It has been a tough slog for crude traders over the past few months, especially as much of the speculative community has sat on the sidelines watching as oil has rallied by 35% off its lows. At IP Week in London in late February, it was our sense that everyone was bullish but no one was long, and much of the CFTC data since then seems to confirm our instincts. Positioning has remained relatively flat, with the small increase in net length since the start of the year more a function of short liquidation than new long positions being added. In short, there is plenty of fuel that could be added…but only if the spec community embraces the bull narrative.
|Fig 1: Combined crude gross positions, k lots||Fig 2: Combined crude net length, k lots|
|Source: CFTC, ICE, Energy Aspects||Source: CFTC, ICE, Energy Aspects|
But thus far, the managed money crowd has been reluctant to reload on crude and there are several reasons why. The first is that there is and will continue to be a fear that a wall of producer hedging will mute any upward momentum in prices. Moreover, producers entered 2019 underhedged relative to the last few years, in large part due to how fast prices capitulated in Q4 18. But as oil prices have rallied to start the year, we have seen producers locking in hedges at these higher prices and open interest in the WTI December 2019 contract has moved higher steadily. In the last week alone there have been reports of Petrobras entering its annual hedges. Given the uncertainty on price, we would expect to see more aggressive hedging the higher prices go, though there is a limit to how much hedging can ramp up. But looked at another way, if not for the producer hedging taking place over the last month, prices could have rallied more.
|Fig 3: WTI Dec historical open interest, k lots||Fig 4: WTI % price appreciation ytd|
|Source: Bloomberg, Energy Aspects||Source: Bloomberg, Energy Aspects|
Waiting for a shoe to drop
The second reason why the spec community isn’t jumping to take on long exposure is that the macro backdrop does not inspire a lot of confidence. While traders love volatility, they hate uncertainty. The US equity market has surged this week—despite slumping earnings expectations, disappointing macroeconomic data, US-China trade deal uncertainty, and Brexit chaos—even as the bond market has largely ignored this bout of risk-on. Given these headwinds, the continued rally in equities is a little perplexing.
There is a growing chorus that believes that there are two technical factors driving demand for stocks right now. The first is related to buying ahead of options expiry today (15 March)—a ‘quadruple witching’ where stock index futures, stock index options, stock options and single stock futures expire simultaneously. Some believe that the looming expiration of options contracts has fuelled the purchase of those stocks as owning options becomes ever riskier the closer we get to expiry. This is why the S&P has shown a bit of a seasonal dip in March/April in the last five years. In fact, it tends to show a dip at the anchor months each quarter: March, June, September and December.
The second driver is considered to be the shifting flow of buyback purchases as corporates enter a blackout period. This blackout is when companies and corporate insiders are prohibited from repurchasing their own shares in the month before the release of their quarterly results. The unofficial blackout period generally goes from the last two weeks of a quarter until after earnings are announced. The rule isn't hard and fast, but many are pointing to next week as the start of the blackout season. The combination of these two trends has spurred demand for equities and many believe it is an important driver of the rally this month. We do not claim strong opinions on these trends as they fall outside our expertise. However, what we do know is that there has been very little fundamental news or data sets to justify this rally. Moreover, much like most of last year, the bond market has not rallied in conjunction with equities, suggesting that this move is more technical than fundamental.
|Fig 5: Stocks vs bonds change since 1 Oct||Fig 6: S&P ytd seasonal % change 5 year avg|
|Source: Bloomberg, Energy Aspects||Source: Bloomberg, Energy Aspects|
Given the strong correlation between oil and equities last December, it is hard to ignore these trends. Increasingly we hear from oil specialists that they are worried that equities will trump oil fundamentals should there be a risk off event. But again, as we said last week, it was this time last year that oil, equities and the dollar all disconnected.
It’s just a matter of trust
The final reason that the market is reluctant to jump in with both feet is because there is still apprehension at Saudi motives. While the Saudis have delivered on everything they have promised (and then some) since December 2018, the market is looking at Saudi policy the way Charlie Brown eyes Lucy as she invites him to have another go at kicking the football. Despite Saudi Arabia severely cutting both production and exports, the market still feels betrayed by last summer when the Saudis pre-empted the Iranian output losses.
We have always said “look at what the Saudis do more than what they say”. And regardless of whether the market is convinced of Saudi Arabia’s commitment to tighten the market and push prices higher or not, the reality is that the Saudis have delivered and continue to take measures that push the market into deficit.
Energy minister Khalid al Falih gave some useful insights into Saudi policy this week, though the market may have missed the more important message. When asked about the upcoming OPEC+ meeting in April his answer was misinterpreted by the market:
"We will see what happens by April if there is any unforeseen disruption somewhere else but barring this I think we will just be kicking the can forward…We will see where the market is by June and adjust appropriately."
Many have interpreted this to mean that OPEC will defer a decision on extending the OPEC+ agreement until it meets again in late June. However, this is not the case. Saudi Arabia specifically asked for an April meeting since the current agreement expires at the end of June. But July and August barrels will be trading in May and June, and so the Saudis wanted to get ahead of any uncertainty or ambiguity on volumes like last year when the Kingdom started raising production in April and May ahead of the June meeting. We expect Saudi Arabia and Russia will agree, at the April meeting, to extend the current agreement through the end of 2019. This is what the minister meant by “kicking the can forward”. Then, when the group meets again in June, there will be more visibility on Iranian and Venezuelan production, and if the market looks at risk of over tightening, they can make adjustments accordingly. Most in the market do not yet have an OPEC+ extension through the year-end in their balances, much like us. We again reiterate that the Kingdom would like to see Brent prices closer to $80 than $60.
