On the margin

Published at 14:28 1 Nov 2019 by . Last edited 15:43 1 Nov 2019.

The global economic slowdown, and all the demand uncertainty that comes with it, has been a big headwind to the crude market this year, despite a very strong physical market. With flat price continuing to fall, some now believe that demand must be lower than the implied data suggest, otherwise prices would not be so weak. There is a lot of backfilling of narratives to match the price action.

Regardless of what anyone’s balances might say, the reality is that the price action does not reflect distress in the products market. Refining margins are stable, with strength expected for gasoline but with diesel vulnerable to IMO 2020 trade unwinds. Broadly speaking, even with potential downside to diesel cracks in the near term, product spreads and diffs are resilient and do not reflect the kind of weakness one would expect if demand truly was capitulating.

Annual demand contractions have been rare in the oil market. The only recent years that saw negative growth were 2008 and 2009, when the credit market collapsed and destroyed demand. When the credit market ground to a halt, global trade came to a standstill. Notably, the US Fed has taken to comparing what is happening now with both the 2011 and 2014–15 slowdowns in growth. We note that, in both of those slowdowns, oil demand still grew y/y by over 1 mb/d. There is no doubt that demand growth has slowed materially with the slowdown in economic growth and trade. But demand is still growing in 2019 by 0.85 mb/d. Even assuming tepid economic growth in 2020, we expect demand to grow y/y by 1 mb/d.

Fig 1: Global oil demand, y/y change, mb/d Fig 2: US Refining ETF index vs crude ($/b)
Source: Energy Aspects Source: Bloomberg, Energy Aspects

All it is cracked up to be
Since early September, refiner equity share prices have been surging, primarily due to an expectation of stronger margins that has since been realised, at least in the US. While Asian margins have been struggling, US margins have remained strong, largely due to an unexpected outperformance in gasoline (see our newly launched Weekly margins report, 28 October 2019). Meanwhile, diesel has been selling over the past week, with the NYMEX Heating Oil crack giving up the last two month’s gains in two weeks. The chatter is that IMO trades are getting unwound, as fears of an overtight distillate market fade with VLSFO acceptance growing by the day (see Middle distillates Outlook: Dirty deeds, 18 October 2019). With manufacturing still in the dumps, it is possible the market has run out of buyers. In the US, total product stocks ex-other oils plus propane are now below last year’s levels, while the principal products have been drawing counter-seasonally. Once the IMO distillate trade works itself out, gasoline should continue to support margins in the US. Normally, gasoline prices tend to ease after August as the market transitions from summer to winter grade in September. This year, optimism for gasoline cracks is being driven by a belief that Tier 3 regulations (see Light ends Outlook: Credit crunch, 11 October 2019) will make the gasoline blending cocktails very difficult to produce. US refineries are best equipped for this and so are best positioned to capture the returns. Meanwhile, US crude remains relatively cheap, which continues to give the US refining system an advantage over Europe and Asia, which are also exposed to higher freight costs. Finally, despite fears of a weakening fuel oil crack due to IMO, heavy sour crude prices have also not fallen which is depressing Asian margins and preventing utilisation rates from going higher. As long as the economic data continue to show some stabilisation, and the macro environment does not deteriorate further, strengthening margins should be a positive portent for crude.

Fig 3: Nymex December cracks, $/b Fig 4: USGC margin - gasoline oriented, $/b
Source: Source, Bloomberg Energy Aspects Source: Argus Media Group, Energy Aspects

Holding pattern
Yesterday, the Fed cut interest rates for the third time since July. Ahead of the meeting, the market was perhaps prepared for a signal from the central bank that it was unlikely to cut rates again soon, instead wanting to take its time and digest the impact of any action on the real economy. After all, cutting more than three times makes it difficult to classify the action as a ‘mid-cycle adjustment’, as chair Jay Powell has done to date. Instead, what the market got from Powell was a commitment that the Fed is not just going to pause on rate cuts, but it’s likely on hold unless ‘there is a material reassessment of [the economic] outlook’. What probably got the market most excited was the comment that the Fed is unlikely to hike interest rates any time soon. The market is not pricing in another rate cut until H2 20 at the earliest.

