Paradigm shift

Published at 18:10 12 Jan 2018 by

Both Brent and WTI have rallied hard this week, leading the energy complex higher to start the new year. In fact, both Brent and WTI have outperformed the broader commodity space and the S&P so far in 2018. To say that the sentiment about oil has shifted is an understatement.

But with oil now hitting three-year highs (Brent touched $70 per barrel this week, for the first time since December 2014), and a number of technical levels looming, several questions remain for the market: now what? Is this the top or does this rally have a lot more room to run?

Very clearly, there has been a paradigm shift in expectations with regard to oil. For the last three years, Brent has been trading in a roughly $40-$60 per barrel range (with a brief spike higher in early 2015 and a brief dip lower in early 2016). The reason for this has been that global oil inventories remained high and the market remained grossly over suppled. Going into 2017, the conventional wisdom was that while OPEC cuts would begin a rebalancing process, the situation would take many years to resolve. However, it was this unexpected pace and intensity of crude stock draws, particularly in the US, and especially in Q4 17, which appears now to have decidedly shifted sentiment to a more bullish stance.

Fig 1: Brent weekly price, $/b Fig 2: WTI, $/b and Relative strength index 
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects


The dramatic fall in crude inventories shifted the curve into backwardation, which is an important signal for investors. The steepening backwardation has now begun to attract new money, which is providing a persistent bid. With the two-year US Treasury yielding 2% and one-year backwardation in WTI yielding close to 8%, there is heightened interest in parking money in the WTI curve and letting the backwardation roll up, especially as inflation expectations creep higher. This ‘new buying’ is pushing up prices and helping to support structure.

The combination of continued crude draws and passive money flowing into oil should help create a new paradigm going forward. As oil prices broke through the ranges of the last few years, the market has had to recalibrate. The decisive break higher in prices in both WTI and Brent has forced the ‘range traders’ who have been selling volatility to run for cover. Traders were quite happy to sell calls and puts and so long as oil traded within the range, they would collect this premium. The closer crude approached $60 per barrel, the more those who were short calls needed to buy futures to cover their exposure. We believe this process may yet still have some way to go. However, with prices breaking higher and inventories set to continue to draw early in the year, suddenly the price outlook for WTI looks stronger. This has led to a clearing out of legacy positions. Its very possible that the rally to start this year has been due to a combination of these two trends, namely new money inflows and clearing of legacy positions.

Too much, too fast?
But the question now is whether flat prices has rallied by too much, too fast? Oil is up by close to 50% since summer 2017. WTI, given expectations for continued draws in January at Cushing, and being the beneficiary of investment flows, may have some room to continue to rally. But Brent, in particular, looks a little over extended. While Brent spreads and differentials have remained strong, margins were lurching lower into the end of last year and this has continued into the new year. This is in contrast to Q3 17, when margins were rallying, dragging up spreads and diffs with them. And while refinery maintenance will help improve margins, demand for crude should ebb, and this should perhaps help take some of the steam out of Brent. Thus, we would not be surprised to see the WTI-Brent spread narrow in the near term given our expectation of continued Cushing draws.

Fig 3: Brent vs x-day moving averages, $/b Fig 4: Promt Brent and M1 vs M2 spread, $/b
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

We noted as early as last August that flat price was lagging the fundamental changes that we see in the products markets, and then by September 2017 in spreads. For us, it was the fact that products took the lead that underpinned our bullishness and our belief that oil prices would continue to rally. As inventories continued to fall, demand surged higher, and spreads continued to rally, we believed that oil prices should move higher (for more details please see Macro energy digest: Green means go, 22 September 2017). But now flat price has caught up and we need to see product strength returning to have confidence in the upside for oil from here.

Moreover, now both Brent and WTI are flirting with some very psychologically important levels. While Brent popped above $70 per barrel for the first time since December of 2014, for WTI that number was $64 per barrel. These are very old resistance levels that will perhaps be difficult to overcome, and thus, it’s not surprising that these levels failed on their first test. But we do expect to see them tested again soon, especially if stocks in Cushing and PADD 3 continue to draw in the coming weeks.

The market will now try to establish a new, higher trading range. Is it $50 to $70? Is it $60 to $80? Or is it $50 to $80? Regardless of what it is, energy equities and in particular the shale names remain grossly undervalued relative to this new price dynamic (for more details please see our Macro E-mail Alert: The great energy equity decoupling, 13 December 2017).

The backwardation in crude will hold, which will continue to drive investor appetite for crude. But there may be a case for crude consolidation in the near term as the rest of the energy complex catches up to the bullishness in flat price. We still expect to see a new higher range for oil prices in 2018. But it does not have to happen all at once in Q1 18.

The Outlook
Brent: While Brent spreads and diffs look very strong, there are some warning signs to watch out for going forward. Namely, margins have been trending lower for some time. In Q3 17, it was strong products and margins that drove first Brent spreads and then flat price higher. It is hard to sustain a crude-led rally. Maintenance is likely to help fix margins, and the outlook for 2018 remains robust. But with heavy maintenance comes lower demand for crude, which should help to temper some of the strength in both spreads and diffs. If it doesn’t, then it means the crude market is much tighter than anyone realises. And if products are unable to match the strength in crude, the rally cannot be sustained.

Fig 5: Urals Cracking margin, $/b Fig 6: Urals NWE vs Dated Brent, $/b
Source: Reuters, Energy Aspects:  Source: Reuters, Energy Aspects: 

: Spreads continue to rally on the back of unexpectedly strong stock draws nationally but in particular in Cushing. The freeze-offs in the Permian have helped to moderate flows on the Basin pipeline, helping to drain Cushing stocks. With inventories set to draw through January, we would expect WTI spreads to play some catch up to Brent. US domestic grades remain strong, and as WTI continues to rally and Atlantic Basin crude grades ease, we’d expect exports to moderate somewhat. The dynamics for H2 18 do not look nearly as constructive. But for now, WTI spreads should continue to rally in the coming weeks.

Gasoline: Despite significant disruptions from winter storms, US gasoline stocks rose by slightly less than seasonal norms, up by 4.1 mb w/w to 237.3 mb in the week ending 5 January. As a result, stocks were 0.6 mb below the five-year average, which is the first time that inventories have been in a deficit since late November 2017. Moreover, despite inventories building steadily some 27 million barrels over the last two months, spreads have held up rather well. The Feb-Mar spread is currently reading -1.85 cents per gallon, which still higher than the last two years. It could be that traders are already looking past seasonal weakness, to improving weather and maintenance later in the month, which should help ensure that builds begin to moderate. But for now, gasoline does not look great

Distillate: US distillate stocks rose for a fourth straight week, up by 4.3 mb w/w to 143.1 mb. High refinery runs and strengthening distillate cracks boosted stocks in PADD 2 and PADD 3 w/w by 1.2 mb and 3.3 mb respectively. More moderate temperatures along the USEC are likely to dampen the recent surge in heating oil demand, but upward pressure on stocks, which were 3.3 mb below the five-year average, will be capped by upcoming turnaround activity. Again, despite the deterioration recently in fundamentals, spreads continue to price aggressively relative to the last few years with the HO Mar-Apr spread trading at roughly 1.9 cents per gallon, whereas this spread was negative in 2017 and 2016. Distillate stocks remain very low relative to last year and remain below the five-year average. 

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