In the last few weeks, the main question being asked of us in the macro space is: if the physical crude market is really so tight, then why are prompt Brent spreads and the entire WTI curve still in contango? The lack of proper backwardation in either benchmark has been a mental hurdle for many and is one reason why there has been only modest uplift in flat price, especially given the strength in the physical market. Thus, the market observed with great interest when the Brent market slipped into the slightest of backwardations this week, seemingly on little news.
A few weeks ago, we noted that crude had started the new year a little stronger than many had anticipated, but that this was due to some very transient factors that should abate at some point: Chinese buying came in early and often, a backlog of tankers at the Turkish Straits, and outages in Libya all helped to boost flat price in January and February (see Perspectives: Air and mixtures, 4 February 2019). We warned that some of these would begin to reverse by March, and they have: Chinese buying has slowed after refiners overbought since December, the Turkish Straits backlog has almost disappeared and Libya’s NOC announced this week that Sharara was restarting.
So, with more prompt supply returning, we found it surprising that Brent spreads caught a bid this week. There was no specific trigger, meaning there was no obvious supply outage reported, and the only fundamental driver we can point to is that simple refining margins have improved dramatically in the past week. But the more crude structure improves, the more comfortable speculators will be in buying up flat price. With refinery maintenance nearing its peak globally, there should be a bid for crude as refiners prepare for their return. That spreads are strengthening as some of the supply bottlenecks are beginning to ease is curious and while physical market positioning is a big driver, there is no doubt that the overall market looks in far better shape than last year.
|Fig 1: Urals Hydroskimming margins, $/b
||Fig 2: Refinery turnarounds, mb/d|
|Source: Refinitiv, Energy Aspects||Source: Company reports, Energy Aspects|
We have been saying that the fundamental set up for crude looked good. After all, the strength in physical crude came at a time when crude demand was supposed to be weakest—when refinery works and poor margins would sap demand, bloating inventories and putting downward pressure on prices. But that hasn’t happened.
In fact, if anything, the opposite is so far true. Inventories have not built in the US as many had expected as total petroleum stocks are roughly flat on the year (much like last year’s expected Q1 build failed to materialise). Moreover, much of the weakness in margins everyone was freaking out about in January and February was wholly a function of stronger crude rather than weak products. But now products have caught up, is crude ready to rally?
False sense of security?
Last year, the tension in the energy complex was very much crude driven, as the sanctions on Iran led to a shortage in Q3 18 even as demand growth slowed. There could very well be more crude tension this year as the Trump administration has maintained an aggressive posture and has imposed new sanctions on Venezuela while at the same time preparing to squeeze Iran even further. The administration is actually considering adding additional secondary sanctions on Venezuela and looking for buyers of Iranian crude to commit to further volume reductions before granting waiver extensions in May.
One reason the administration could be feeling confident that it can keep oil contained while squeezing OPEC producers further is because of the bearish outlook that the US EIA has for global balances in 2019. Our understanding is that the administration is using the EIA baselines for its decision making on sanctions. Currently, the EIA forecasts supply will outstrip demand in every quarter of 2019 and 2020. It also has OECD inventories building back to the 2016 highs. Certainly, if that were to happen, it would put inordinate downward pressure on prices.
|Fig 3: EIA Supply/Demand forecasts mb/d||Fig 4: EIA forecast OECD stocks, mb|
|Source: EIA, Energy Aspects||Source: EIA, Energy Aspects|
The administration may also have a false sense of security over its ability to manage the oil market given what happened to prices in H2 18. While the wavering on waivers did indeed trigger the initial sell-off in crude, the velocity and depth of the sell-off was more a function of negative gamma driven by producer hedging, positioning and CTA activity. It was a rare confluence of issues that led to the massive capitulation in positioning in November 2018. This is perhaps also fuelling a perception within the Trump administration that they ‘get’ the oil market. Certainly, if the US further squeezed Venezuela, while also trying to force further reductions from buyers of Iranian crude, the oil market is going to sharply tighten in Q3 19, which then may ultimately force a response from an OPEC that has been overdelivering on promised cuts. The point is that OPEC remains reactive and will let the market tighten before it responds. Then it won’t simply be a function of quality as we have been arguing; it could also become a question of quantity again. If anything, the Trump administration is currently at risk of overreach.
|Fig 5: Energy Aspects global liquids balance, mb/d|
|Source: Energy Aspects|
Meet me at the Plaza
Ironically, in the very near term, while benchmark crude fundamentals are perking up, there are some strong macro headwinds looming in the form of a potential equity correction coupled with the risk of further dollar appreciation.
Ever since Trump and Mnuchin hinted a couple of weeks ago that currency was going to factor into a US-China trade deal, expectations have been building that a sort of ‘Plaza Accord’ was in the making. Back in the 1980s, after the Fed under Paul Volcker hiked rates aggressively, wreaking havoc on the global economy, there was a meeting at the Plaza hotel in NY where an agreement was reached among the G-5 nations—France, Germany, the US, the UK and Japan—to manipulate exchange rates by depreciating the US dollar relative to the Japanese yen and the German deutschmark. While a weaker dollar would fix a lot of problems, it is still very premature to talk about a coordinated move by global central banks to weaken the dollar.
But that has never stopped expectations from getting wildly ahead of reality. Any talk of currency coordination would be pushing on an open door, as so many want to believe it. The Trump administration must also recognise this. Our understanding is that there is going to be a currency component to the US-China trade deal, but it is much more modest and falls far short of a Plaza Accord-type agreement. The verbiage is likely to more closely resemble that recently written into the USMCA, with commitments by both China and the US to avoid competitive devaluation.