Key to the decision was the pairing of what Powell termed a ‘notable easing in the balance of risks’ with the prevalent view in the Fed that monetary policy was now ‘accommodative’. Given this was the third cut in the cycle, the Fed wanted to make clear it would not ease more until forced to do so. In the Q&A, Powell was asked what it would take for the Fed to cut rates again and conversely to hike. He responded on the latter ‘we would need to see a really significant move up in inflation that is persistent before we even consider raising rates’. Given there is currently very little visibility for higher inflation, the market took this to mean that the bar is very high for hikes in the future. This was, of course, well received by the stock market. Meanwhile, the bar may not be so high for future rate cuts, given that one of the primary reasons for optimism in the Fed was the sense that risks associated with trade tensions and Brexit were showing signs of improving. In some ways, Powell has put the onus on Trump to secure a China deal to stabilise financial markets. Headlines appeared on Thursday morning stating that, while China was moving towards this ‘phase 1’ deal which Trump has been touting, it was sceptical about the prospects for a longer-term deal with the US. This removed some of the optimism from the Fed decision. It seems that the Fed, much like everyone else in the world, is waiting for clarity on the US-China trade war before making decisions going forward.

In some ways though, the market should have expected that the Fed would effectively mark to market. After all, the S&P has recouped all of the losses since the Fed started cutting rates in July; financial conditions have eased materially since tightening in the summer; the ITB construction ETF (a useful barometer for a Fed that understands the importance of the US housing market to the broader economy), after stalling over Q2 19, has been materially rallying in September and October; and rates have stabilised. In short, market conditions look much more favourable today than they did in mid-July when the Fed started cutting rates.

But the market also very easily forgets, and narratives tend to shift quickly. In October 2013, for example, the universal consensus was the that Fed would never taper, the politics were completely dysfunctional, and growth would never top 2%. Yet, in December 2013, growth surprised to the upside, and the Fed tapered. In both cases, the market bought stocks. Just a year ago, the Fed was signalling that it would, based on its available data, hike rates one more time in 2018 and at least three more times in 2019. Of course, we all know what has happened since then. All the Fed did on Thursday was state the obvious. It thinks it has done enough given the market response over recent months, but should things turn worse once more, of course it will cut again. In the meantime, do not worry about rate hikes because they are not on the radar. Until they are. Narratives can change quickly. Were it not for the China comments, the market would have taken the Fed moves yesterday as a net positive. But now we will have to wait for clarity on the US-China issue.

Fig 5: US Construction ETF vs financial conditions index Fig 6: Stocks vs bonds
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

The Outlook
Brent: The physical market continues to exhibit unprecedented strength, with both eastern grades and North Sea crudes fetching hefty premiums. Brent expiry this week resulted in a spike in the prompt spread, and Urals spiked on a very low November export programme as Russian refiners began ramping up after maintenance. Meanwhile, in the Middle East, differentials remain strong. Even as some differentials have eased off their highs, they remain well bid, in part because freight remains very tight. With Atlantic basin refiners coming out of maintenance, we would expect Brent spreads to remain well bid, getting pulled higher by the strong bid out of the East.

Fig 7: Espo crude diff to Dubai, fob Kozmino  $/b Fig 8: Freight dirty USGC - China 270kt $/t
Source: Argus Media Group, Energy Aspects Source: Argus Media Group, Energy Aspects

WTI: Crude stocks built by more than the seasonal average last week, although some of this was catch-up from the prior week’s surprise draw due to a collapse in crude imports. But even as crude stocks built, total petroleum liquids again drew. Traders experienced a volatile week in spreads as a Cushing build pressured spreads lower. However, reports of yet another Keystone pipeline disruption resulted in shorts briefly covering. If the line can be restored within a few days, the resulting impact on Cushing will not change our outlook, especially if flows on the pipeline are not significantly restricted by the pipe safety regulator PHMSA, and if drag reducing agent can restore throughput. However, there is clearly more risk to spreads until there is clarity on the extent of the disruption to Keystone. With rumours suggesting a quick return, spreads have sold off somewhat. Meanwhile, there are reports that EPIC’s converted NGL line is flowing a lot less crude than originally expected. If flows on EPIC or other pipes remain depressed, Permian draws in November may be difficult to achieve (see E-mail alert: Keystone woes and less than EPIC flow, 31 October 2019)

Fig 9: Crude, distillate and mogas stocks, mb Fig 10: WTI March - April spread, $/b
Source: EIA, Energy Aspects Source: 

Yasser Elguindi, Market Strategist
+1 646 760 8100 (direct)

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