|Fig 7: Saudi exp (mb/d) vs US crude stocks||Fig 8: US liquids ytd change in inventory, mb|
|Source: EIA, Energy Aspects||Source: EIA, Energy Aspects|
One or the other, but not both
This should make absolutely clear that the Saudis will remain reactive and wait to see whether or not the Trump administration decides to tighten sanctions against Iran and Venezuela. Our soundings indicate that the US is unlikely to squeeze both countries. Much of the lack of clarity on whether to extend Iran waivers is because the administration is waiting to see how its sanctions on Venezuela evolve. The US is preparing to impose secondary sanctions on Venezuelan oil exports soon to bring maximum pressure on the Maduro regime, which is quickly running out of cash and gold reserves. If the Venezuela situation is not resolved before the early May deadline for Iran waivers, then the US is very likely to arrange a rollover of waivers for many of Iran’s buyers without insisting on further reductions—China, India, and Turkey would likely have simple rollovers, while Korea could be asked to cut by a small amount (perhaps 10%). We understand Japan may only be granted a nominal waiver, if any at all, forcing it to sharply reduce purchases of Iranian crude. Taiwan, Greece and Italy would not see their unused waivers renewed.
More broadly, the real question is: what is the endgame in Venezuela? Clearly the administration is not getting the traction with the Venezuelan military it had hoped for, and the gamble that there would be a swift resolution has not paid off, at least not yet. As a result, we understand that discussions are taking place between the US and Russia to explore whether a negotiated settlement in Venezuela is possible. This would involve a negotiated exit for Maduro. The Russians and the Venezuelan military understand that Maduro’s utility has expired, and he is now a liability. If nothing else, the Maduro era is coming to an end, but what replaces it is far from certain.
The sticking point for Russia is that it refuses to allow the opposition, let alone Guaido, to assume control, and instead the Kremlin is trying to get a military loyalist to step in and act as caretaker until new elections can be set up. It is unclear if there is a compromise to be had here, because the Venezuelan military is clearly buying time, and would make every effort to tilt the result of any elections, while the Trump administration is insisting that this be a mere formality to transition power to the opposition. Both sides view the other proposal as a non-starter.
Though we think the odds are low, if there were an announcement of an exit for Maduro and a replacement/caretaker is named, then this could be an opportunity for the Trump administration to declare victory and create a pathway to lifting the sanctions. There is a lot of Venezuelan oil in storage (some 35mb in total, of which 15 mb is currently floating) that could be released to the USGC immediately if sanctions were lifted. Clearly, such a headline would be very bearish in the short term. However, such a negotiated compromise would also mean there was no clear resolution in Venezuela until after any elections. So, over the medium term, efforts to stabilise Venezuela production and ultimately reverse declines would get pushed back.
At this point it is hard to see a compromise in Venezuela being reached before the decision on Iran waivers at the start of May. This is why we believe there is a very good chance that the Trump administration will choose to roll over the Iran waivers as outlined above, which would trim volumes to around 1 mb/d of crude and condensate combined, rather than a more significant reduction or total expiry of waivers.
Brent: Fundamentals in the Atlantic basin continue to tighten, with Venezuelan and Iranian production curtailed and Saudi Arabia continuing to aggressively price its crude. US total liquids inventories have now drawn at a time when they were supposed to build, very much against the consensus view. Brent spreads have rallied impressively over the last month, and we believe that the path for spreads remains upwards, albeit more gently inclined. The bid for crude is currently softer as we are in peak turnarounds and Chinese buying has paused, but inventories are likely to draw again in the Atlantic basin as refiners exit turnarounds. As crude stocks dwindle, refiners will scramble to source local barrels, supporting Brent spreads. It will, however, take patience.
WTI: Timespreads rallied slightly over the course of the week, though remain in contango, as the market moved to cover shorts as it becomes increasingly clear that Cushing will not build in March by nearly as much as the consensus had believed. With many publicly listed companies marking down production growth forecast for 2019 during the latest earnings season, there is now plenty of scepticism around some of the more ambitious US production growth forecasts. In meetings this week with upstream, midstream and service companies, all agreed that production was likely flat to down q/q in Q1 19, with several pipe commitments going unfulfilled. Additionally, they expect Q2 19 production to only grow marginally before the big push higher in H2 19. Deteriorating quality of DUCs, rising parent-child issues and the lightness of the crude remain recurring themes adding to the pessimism. Our production figures already reflect a similar profile, with a pick-up in production from mid Q2 19. We still believe that Cushing stocks will be rising through Q2 19, but not nearly reaching as high as market expectations and tank tops are unlikely. For more details see our Data review: USDepartment of Energy, 13 March 2019.
|Figure 9: Simple vs complex margins, $/b||Fig 10: Rbob vs Brent crack, $/b|
|Source: Refinitive, Energy Aspects||Source: Bloomberg, Energy Aspects|
Products: One of the most surprising performers so far this year has been gasoline, which has seen a spectacular reversal of fortune. With cracks and spreads capitulating in December, and with the crude quality issues still front and centre of refiners’ minds, many (including us) expected to see weakness in gasoline extending into the summer. However, the gasoline cash strength is very likely due to demand for summer storage, which ironically has helped to tighten the prompt. But with so many storing gasoline, even as refiners are down for maintenance, this is still likely to create problems down the road when refiners exit maintenance. We think there is a window for gasoline to perform over the next several weeks, but with the potential for heavy imports to arrive from Europe, and given how strong simple refining margins are, we expect to see a very steady supply of gasoline heading into summer. Our view on strong distillate and weaker gasoline remains unchanged, and if anything, the more gasoline rises here, the more attractive the entry points for heating oil vs RBOB.
Yasser Elguindi, Energy Market Strategist
+1 646 760 8100 (direct)