Oil faces moment of truth
Bank of America Merrill Lynch’s Global Energy Weekly report has been released by Francisco Blanch and their Global Commodity Research team.
Prepare for steep backwardation in Brent and even WTI…
Oil prices have tumbled in recent days as record US crude inventories have clashed with record non-commercial oil net length of 557 thousand contracts. Still, while US crude stocks are high, total OECD oil stocks dropped by 115 million bbls on a net basis in 2H2016 before OPEC cut production. Given expectations of a global deficit of 575 thousand b/d this year, a further 210 million bbl total draw in 2017 is likely. Three dimensions to the ongoing global oil market rebalancing exercise blur the picture: a regional angle, a crude oil grade element, and a petroleum product rotation. With cuts coming from the Persian Gulf and US shale output growing again, Dubai crude prices have led Brent. WTI has lagged. Similarly, light crude oil prices have fallen relative to medium and heavy grades, while propane and butane have tightened ahead of diesel and gasoline markets.
…as US crude and petroleum product exports take off
Crucially, prices at the prompt for many crude and product markets have risen on the back of an expected or observed inventory drop, while long dated prices have continued to roll over across the board. This trend of lower long-dated crude oil prices should continue, as oil-on-oil supply competition in the US forces renewed producer hedging pressures. Still, the spot oil market may change direction very rapidly here. The key to the rebalancing of global oil markets is a surge in US oil exports, in our opinion, as it will help clean up the large North American surplus. The ramp up is already underway. But to clear the global glut, Brent-WTI spreads at the prompt may need to widen further. With global oil demand still very firm, we still see spot oil prices moving higher.
Propane and butane are a cautionary tale
The recent NGL spike is a cautionary tale, in our view, for global oil consumers. The surge in US propane exports has occurred very swiftly. NGL inventory levels dropped at a rate that far exceeded market expectations, leading to much tighter US butane and propane timespreads. Of course, the term structure of the propane market moved to super-backwardation within very short order, far exceeding the backwardation built into the Dubai market in the past few weeks. While forward oil prices are set to remain under pressure due to producer hedging flows, prompt prices for all global crude and petroleum markets could rapidly shift into backwardation. True, a more hawkish Fed hiking path may prevent a Brent move to $70/bbl by June. But for consumers or investors seeking energy inflation protection for the summer, this oil dip is a buy.
OPEC, non-OPEC members agreed to cut production...
Global oil production growth has fallen into negative territory in recent months, helping support an uplift in prompt Brent crude oil prices from lows of $28/bbl last January to a recent high of $57/bbl in January. The drop in supplies has come on the back of a natural decline in non-OPEC investment and a deal between OPEC and Russia to curtail supply. As we warned ahead of the Algiers meeting in September, it is likely "The oil price war" is over and OPEC will now revert to what it does best: verbal and physical manipulation of the oil market to push oil curves into backwardation.
...to further fuel the ongoing reduction in OECD oil stocks
Backwardation in oil markets will squeeze refiners, punish forward sellers, and reduce the downside risk to oil prices. Based on estimates, the global oil market balances will likely shift from an average surplus of 900 thousand b/d in the past three years to a deficit of 575 thousand b/d this year. But it is crucial to understand that the rebalancing of the global oil market already started in July of last year when total OECD oil inventories peaked at 3.1bn bbls. By December, total OECD oil stocks had dropped by about 115 million barrels to 2.98bn bbls. Note that this drop in stocks occurred despite OPEC running at close to maximum capacity levels and well ahead of the January OPEC cuts. Now that OEPC is cutting, OECD stock declines of 160 million bbls over the course of this year have been seen.
Financial markets have rushed to price in an oil price recovery...
Of course, inventories are not all moving in the same direction. There are at least three different angles to the ongoing global oil market rebalancing exercise: a regional dimension, a crude oil grade element, and a petroleum product rotation. For example, the Dubai market has led the tightening while Brent and WTI have lagged. After all, most of the cuts have occurred in the Persian Gulf and have only slowly filtered to Europe and have yet to impact the North American market. This rapid shift in leadership is easily observable in front-to-third month contract spreads for these three grades. Similarly, prices at the prompt for many crude and product markets have risen on the back of the expected forward tightness, while long dated prices have continued to roll over.
