My Comments: If you pay for the gas you use in your car, these are good days. If your life depends on a job in the oil extraction industry, no so good. You can argue the merits, or lack of merits, of fracking, but as the worlds largest consumer of oil, we’re increasingly unaffected by the global supply chain. As we slowly move toward electric or natural gas transportation, this trend will continue. Invest wisely!
Oct. 26, 2015 Andrew Hecht
Crude oil continued lower this past week as the market rejected prices above the $50 level on active month NYMEX crude oil futures. With both WTI and Brent now comfortably below $50 and prospects for commodities looking shaky at this point, these markets could be in for more losses in the sessions ahead. Technical action points lower in crude, as momentum is certainly negative. Fundamentals are also negative from both a macro and micro economic perspective.
Huge inventories weigh on price
These days, the world is awash in crude oil. In the United States, the Energy Information Administration reported last week on October 21 that crude oil inventories rose by 8 million barrels for the week ending on October 16, bringing total stockpiles to 476.6 million barrels. The prior week inventories rose by 7.6 million barrels. These are the highest inventory levels since April 2015. The stockpiles of U.S. crude oil rose for the fourth consecutive week. Over recent weeks, there have been some massive builds in U.S. crude inventories.
Brent crude has also been weak as OPEC members continue to pump record amounts of the energy commodity. Last week markets received two signs of a continuation of the global economic weakness that weighs on the demand side of the fundamental equation. ECB President Mario Draghi said on Thursday that European interest rates are likely to move lower in December and signaled that quantitative easing could continue beyond the September 2016 deadline for the program. While lower interest rates are not necessarily bearish for commodity prices, including oil, economic lethargy is certainly a negative factor for demand.
On Friday, the Chinese government cut domestic interest rates for the sixth time in 2015. The government continues to combat stagnant growth in the Asian nation with a number of economic tools including monetary policy. It is likely that economic numbers due out in the near future will show continued pressure on the Chinese economy. Economic weakness in China is negative for crude oil demand as the Chinese are the world’s largest consumers of commodities by virtue of the size of their population. Recent data has pointed to China transitioning from a manufacturing-based economy to a consumer-based economy.
OPEC members and the Russians are continuing to pump and sell as much crude as possible onto the international market, which is yet another negative factor for price. Last week, the final approval of the deal with Iran that will ease sanctions just means more crude oil finding its way to the market.
Meanwhile, as inventories grow in the United States, there are signs that production will fall soon.
Brent-WTI moving back to historical norms
On Friday, October 23, Baker Hughes (NYSE:BHI) report that rig counts in the oil patch fell by another rig over the past week, bringing the total number in operation to 594. Last year at this time, the total rig count stood at 1,595. This means that U.S. production will eventually fall below the 9 million barrel per day level. The EIA said in September that the agency expects that daily U.S. production will fall to 8.8 million barrels per day in 2016. Falling rig counts is the reason. With OPEC production high and U.S. production falling, eventually, this could mean that the long-standing premium for Brent crude over West Texas Intermediate could soon become a thing of the past. In fact, prior to the Arab Spring in 2010 that took the Brent premium to over $20 above WTI, the latter traded at a premium to Brent for a majority of the time.
The Brent-WTI spread closed last Friday at $3.39 per barrel premium for the Brent on December futures. The spread closed at $3.20 on January futures contracts. Recently the spread traded down to around the $2.50 level, but increasing U.S. inventories over recent weeks has put additional pressure on WTI. However, the trend in this spread is certainly lower and given the continuing flow of oil out of the Middle East and Russia, we could soon see this spread return to a premium structure for the U.S. crude.
There is always a chance of big volatility in the Brent-WTI spread, as the political premium in crude tends to show up in the price of Brent. Brent is the benchmark pricing mechanism for Middle Eastern, African and European crudes. Meanwhile, as the price of crude oil moved lower last week, one aspect of market structure, processing spreads, showed some signs of life.
