Last week, we noted that both Brent and WTI were among the best performing assets in Q3 17, with Brent rallying by nearly 32% over the course of the quarter. But the bulls got nervous as combined Brent and WTI long positions had returned to close to the highs seen at the start of the year. Moreover, with momentum indicators suggesting that the rally was fatigued, the concern was prices would also follow the H1 17 narrative and fall. Indeed, as oil prices swooned at the start of the week, there was one consistent question from clients: what pushes prices higher?
Seasonally, this is not a particularly bullish time of the year for prices, and product cracks have come under pressure as refiners start to crank out more and more products during the shoulder season. But the reality is that fundamentals have not changed one iota in the last week. Rather, the market started to get bearish simply because it had been so bullish.
|Fig 1: Combined crude net length, k contracts||Fig 2: WTI vs 14 day RSI|
|Source: CFTC, Bloomberg, Energy Aspects||Source: Bloomberg, Energy Aspects|
The reality for those wanting to see oil prices go higher is that the market faces the exact same headwinds today that it faced back in Q1 17—the crude market needs a new source of buying to push prices higher. With hedging overwhelming the back end of the curve the absence of “new” buyers is particularly acute given the dearth of liquidity the further out the curve you go. The loss of so many commodity funds that would be the natural buyers from those producers looking to sell forward production, coupled with the closure of so many bank trading desks, is making it difficult to absorb that intensity of hedging, which is putting inordinate pressure on the curve.
The big difference between Q1 17 and today is that oil market fundamentals have strengthened materially. All the major energy contracts are in backwardation with the exception of WTI. Brent is in backwardation for two years out, but the market continues to under appreciate the balance for 2018, while distillates has strong fundamental demand growth driving backwardation, even before any sort of winter has been factored in. In short, the backwardation in these curves looks sustainable.
CYA: Cover your assets
Multi-asset allocators are now laser-focused on two things that will impact their allocations to oil: OPEC’s commitment to price stability (i.e. not allowing it to go lower), and the shift of the crude curve from contango into backwardation. We have started to see a few real asset allocators begin to pitch their clients on the benefits of backwardation. The longer this market remains backward, the more likely we will see a response from investors.
Basically, what the oil market needs right now is a good old fashioned rebalancing in commodity allocations. Given how most other commodities remain well in contango, oil would benefit the most from that.
|Fig 3: M1 vs M6 sporead as % of prompt month||Fig 4: Select commodity M1 vs M6 spread|
|Source: Bloomberg, Energy Aspects||Source: Bloomberg, Energy Aspects|
Another potential source of buying will come from the energy equity side, as many are starting to notice just how undervalued the energy space has been both relative to other equities, but also relative to the flat price. Many banks that had been underweight energy are now shifting to overweight, both because of the relative under-performance to the broader equity indices and because they have not matched the move in crude. We would note that over the last week, energy equities have outperformed crude.
Salman fishing in Russia
Part of the reason we are confident that the Brent backwardation will persist well into 2018 is because of OPEC. For some reason, the market remains myopically focused on binary outcomes at the OPEC meeting in November: either OPEC will extend and hold production flat, or it will not extend and will maximise production, pushing output back to Q4 16 levels, thus crashing the price. The latter scenario is just plain absurd. More than likely, we will get an extension of the agreement, with only the how long and when of the announcement still to be determined.
This week’s visit by Saudi King Salman to Russia, the first by a Saudi monarch, should have reinforced to the market the strategic nature of the cooperation and coordination currently taking place between Saudi Arabia and Russia. This clearly extends beyond the oil market, with many important political issues driving this improvement in ties. What the market fails to understand is that even if the production agreement were to end today, it would not end cooperation and more importantly coordination between the two countries.
Thus, given our expectation of continued OPEC/Russian discipline in 2018, and our expectations for a continued global stock draw, there is every reason to believe that the backwardation in Brent will persist as destocking will continue. And this persistent backwardation will serve as a magnet to a potential new source of buying for the crude market: passive investors.
Brent: Given the vast amount of US exports set to arrive in Europe, and that North Sea maintenance is finally coming to an end, a bit of retracement in Dated Brent was on the cards, although we expect backwardation is not going away anytime soon. Brent spreads never followed Dated all the way up and so, the downside from current levels is limited. Though refining margins have given back a lot of their Harvey-related gains, strong diesel pricing still offers incentives for refiners to continue running hard where possible.
WTI: US crude exports surged this week hitting close to 2 mb/d but we expect exports to be sustainable at an average rate of 1.3 mb/d in Q4 17. Harvey-related builds have weighed on Cushing balances, as Port Arthur refineries struggle to return from works and as Permian crude is diverted into the hub. Q4 is a seasonally weak period for Cushing, and we are expecting a build of roughly 5.5 mb, which is slightly below the five-year average. The outlook for Q1 18 is a bit more complicated with several new pipelines coming onstream. This is supportive for Cushing in Q1 18, despite the usual low demand from refineries as PADD 3 works rise in earnest from late January again, as long as WTI-Brent spreads continue to roll down below -$5, thus ensuring a steady export flow (for more details please see our Data Review: US Department of Energy, 4 October 2017). These incremental factors make us less constructive WTI spreads in Q4 17, but slightly more constructive in Q1 18.
|Fig 5: Prompt crude spread, $/b||Fig 6: LLS cracking margin, $/b|
|Source: Bloomberg, Energy Aspects||Source: Reuters, Energy Aspects|
Gasoline: There was some unexpected support for gasoline despite inventories building slightly this week: the build was not nearly as much as the market was expecting and New York Harbor stocks drew. Falling domestic gasoline prices have helped to boost export economics alongside continued disruptions to Mexican refinery output. Also, the emergence of another storm which looks like it will become Hurricane Nate and is likely to threaten Louisiana’s refineries this weekend also provided some buying impetus later in the week. Broadly speaking, the only thing working against gasoline right now is seasonality. The combination of restrictive Q4 17 gasoline export quotas for Chinese refiners and run cuts at the first phase of Iran’s Persian Gulf Star splitter should help to draw European barrels east and limit inflows into the USEC as we move through October.
Distillate: US stocks drew for the fifth straight week, widening the y/y deficit to 25.3 mb. Strong export demand has helped limit inland resupplies from recovering USGC production. Its now time to start watching for weather forecasts. A normal to cold winter would be very bullish for distillates given current inventories levels.