Eye of the needle

Published at 14:16 8 Jun 2018 by . Last edited 15:12 5 Nov 2018.

There is no doubt that Saudi Arabia is under intense political pressure to get oil prices down going into the OPEC meeting. The ‘why’ is a little harder to understand. It could be because they know something about the US administration’s intentions vis-à-vis Iran and/or Venezuela, or it could be that they have an eye on the US political season with the midterms just around the corner. While it would be easy to dismiss this as the Saudis throwing the Trump administration a political bone, there is perhaps more going on here. Prices have clearly rallied much faster than the Saudis anticipated, and while they clearly don’t want to see prices rising much from here (at least for now), given the complaints that they are receiving from their customers, they also don’t want to see prices falling either. The Saudis are worried about losing control of prices. In the past we have described this as trying to thread a needle with a rope. But that rope keeps looking bigger and bigger.

Ever since Russian energy minister Alexander Novak told the press in St Petersburg that OPEC+ could increase production, the net length in the oil market has gotten shaky and what seemed like a straight shot for prices to be well over $80 per barrel Brent by Q3 18 is now a little less certain, at least on the surface. Both Brent and WTI prices have bounced off of some technical levels in the last couple of days, but very clearly the outcome of the OPEC meeting will dictate whether we rally or sell off another $10 from here in July. And while both Russia and Saudi have expressed a desire to hike production, there is very little support among the other OPEC members, particularly Algeria, Kuwait, Iran and Iraq. This is going to be a highly contentious meeting as the Saudis will attempt to bully the other members into agreeing to increase production. It is unclear if they will be successful, or what the consequences of failure will be. Both Novak and Falih have insisted that consensus is of the utmost importance. If true, then a compromise of smaller volume increases is doable. But it is not clear if this will be enough.

Thus, it may be a little premature to declare that the bottom is in for prices. After all, a very good trader once cautioned ‘bottom pickers have smelly fingers’. It was good advice as one of the hardest things to do in trading is to call tops and bottoms. But this week, oil has weathered a good deal of the bearish news flow. With the Brent physical market still relatively weak, and Brent structure selling off accordingly, it is rather telling that Brent flat price had sold off only 7% at its weakest point in the week and has rebounded strongly since then.
But the outcome of the OPEC meeting in two weeks’ time will still be meaningful and is expected to continue to drive volatility for both prompt prices and spreads, as the organisation debates how much crude it should add to the market. It is clear to us that Saudi is now committed to trying to forge (some would say bully) a consensus at OPEC to increase production, and our soundings indicate that they would prefer a higher number to a lower one. But we also understand that the Saudis are alone within OPEC in wanting anything like the increase they have been shopping around. The Saudi and Russian motivations are more about politics and managing the upside than anything else.

Despite the mini sell-off, there has been no meaningful rise in short positions in Brent, and most of the selling has come from the long side as the market somewhat derisked. OPEC at this point risks losing the plot and any meaningful increase in production north of a nominal 0.5-0.6 mb/d would likely send many of those longs parked in the prompt running for the exits.
But in some ways the market has moved beyond the very near-term dynamics and is already sceptical that OPEC can ’stick the landing’. With Venezuela and Iran at risk of losing a combined 1 mb/d in output between now and the end of the year, any meaningful attempt to increase production in Vienna will likely be offset with declines from elsewhere. All OPEC will have done is managed to erode spare capacity and push out an extreme tightening in the balance. Thus, while we would expect a negative reaction if OPEC were to increase more than 0.5 mb/d (and that remains a risk), the downside would be centred almost wholly in the front, and we would expect that buyers would emerge for Calendar 2019. Our sources continue to vehemently downplay the potential for a complete breakdown at OPEC. Regardless of what is decided, it will be a consensus decision which is why we believe the path of least resistance will be for a nominal increase focused on improved compliance.

