Delayed reaction

Published at 17:36 10 Nov 2017 by

Crude traders have been grappling with conflicting signals all week as rising tensions across the Middle East have brought geopolitical risk back into the equation just as Brent fundamentals are softening. Brent spreads, which had been persistently bid over the past two quarters, have stalled, in part due to weakness in gasoil, where spreads have been easing over the past month. Rising US and European refinery runs are driving concerns that the distillates complex will collapse under the weight of new supply as winter struggles to gain a footing across the Northern hemisphere.

Weakness while not uncommon at this time of year for gasoil, is worrying considering the considerable length built over the course of August and September. And while Q1 18 balances look supportive, that is still a long way off, and the risk here is from positioning. As for crude, now that the flat price has finally caught up to the strength in crude spreads, the market looks more balanced today than it has in a long time. The problem is that between gasoil softness and the OPEC meeting looming in the background, the risk reward to being long at $65 per barrel as opposed to when prices were $55 a month ago seems less obvious. Moreover, with clear signals from Russia that prices may have risen by too much and too fast for its comfort, we would expect to see attempts to ‘talk down’ the market. Furthermore, the lack of uptick in the flat price given the massive call buying that has taken place this week is worrying, And, coupled with wobbly signs from Brent spreads given the influx of US crude exports expected in December and January, this crude rally looks exhausted. It’s hard right now to make the case for crude prices to be higher from here unless there is a major catalyst (like war in the Middle East).

Fig 1: Prompt spreads, $/b Fig 2: Benchmark prices, $/b
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects 


But even if crude does take a breather here ahead of the OPEC meeting, the fundamental support is still there going forward. US petroleum inventories declined again this week, bringing the cumulative stock draw to 65 mb, the bulk of which has been in products. The only bigger YTD draw in inventories came in 1999 when stocks drew some 130 mb, excluding the SPR. The problem for the oil market is that oil has already rallied some 40% off its summer lows, and the question traders are rightfully asking is can it rally by another 10%? To do so would take Brent prices close to $70 per barrel, which seems like a huge psychological leap of faith right now for the oil market. 

But this is the context that the oil market is currently debating the upcoming OPEC meeting on 30 November. A rollover extending the agreement through the end of 2018 likely solidifies the technical strength in crude and puts WTI and Brent on a footing to achieve those higher levels, though they may come later in 2018, after a seasonally weak Q1 18. However, failure to extend the deal would also cause the market to believe that OPEC does not want prices to go higher, which is not the case. A little breather for crude between now and 30 November would not be the worst thing in the world.

Energy equities need to catch up
This year has been one of delayed reactions: crude spreads responded with a lag to product strength, and flat price lagged the move in crude spreads. But nothing has underperformed quite like the energy equities have this year.

We have written at length about the relative under performance of US energy equities both relative to the flat price, but also relative to the S&P. While Brent has risen by close to 40% since early July, the MSCI energy sub index has rallied by only 13%, The XOP US producer index ETF is up only 26%, and the oilfield service index ETF, OIH, is up only 19%. More importantly, most of the energy equities are still down on the year, while Brent is up by 11% in the year-to-date.

Consistent with the theme of delayed reactions, we think that energy equities have a long way to catch up with the new reality in oil. This year has seen a very strong divergence in the relationship between energy stocks and WTI. Historically, there has been strong correlation between the S&P energy sector relative to the broader index. The market capitalisation ratio between the two has tended to move in tandem with the oil price. As oil prices go up, there tends to be a rotation into energy, and when they go down, a rotation out. But this dynamic notably diverged in 2017. Part of the reason for this has been because of the focus on technology and other sectors at the expense of energy since the election of Donald Trump, the so called ‘Trump trades’.

Since early September, however, energy equities have come to life, with the US producer ETF outperforming most everything related to it. And, over the past 10 days, that trend has extended to things not related to it, with the energy subsector outperforming relative to both the broader index and the tech subsector. The market has been punished all year for trying to pick the timing of a sector rotation into energy. But with the crude oil rally of the past month, its hard to ignore how cheap these names are relative to the rally in the flat price. And, if oil prices look to extend this rally into 2018, many of the energy equity names are grossly mispriced relative to that reality.

Fig3: Energy/S&P (%) vs WTI ($/b, Rhs) Fig 4: WTI vs sub sectors, factor 100=2016
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects 


The Outlook

Brent: Since June, Brent spreads have been strengthening, both at the prompt and relative to the shape of the curve writ large. Fundamentals have been driving the move to backwardation. But lately, Brent spreads have softened, dragged down by an influx of US crude exports into the Med, as gasoil spreads have been weakening materially. Moreover, with the December Arb wide open, there is expected to be more volumes in Europe. This does spell a period of weakness for Brent spreads in the near term, but some of these effects should be self correcting. As US and European runs return in earnest, exports from the US should slow, and support Brent spreads again. But much of this is a function of the current destocking, which has clearly not yet run its course. Spreads could come under some near term pressure, though we see support beyond that.

WTI: Time spreads have also paused, much like Brent, but perhaps for different reasons. PADD 3 stocks built this week on an unexpected drop in exports. As a result, PADD 3 stocks rose by 1.6 mb. Despite this small build, October crude stocks drew by 8.4 mb, compared to the five-year average of a 16 mb build. We expect draws to continue through November (-13 mb) and December (-18 mb), especially as runs start to recover (last week runs rose by 0.3 mb/d to 16.3 mb/d). We maintain our view that exports will have to come off from October’s average levels of 1.7 mb/d as sustaining such levels of exports alongside supporting runs above 17 mb/d in December will push PADD 3 stocks below operational minimums (for more details, see Data Review: US Department of Energy, 8 November 2017 ).

Gasoline: Stocks fell by 3.3 mb and have fallen by more than 20 mb since Hurricane Harvey, dropping below the five-year average for the first time since 2015. Draws were again led by PADD 1 as imports into the USEC dropped to 0.37 mb/d. Stocks also fell in PADDs 2 and 3, driven primarily by refinery maintenance and an unplanned outage of the Explorer pipeline. However, Chicago prices have fallen back now that service on the Explorer pipeline has been restored and regional refineries are returning from works. While this will eventually help to back out some supplies from PADD 1, resupply from Europe amid a strong pull from the East remains stubbornly low and export demand from countries such as Mexico remains robust. Inflows from Europe should pick up towards the end of the month as shipping fixtures have picked up; so gasoline strength should fade over time with resupply, though it may take a few weeks for that to develop. 

Distillates: HO stocks drew impressively this week, taking stocks down by a whopping 36 mb in the year-to-date. However, gasoil is weighing down on distillates more broadly as the market had gotten overextended. With winter yet to arrive, and expectations for rising crude runs over November and December, there is reason for gasoil to ease off seasonally, especially relative to the length that had been built over the last two months. For all the hand wringing over the recent “weakness” in HO and GO, the reality is that spreads remain high relative to previous years, and Q1 18 turnarounds should tidy up the market, with only the veracity of winter dictating the degree to which distillates will clean up.

Fig 5: Ytd chg. in US petroleum stocks, mb Fig 6: Ytd chg. in US distillate stocks, mb
Source: EIA, Energy Aspects Source: EIA, Energy Aspects 

 

 

 

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