Signs of life in refining spreads
Crack spreads have been moving lower over recent weeks. We are in a limbo time of the year for oil demand as driving season ended with summer and heating oil season is still ahead. Refinery utilization stands at around 86% due to the slowdown in operations at the start of the fall maintenance season.
Stockpiles of gasoline and distillates have moved lower according to the latest data. Gasoline stocks were down for the first week in six weeks as demand strength was stronger than a rise in imports and production. Analysts expected a 1.5 million decrease in stocks and the number came in at a 2.26 million barrel fall. Distillate (heating oil and diesel) stocks also fell by 1.52 million barrels beating estimates for a 600,000 barrel draw. Despite the draw in stocks, inventories of gasoline and distillates remain well supplied at 7.6% and 18.5% above last year’s levels respectively at this time.
The better-than-expected news led December NYMEX cracks spreads to recover from very low levels.
In January 2015, crack spreads started moving higher, which eventually led to a bounce in the price of raw crude oil in March. It is too early to tell if the current rally in processing spreads is for real, but action late last week is certainly not overly bearish for the near term. Meanwhile, recent action in term structure is bearish.
Term structure and the dollar says the upside is limited
One of the best tools for monitoring the real-time impact of supply and demand in the world of commodities is term structure or the forward curve. Last week, crude oil term structure told us that prices may fall for oversupply reasons as the contango widened.
The December 2015-December 2016 NYMEX crude oil spread closed the week at $6.06 on Friday, October 23. This amounts to a contango of 13.6% – up from $3.85 or 7.7% on October 8 when crude oil was on its way to just over $50. The Brent December 2015-December 2016 spread closed on Friday at $6.94 or a contango of 14.46%.
The Brent contango is higher than the NYMEX contango because of expectations of increases of output from Iran, however, both spreads have widened as inventories grow around the world. This is clearly a negative signal for price right now.
While the purpose of interest rate cuts around the world is to stimulate economies, the result of those actions was an explosion in the value of the U.S. dollar late last week.
The U.S. currency has moved 3.6% higher since October 15, which is a huge move for a currency. The dollar is the reserve currency of the world and the pricing mechanism for commodities. There is a strong negative correlation between commodity prices and the dollar. The rise in the dollar is an offset to the effort to stimulate economies, and the currency looks like it is breaking out to the upside on a technical basis. This could mean more pressure ahead for commodity prices in general, including for crude oil.
December 4 is the target date
At this juncture, the price of crude oil looks like it has more room on the downside given the current state of market structure and momentum. However, the one bright spot last week was a shift in product inventories and a rise in crack spreads from low levels.
The truth about crude oil prices is that while fundamentals and technicals still favor downside price action, all that can change as we come closer to the December 4 biannual meeting of OPEC, the oil cartel. Last year OPEC said to the world, let it fall. The powerful producers in the cartel stated that they did not care if the price of oil fell; in fact, they welcomed a price that would curtail U.S. production from shale and build future market share for themselves.
Now, one year later, the cartel will meet again with many of its members suffering economic hardship and widespread cheating going on as members sell above the quota levels. The cartel has looked the other way as the production ceiling of 30 million barrels per day has been ignored and current production is running over 1.5 million barrels higher. That number is likely to increase now that sanctions on Iran have eased.
As one of the most political commodities in the world, any one of a number of events can turn the price of crude oil on a dime. I expect increased volatility as we get closer to the OPEC meeting. The high odds play is that the cartel will not change policy and that they will remain on the same path in an effort to hand out more pain in the U.S. oil patch. That opens up the potential of a real price spike if they surprise the market with a production cut. While crude oil is likely to continue to drift lower, uncertainty surrounding the December 4 get together will prevent it from making new lows below $37.75 per barrel basis the active month NYMEX futures contract.
Keep your eyes on crude oil market structure, particularly processing spreads and the forward curve in the weeks ahead. These spreads could yield important clues as to short- and medium-term direction for the energy commodity. For a handle on the longer-term prospects, we will have to wait for the word from OPEC. I have prepared a video on my website Commodix.com, which augments this article and provides a more in-depth, detailed analysis on the current state of markets to illustrate and highlight the real value implications and opportunities available.