...resulting in record net spec length in Brent, WTI markets
Meanwhile, non-commercial net length in the crude oil market has spiked in recent months to reach a high of 557 thousand contracts. The sharp move up in speculative or non-commercial length has created a perception among market participants that investors are very long oil. While there is some truth to this concern, it is also worth pointing out that commercial length in oil markets is very low because consumers have been notably absent from the market, while producers have rushed to increase their hedges on the back of the announced OPEC cuts. High inventory levels have also contributed to a large short commercial position amidst storage operators, further ballooning open interest. Some of the volatility in recent days may be partly attributable to positioning shifts among market participants.
As investors expect stocks to normalise, vol has dropped
However, volatility in crude oil markets has generally been very well behaved, with implied vol on three-month options dropping as low as 25 per cent in recent months. Inventories in many regional crude and product markets are, of course, extremely bloated. But the expectation of a sizable inventory drop in the months ahead has allowed for a meaningful drop in volatility. As we have explained before, oil volatility is a function of macro vol (defined as the VIX) as well as inventory levels. Typically, oil volatility tends to be at its lowest range when inventories approach seasonal norms.
Yet physical markets have not adjusted as fast as financial...
True, total US crude oil stocks are far from the seasonal norms. In fact, crude oil stocks in America are still extremely bloated and reached a record high this week of 528 mm bbls, so it is clear that the physical markets are lagging financial market expectations for WTI crude oil. For instance, physical WTI crude oil prices have traded at a xx/bbl discount to the front-month futures contract for quite some time, and the same case applies to the spread between the Dated Brent and the front month ICE contract. The price discount between the physical barrels and the futures contract is a reflection of today's market weakness.
...but demand and exports could change this very rapidly
Still, we retain our view that the oil market is likely to change direction very rapidly from here. On the one hand, global oil demand remains very resilient following two years of tremendous growth in 2015 and 2016 and momentum remains positive, as evidenced also by strong global PMI’s. On the other hand, while total US crude and petroleum product stocks are indisputably high, export growth has accelerated massively in recent months to meet a tightening global market. This acceleration in US oil exports is key to the rebalancing of global oil markets, in our opinion, as it will clean up the large North American surplus. Inventories are likely to start to draw at an accelerated pace in the second quarter with North America joining Europe and Asia, allowing prices to move higher and timespreads to tighten.
Dubai timespreads have lead and are now in backwardation...
For now, the Dubai crude market has tightened very rapidly as OPEC oil in transit and Iranian floating storage has collapsed and inventories in the region have started to draw. In essence, this rapid rebalancing of the Middle East crude oil market has occurred as a direct consequence of the ongoing OPEC supply cuts. The reduction in supplies of course has forced the term structure of the Dubai market from a very steep contango to a fully backwardated market across the board. The rapid rebalancing of the Middle East crude market has fed quickly into Asian markets and it is now moving over to Europe.
br /> Europe is now following Dubai into a tighter term-structure...
Arguably, the Brent crude oil market has moved in sympathy, albeit at a slower rate, than the Dubai market. The term structure of Brent is now in backwardation in the outer years, but still retains a contango in the near-dated months. The clean-up in the Brent market is also observable in the reported inventory levels. With refinery runs in Europe picking up to reflect an improving macro outlook, crude oil stocks in the region measured in days of forward demand coverage have fallen and are now back to the seasonal normal.
...but the term structure of WTI has failed to recover much
Still, in contrast to the rapid tightening observed in the Dubai and Brent crude oil term structures, WTI has lagged. Spreads in near-dated contracts remain in steep contango and crude oil stocks in the US refuse to decline for now. Yet, this is likely to change very quickly over the next four months as refinery run rates ramp up into the peak of the US driving season from 15.5 million b/d to 16.8 million b/d. With US crude exports picking up already and imports set to remain subdued, US crude stocks alone could probably drop by more than 70million bbl barrels over the next 24 weeks.