War and peace

Published at 13:52 13 Apr 2018 by . Last edited 15:12 5 Nov 2018.

The price action over the last two weeks was driven primarily by war and peace. Last week, fears of a trade war between China and the US weighed heavily on broader risk assets. But by Monday, risk had rebounded from last week’s swoon after Chinese President Xi Jinping struck a conciliatory tone, suggesting we had gone back to a ‘trade peace’. But, as the US, the UK and France plan their response to what appears to be yet another use of chemical weapons by the Assad regime in Syria, it is the threat of actual war that gave oil prices their boost this week. Should prices finish higher today, it will be the largest one-week gain in prices since the December 2016 OPEC meeting.

But, the fact that oil prices failed to sell off materially on Thursday following congressional testimony by Mike Pompeo, Trump’s pick for Secretary of State, and Secretary of Defence Jim Mattis, who both tried to quell expectations for military strikes and escalation relating to both Syria and Iran, suggests that there is a lot more to the rally than just geopolitics, even if it has been the main impetus to this week’s move. The reality is that crude is now flirting with some very key resistance levels, just as WTI options are set for expiry next week. At the moment, there appears to be much more put open interest than call open interest, especially in nearby strikes. But there is no denying the importance of geopolitics in the crude rally of the last few weeks.

Fig 1: WTI ($/b) vs energy as % of S&P Fig 2: May WTI options open interest, k lots
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

Crying wolf?
Meanwhile, energy equities are still struggling to achieve critical mass on a technical basis. We have noted the recent relative outperformance of energy equities relative to tech stocks, and also crude’s outperformance relative to equities more broadly since 1 March. Considering the risk-off nature of trading over the last month, prior to the current rally, the resiliency of oil is impressive.

And while most energy equity traders must be looking at these charts like Charlie Brown would look at Lucy holding the football, it’s still hard to ignore the relative underperformance over a longer time horizon of the energy equities relative to both the commodity and the broader S&P. At the moment, the energy sector as a percentage of the overall S&P is at the lowest levels since the late 1990s. It’s almost as though the last 20-year oil cycle never happened.

The one thing that has been lacking since the 2016 energy equity rally has been the participation of long-only funds, which have been far more enamoured with the tech sector. Their interest in oil will be necessary to get some performance. Anecdotally, we continue to hear that institutional investors are starting to dip their toes (well the little pinky anyway) back into the sector. If sustained, this would mark an important turning point for the sector. The longer oil prices stay closer to $70 than $60, the more confidence energy investors will have in the equities.

Fig 3: Sector ETFs, % change 1 Mar Fig 4: Crude vs equities, % change 1 Mar
Source: Bloomberg, Energy Aspects Source: Energy Aspects

The problem here is that crude has perhaps outperformed most expectations for this time of year and may have rallied too far too fast. We had expected oil prices to rally later in Q2 18, in fact closer to Q3 18. And there is no doubt that geopolitics has factored prominently in the rally of the past week. Even the rally in crude spreads has, by and large, been driven by technical factors and positioning. Namely, a reversal in WTI-Brent positioning coupled with some short-covering in Brent timespreads and WTI hedging in the Cal 19 strip has amplified the movement in the crude curve, perhaps making the market look slightly healthier than it really is (which is not to say it looks unhealthy, but the rally in the paper markets has far outpaced that in the physical). But given the risks (Venezuela and Iran sanctions, potential Syria bombings, and actual Houthi missile attacks), traders may be hard-pressed to short flat price going into the weekend. Until there is a little more clarity on US sanctions against Iran on 12 May, shorting oil would be a very risky endeavour, especially as momentum for oil accelerates. But it feels like the higher we go from here, and considering the hot money length added in the last couple of weeks, the more urgency there is for geopolitics to carry the move higher in crude, at least until fundamentals reassert themselves later in Q2 18.

You down with OSP?
Saudi Arabia’s decision to increase the May Arab Light Official Selling Price (OSP) to Asia has caused a stir in the market. Given the contango in the Dubai curve, many had expected the Saudis to cut the OSP for Arab Light to Asia and so were surprised when the Saudis actually hiked it by 10 cents. And as always, Iraq, Iran, Kuwait and other Middle Eastern producers followed Saudi Arabia’s lead in either keeping light crude prices to Asia unchanged or raising them slightly. Several refiners cried foul in response to the Aramco hike, particularly Sinopec, with the Chinese major announcing its intention to ‘cut 40% of its term volumes’ from its May nominations due to Aramco’s ‘aggressive’ pricing for May volumes.

But it would be incorrect to assume that the cut in term volumes by Sinopec is indicative of a demand wobble, even though refinery maintenance in China is picking up, as is the focus on the environment, leading to further run cuts. Still, the OSP spat is separate to these factors. Chinese buyers have been playing games with the Dubai benchmark and have been trying to manipulate the shape of the Dubai crude curve to force lower OSPs. Aramco’s price increase was intended to be a clear response to what is viewed as a blatant attempt to manipulate the pricing mechanism. In short, the Saudis have called the Chinese buyers out in a very public way.