The 2019 balance
Earlier this week, we published the first cut of our 2019 balances, where both Russia and the GCC will have to raise production further, by 0.9 mb/d y/y, to help partially offset further disruptions in Iran and Venezuela. Even so, even with a slower rate of demand growth (roughly 1.1 mb/d), this still gives us annual average stockdraws of around 0.5 mb/d. The biggest issue is that most GCC producers will be close to producing at maximum rates with effective spare capacity at well below 1 mb/d or less than 1% of global oil demand, last seen in 2008, and comes just ahead of IMO 2020. How OPEC communicates on 22 June will determine short-term price action, but they may be able to do little to stop a price spike in 2019. Everything the Saudis are doing now is about keeping a lid on prices as long as they can in 2018 (for more details, please see Perspectives: OPEC and the 2019 balance, 4 June 2018).

It is in this context that the upcoming OPEC meeting reminds us of another OPEC gathering back in September 2007. Inventories were also falling at that time, and the market was beginning to worry about spare capacity. OPEC ‘surprised’ the market by agreeing to increase production by 0.5 mb/d. Prices sold off on the headline, but overnight it was bought back and proceeded to rally until prices peaked nearly a year later in 2008 at $147.50 per barrel. It could be that this June meeting will have a similar impact, as any increase by OPEC is likely to be absorbed by the market and attention will then shift to the supply deficit by Q4 18 and the erosion of spare capacity in 2019.

The US is experiencing déjà vu
But before we start thinking about 2019, it is worth looking at the remainder of 2018. The market has been a bit wrong-footed by the massive US stockbuild reported this week—and, in fact, that total petroleum stocks have risen by some 24 mb since early April. But we would note a couple of things. First, it is always darkest before dawn, and right now we are virtually on the cusp of turning the corner in the US as runs look set to rise, more or less like we did this time last year, and so crude stocks should decline. The trajectory of US inventory changes is mirroring that of last year.

Through the first five months of 2017, production and net imports minus refinery runs left a small surplus on the year as stocks built by roughly 0.12 mb/d and then began to fall materially from July onwards. In H2 17, US crude production growth was roughly 0.3 mb/d, while runs picked up by an equivalent amount. But notably, net imports declined materially and in fact a big chunk of the US stockdraw in H2 17 was that difference. In H2 18, we again have US production growing by 0.3 mb/d y/y, and the increase in runs should offset that, hurricane season notwithstanding (in fact, should there be no meaningful hurricane season this year, the crude balance will tighten even more). And then it falls to net imports to dictate whether US crude stocks will rise or fall in H2 18.

fig 1: US petroleum stocks change ytd, mb Fig 2: US crude exports, m b/d
Source: EIA, Energy Aspects Source: EIA, Energy Aspects

Last year, net imports from June to December fell on average by some 0.8 mb/d y/y as imports dropped by 0.5 mb/d and exports surged by 0.35 mb/d y/y, with much of the latter coming in Q4 17. The fall in gross imports is expected to follow last year’s seasonal pattern as production outside of North America broadly declines, but also as US exports continue to trend higher. We have said repeatedly the current state of crude exports is not sustainable unless refinery runs stay low. Our expectation is that a combination of higher runs and still relatively elevated exports will mean inventory declines in H2 18.

Moreover, we are almost exactly at the same juncture today as we were one year ago. In fact, it could be argued that even with US production growth roughly 1.5 mb/d higher y/y in June, inventories are starting from a lower base than they did one year ago.

US crude differentials are now spiking back to Q4 17 levels. As US refiners have started to exit maintenance, the competition for barrels in the Atlantic basin is now beginning in earnest. Moreover, Saudi pricing has remained largely aggressive, with OSPs coming in at the high end of expectations. Crudes to Asia continue to be priced aggressively, while crude to the US is more competitive.

So even as Saudi production ticks higher, and nominations have increased, it is happening at prices that remain strong. The market is continuing to pull barrels out of Saudi Arabia rather than the Saudis trying to push barrels onto the market. This is an important distinction to keep in mind.