China’s policy has already been to keep the yuan stable (because the PBOC doesn’t like how depreciation expectations can trigger capital outflows) and China didn’t weaken the yuan when the dollar was rising last year. So, this was not a difficult concession for China to find language that says neither party will resort to competitive exchange rate policies. The yuan got a small pop a couple of weeks ago as word of this section got out, but in practice, it means little to China as it has already been managing the currency and avoiding sharp depreciation is in China’s interest anyway.
Getting the dollar to depreciate from here is going to be difficult as it requires people to sell their dollars and park their cash somewhere else. The reality is that the US economy is doing very well and relative to what is happening in the rest of the world looks decidedly more stable. What are the alternatives? Would investors seek the pound with the possibility of a ‘no deal’ Brexit hanging over their head? Would they own the yuan with all its limitations? Or the euro with Italy in recession and the very sanctity of the European experiment seemingly hanging in the balance? While the US economy and the dollar are not perfect, with massive structural problems in the medium and long term, in the near term, as the old adage goes: in the land of the blind, the one-eyed man is king.
As if to reinforce this view, on Thursday, the euro was smacked lower as Mario Draghi overdelivered on expected dovishness from the ECB, with the central bank dramatically marking down growth and inflation expectations in 2019. The technical set up for the dollar is again bullish. A break out above 97.11 on the dollar index would confirm upside bias, which would be devastating for risk and the favoured emerging markets. If the dollar does move higher, the EM trade is basically over. Moreover, the Fed does not meet until 19-20 March, which is still almost two weeks away. We feel there are important inflection points for both equities and the dollar which will matter greatly for risk assets in the coming weeks. Everyone should be in 24-hour Trump tweetstorm watch (especially Jay Powell). Tail risks abound.
It was around this time last year that oil managed to rally even as equities sold off in March until early April. Interestingly, the dollar also rallied from early April until June when oil also saw a near-term peak. The imposition of Iran sanctions was the catalyst for the oil rally last year. This year, again the question is whether the sanctions against Venezuela can also act as the catalyst for crude to rally even as equities sputter and the dollar rallies.
|Fig 6: S&P 500 index vs 200 day moving avg||Fig 7: US index DXY, weekly|
|Source: Bloomberg, Energy Aspects||Source: Bloomberg, Energy Aspects|
Brent: With gasoline and gasoil performing, and crude still relatively cheap, simple refining margins have exploded, even as complex refiners continue to suffer from the super strong physical sour crude market. With refiners coming out of maintenance soon, Brent spreads have caught a bid this week, somewhat surprising a market that has been conditioned for weakness. Moreover, OPEC is keeping its discipline and Saudi deliveries to the US remain at 10-year lows. The release of Saudi OSPs this week did little to suggest a change of heart. If simple margins remain elevated, demand for light crude should continue to rise, and with refinery maintenance pretty much now at its peak, a sustained recovery in Brent spreads should translate into flat price strength.
WTI: Despite a rather large 7+ mb build in crude stocks, total petroleum stocks actually drew on the week as product draws overwhelmed the crude builds. With total petroleum stocks now virtually flat on the year, and with more and more listed E&Ps guiding to lower 2019 growth, the outlook for the supply side could be shifting going forward. Based on our gas scrape data, which informs our short-term oil production model, we believe US production is underperforming, with freeze-offs in the Permian and STACK/SCOOP this week weighing on output, following freeze-offs in the Bakken in February. US crude exports continue to increase. The degree to which the rest of the world is able to absorb the increasingly lighter quality of US crude is going to be material for balances (for more details see E-mail alert: US crude growth swinging heavily toward 50 API; refiners raise quality concerns, 4 March 2019).
|Fig 8: US total stocks ytd change, mb||Fig 9: Gasoil curve, $/ton|
|Source: EIA, Energy Aspects||Source: Bloomberg, Energy Aspects|
Products: Very much against the consensus view, gasoline has outperformed most expectations to start the year. Given how much inventories grew in Q4 18, and the outlook both for supply and demand, the rally, which to some extent has been driven by positioning, has been a surprise. Between that and strong expiries in gasoil, it should perhaps not come as a great shock that simple margins have improved dramatically.
There is still a lot of debate over gasoil fundamentals going forward with IMO looming. The market today is of two minds. Some argue the new sulphur caps will be manageable, that refiners will be able to make more than enough distillate and, as a result, inventories will rise between now and August as refiners come out of maintenance, thus justifying the bizarre shape of the gasoil curve and the contango in the middle part of the curve. Others, however, believe that there is not enough of the right type of crude (sour) nor even enough molecules to make all the gasoil needed for the IMO switch. With stocks low, and yield switching capabilities challenged because of crude quality, we sit in the latter camp.
In the past two weeks, the backwardation in the front and the back end of the gasoil curves have steepened, while the middle, where the contango resides, has not changed very much. In our view, there would need to be massive ULSD stockbuild to justify, let alone sustain, that level of contango. However, we also believe that the back end of the curve should remain anchored as IMO buying should persist. So, it is the front that has to go up. Thus, from June to December 2019, we would expect to see those contracts rally relative to January to July 2020 as the curve shifts into backwardation.
As we have observed, the prompt gasoil remains super tight, despite the contango structure, and every month into expiry, the prompt gasoil has been rolling into backwardation. There is reason to believe that once the March contract goes off the board next week (12 March), the set-up is quite positive for gasoil.
Yasser Elguindi, Energy Market Strategist
+1 646 760 8100 (direct)