For Asia, it is the M1-M3 Dubai spread that is the most indicative of how Saudi Arabia will set its OSP. We have noted various times over the last few weeks that the prompt Dubai spread was subject to heavy selling by a Chinese oil major to influence the OSP. The major was not only selling prompt Dubai, it was also buying the third month out, in a clear attempt to push the Dubai M1-M3 spread into steep contango, which would have resulted in a lower OSP had Saudi Arabia stuck to that formula. Aramco, aware of these games, instead decided to look at several variables to assess prices. While structure is one of those variables, it is no longer the only one.

As Sinopec is the largest buyer of Arab light, its decision to reduce May term volumes by 40% was not a trivial move. Moreover, other Northeast Asian refiners are also set to reduce their intake of Saudi crudes by 10%, which is the limit of the operational tolerance in Aramco contracts.

While it may seem to be on the surface an epic…err…hand size contest between a large producer and a large consumer, maybe both sides doth protest too much. We understand that Saudi exports were over-nominated in May, and, in its efforts to keep exports below 7 mb/d, an unfavourable OSP had to be issued. So to some extent this was a stealth cut on the part of the Saudis for the month of May. We aren’t sure if this is what the Saudi energy minister meant when he recently said that the Kingdom would never again allow a supply glut, but Saudi Aramco clearly didn’t mind lowering its term volumes, and Sinopec was willing to take fewer barrels. Later, Sinopec added that refinery maintenance and the closure of Huangdao port in June for anywhere from 7-20 days due to a government environmental mandate means that demand for May-loading barrels would be limited anyways.

It is likely that Saudi Arabia will raise its June OSPs by less than Dubai structure implies in order to compensate and smooth things over, but the key point here is that Sinopec cutting volumes from the Kingdom is not a sign of weaker demand, nor is this Saudi Arabia artificially supporting the oil price. The Kingdom has also made it very public that it knows what some buyers are doing, and will not rely on the Dubai structure alone to determine prices. What we can say for certain is that this is probably the most excited the market has ever been over OSPs.

The Outlook
Brent: Our view of Brent remains relatively unchanged from last week, which is to say that it remains mixed. While futures timespreads have been surging, and not just in the prompt, but all along the curve, steepening the backwardation, the physical market has not been nearly as robust. North Sea diffs remain subdued, while Urals diffs, though off the lows of Q1 18, are still depressed. The move in spreads has been somewhat exacerbated by short-covering in prompt Brent spreads. For the moment, geopolitics has been a strong driver of the move higher in flat price. It would be hard to short Brent given the risks to Iran and broader geopolitical concerns. But until fundamentals reassert their influence later in the summer, Brent will be vulnerable to a correction should the geopolitical paradigm shift.

WTI: While prices have been moving higher and many momentum indicators suggest that crude is ‘overbought’, we note that the relative strength index currently stands at around 62, as compared to an RSI back at the January highs for WTI around 80. The market is not yet overextended from length. Should momentum continue to move higher, and the RSI approach 80, that implies still higher oil prices. Meanwhile, total US petroleum stocks built for the first time in six weeks. And while crude stocks built by 3.3 mb on the week, it was broadly in line with the 2.9 mb seasonal average, and stocks are 105 mb lower y/y. We expect robust PADD 3 exports in April (1.48 mb/d) and May (1.62 mb/d) given attractive economics, which will support stockdraws through summer. However, Cushing stocks continue to build aggressively, this time by 1.1 mb to 36 mb. While stockdraws are expected to resume in the summer, year-end balances still appear soft on a combination of weaker arbs out of Cushing and the prospect of higher Rockies and Oklahoma production.

Fig 5: WTI ($/b) vs Relative strength index Fig 6: Ytd change in US distillate stock, mb
Source: Bloomberg, Energy Aspects Source: EIA, Energy Aspects

: After falling for five straight weeks, US gasoline stocks rose by 0.5 mb w/w to 238.9 mb. USEC stocks climbed for the second straight week, by a sizeable 3.1 mb, as imports into the USEC remained above 0.5 mb/d for the third straight week and regional refinery runs recovered to their highest weekly level since late January. Gains were strongest around New York Harbor, with PADD 1B inventories up by 2.4 mb w/w, slashing the region’s y/y deficit, which had been as high as 8.6 mb in late January, to 1.9 mb. Even with a heavier-than-usual April CDU work schedule, there is still a lot of European summer-grade material ready to swoop in should prices warrant. With crude spreads rallying and gasoline spreads flailing, it’s hard to get terribly excited about gasoline cracks. And while cracks have come off quite a bit, we may not yet have hit a bottom. We will prefer distillate over gasoline for summer, and, unless the fuel gets some help from unplanned outages, only after the prompt inventory overhang is run down in both ARA and Singapore can gasoline have a remote possibility of performing.

Distillate: Last year, despite refinery runs reaching a record high in the US, distillate stocks drew, for the most part counterseasonally, by a whopping 35 mb. This year, runs on average are higher by some 0.5 mb/d in the US, but distillate production is roughly flat y/y, as are exports, and according to the EIA, demand is weaker, although the weeklies will likely get revised higher based on real-time freight data, which remain exceptionally strong. And yet, distillate draws have, in the year to date, matched last year’s draws. Last year, distillate production peaked around 5.3 mb/d. At that rate of production, stocks could only manage to stay flat during a very low demand period. Global distillate demand remains one of the stronger components of the complex, and is a big reason why we continue to favour distillates over gasoline.

Yasser Elguindi, Energy Market Strategist
+1 646 798 1700 (US)

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