets:
Backwardation pulls molecules out of storage.
Contango invites molecules into storage.
Further, Contango invites producers to produce and invest in production while Backwardation leads to future production uncertainty if future prices are unusually low.
Depending on the level of Contango, a producer can cover their cost of carry (storage costs, interest on debt, etc) and then some. It give producers options regarding how long to ‘carry’ inventory and when and where to deliver their product. There is comfort in knowing that what you invest in today is worth more in the future (again, depending on the level of the contango). In addition, it makes it easier to cover the cost of transporting their product on longer journeys. It takes time to load cargo on a ship and time to get the ship to its final destination. The level of contango can compensate for that. A wider contango suggests that the conventional, less-expensive means of storing and transporting have been exhausted and more money is needed to cover the costs of less conventional, more expensive options.
Markets in Backwardation highlight the ‘convenience yield’ of owning a producing asset. You own a producing asset and can deliver your product immediately into the higher-priced spot market. Backwardated markets generally reflect an immediate shortage of product not expected to exist in the future. For example, a major disruption in supply like a pipeline leak will cause the spot market to price at a premium to future markets that reflect the value of the pipeline being fixed. When a commodity is in demand or fundamentally bullish, the ability to deliver immediately garners a premium (like flowers delivered on Valentine’s Day). Backwardation can be temporary or sustained (i.e. short-term, weather-induced or a longer-term supply disruption). Either way, the front of the curve (spot or front-month futures) is the first to react because ‘price’ is the easiest way to balance the change in market conditions.
I mention all of this because the term structures are where people are looking to find and express market sentiment. The thought was that OPEC would extend their existing cuts to production until sometime in 2018, at which point the cuts would end creating a ‘tighter’ supply demand balance in the short to mid-term than it would experience beyond that. The expectation being that this might lead to some sort of backwardation in the price curve. Additionally, one could surmise that backwardation would also help pull molecules out of storage (since it’s more profitable to sell today than in the future) which would organically help to draw down excess inventories.
The problem with this is that it’s more ‘theoretical’ than ‘actual’ at the moment. Meaning, there isn’t ‘actually’ a shortage of supply in the spot market. At least not the type of shortage described earlier in the pipeline leak example. The market continues to keep an eye on gasoline demand with increasing anxiety and the initial impact of an extension of cuts didn’t leave the market with anything tangible to hang its hat on. Rather, it was left with the reality that it will take time for any ‘supply-side’ tightness to actually materialize. It reminds me of 2014 when US production was materially rising, yet futures prices were reluctant to come off. It took evidence of increasingly hard-to-find and more expensive storage to finally seal the deal and futures to sell off. It’s the same this time, there are theories about how these supply cuts might play out and then there will be ‘evidence’. Look for the evidence.
One place to look for that, obviously, is in the product markets. I found it interesting that while crude oil futures across the board shifted materially lower on Thursday, crack spreads were marginally unchanged and have actually moved higher in the last 2 weeks:
The market has built a story around the bearish tone of slowing gasoline demand growth. Yet the spread margins are not where the selling was. Does this mean that the issue is not the fixed refining capacity in the US, rather the ability to export incremental barrels? Meaning we expect there to be enough, however slowing, demand for the amount of finished products the US can both produce for itself and for exports, but that additional barrels of crude can’t economically get to other markets that have more refining capacity. As discussed in previous posts, global oil spreads have moved slightly in favor of WTI (WTI futures have moved below both Brent and Oman futures) in part, due to OPEC’s earlier production cuts.
Taking a look at oil production versus net US imports since 2010:
and more specifically, in the last 17 months:
Its clear that US net imports did decrease as production was on the rise. But since the beginning of 2016 we haven’t really gained any ground. The expectation is that as we would either consume more of our local production and/or export that which we don’t need. Either way, we need to see a reduction in net imports as proof that current production levels can be sustained without significantly impacting prices. That is another piece of evidence to look for.
Finally, some comments regarding this week’s inventory numbers. This week we saw a net draw of (6.1):
I like to put the weekly inventory changes in perspective as a whole by season, like in the Natural Gas markets where inventory is injected into storage over the summer for use (withdrawal) in the winter. While outright inventory levels are important, it’s also key to compare how you are progressing compared to previous years.
In the oil complex, the summer ‘season’ is typically characterized by its demand-related draw-downs of gasoline inventories. Here’s how this ‘season’ compares to the last 3 years:
If it weren’t for outright inventory levels, especially in gasoline, the seasonal totals so far look fairly impressive. We clearly have to look for evidence of gasoline demand and/or a reduction in net crude oil imports to have an impact on outright inventory levels.
Using the last 3 year average inventory changes from here through the end of the season (September), this is how inventory levels would stack-up:
Clearly, market bulls would hope for something better than the last 3 year average draw-downs. This is where the market is hoping OPEC cuts will do the heavy lifting to erode inventories at a faster pace than previous years. This will only happen if market economics favor exports to move supplies out of the US or if gasoline demand materializes over the summer.
When the market is at a cross-roads, there are a lot of false starts while it waits for something to tip the scale. It’s those that spot the evidence first that catch the real move.