Clearly, the market looks the ugliest when fundamentals are at their weakest. Right now, the physical market is fast approaching its bottom for the year as runs pick up in earnest, with domestic consumption in exporting countries rising seasonally for summer, and as global demand for products ticks higher. As Margaret Thatcher famously said, ‘Don’t go wobbly on me now’.

Fig 3: LLS differential to WTI, $/b Fig 4: Mars differential to WTI, $/b
Source: Argus, Energy Aspects Source: Argus, Energy Aspects

The Outlook
Brent: Though Dated Brent remains weak, Middle Eastern grades continue to price strongly, with the Dubai prompt spread pricing at a 75-cent backwardation while ME grades are showing large premiums, with Oman at an impressive premium to last year’s levels. Saudi OSPs were announced with increases in all grades to Asia. The Saudi Arab Light OSP to Asia is $2 per barrel higher than one year ago, and the Oman differential is also $2 per barrel higher than one year ago. Dubai backwardation is 75 cents, compared to a 30-cent contango this time last year. And despite this, Asian refining margins are more or less exactly where they were almost one year ago and rising seasonally much like they did in 2017. US runs rise from here, so crude exports should fall, and Brent will perform again. The spike in US domestic grades is a precursor to increased competition for barrels as US refiners try to keep their crude local, and Asian and European buyers try to coax them out of the USGC.

Fig 5: Oman differential to Dubai, $/b Fig 6: Dubai Hydroskimming margins, $/b
Source: Argus, Energy Aspects Source: Reuters, Energy Aspects

WTI: US domestic grades have been spiking of late as Cushing crude stocks continue to draw and competition to keep US barrels local begins in earnest. Both Mars and LLS differentials to WTI are now higher than they were in Q4 17. Meanwhile, as pipelines remain full out of Cushing, a threat to earlier-than-expected builds has surfaced in the form of reports that July refinery maintenance (namely Valero’s Memphis refinery) in the Midcon is set to rise due to quality issues out of the hub, delivering crude with heavy bottoms and causing issues for refiners. If true, the result would likely be lower July runs, thus reducing flows from Cushing to PADD 2 for June and/or July (for more details please see our Data Review: US Department of Energy, 6 June 2018).

Gasoline: Gasoline production in the US continues to soar as capacity utilisation reaches a record seasonal high. Cheap crude and a supportive distillate market means that refiners have every incentive to keep making gasoline. Supply is not going to be a problem. The stock rise reported on Wednesday came despite imports into PADD 1 totalling 0.59 mb/d across the week, down w/w by 0.19 mb/d. This week’s arrivals into the USEC look very heavy and could push towards the 1 mb/d mark, so further builds are likely for next week’s report. At the same time, outflows from Europe have remained relatively robust since late May, so imports look unlikely to materially slow in June, even though some refineries are still returning from maintenance. PADD 3 stocks also rose, jumping by 3.1 mb w/w despite a series of unplanned FCC outages at refineries such as ExxonMobil’s Baytown and Shell’s Deer Park in recent weeks. With supply set to rise as FCC outages subside, and demand to soften—at least temporarily until later in June when school holidays begin—more builds are likely in the coming weeks. Without significant further outages, it is hard to see how gasoline will perform this summer. We still favour distillate relative to gasoline.

Distillate: US distillate fuel stocks also rose last week, by 2.2 mb to 116.8 mb. PADD 2 led the build (+1.2 mb w/w) on a combination of last week’s shorter working week and high regional refinery utilisation. Planting season has also largely wrapped up, dampening agricultural demand. Still, domestic diesel demand remains very healthy. DAT freight data shows spot truck demand fell by just 3% w/w last week, when the Memorial Day holiday week would typically see load posts drop by around 20% w/w. Meanwhile, export demand from the USGC appears to have remained relatively healthy at 1.66 mb/d last week. With a host of new fixtures added over the past two weeks, any seasonal stockbuilds over the coming weeks are likely to remain relatively modest.

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

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