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By Jason Pearce

The Gundlach Trade of 2017

Every year, investors and money managers flock to the Sohn Investment Conference in New York to hear the investment pitches from the top minds in the industry.  Jeffrey Gundlach, the CIO of DoubleLine Capital, is one of the most anticipated speakers of the event.

Given his track record, it’s no surprise.  This is the man that often outperforms the market and most of his peers, who predicted the Trump election win, and who even told traders to buy natural gas when it was scraping the bottom of the barrel at multi-year lows.

Not that he’s always right (he has been bearish on the stock market for years), but his opinion is not one you want to quickly dismiss.

This year, Gundlach’s big idea was to go long on the Emerging Market Index (EEM) and short the SPY.  Now, he did clarify that this does not mean that he’s bearish on the US stock market.  He simply thinks that the Emerging Markets will outperform the US market.

This idea is not a directional bet on the market.  Rather, it is a relative value play or a pairs trade.  In futures trader parlance, it’s what we call a good ol’ spread trade.

Valuations

One of Gundlach’s main points for this idea is that the US market is overvalued and the Emerging Markets are undervalued.  So with both of them poised for a reversion to the mean, a relative value play is the logical way to go.

This makes perfect sense.  In a prior post, I noted that the current level of the CAPE ratio indicates that the US market is historically expensive.  Right now, the CAPE ratio is either side of 29:1.

The only other two times in the last century when the CAPE ratio in the US was at this level or higher occurred in 1929 and again at the end of 1999.  And we all know how things turned out at the end of the Roaring Twenties and the Dot Com bubble.  Perhaps it’s time to queue up the song Party Like It’s 1999

At the same time, the CAPE ratio on the MSCI Emerging Markets Index is at a historically low reading of 14:1.

The spread between the CAPE ratio in the US and Emerging Markets hasn’t always been this wide.  During the Financial Crisis of 2008, the CAPE ratios for both the S&P 500 and the MSCI Emerging Markets Index had crashed to a similar level of about 10:1.  The ratios for both then rebounded into early 2011 as the US took the lead higher.

Two Paths Diverged

After the ratios of both markets experienced a setback in 2011 and bounced back at the start of 2012, the CAPE ratio on the MSCI Emerging Markets Index rolled over once again.  It continued to drop for another half a decade until it finally returned to the Financial Crisis low in early 2016.

On the other hand, the CAPE ratio on the S&P 500 continued to climb for the last several years.  It is now sitting at a nine-year high.

On an interesting note, when the Emerging Markets CAPE ratio returned to the same level as the Financial Crisis low last year, PIMCO said that buying down there would be “the trade of the decade.”

It looks like they were right, too.  The Emerging Market Index (EEM) has risen a stellar 39% over the last year and a quarter.

So how has your stock portfolio performed over these last fifteen months?

Even though the Emerging Market Index (EEM) has rocketed higher since early 2016, the CAPE ratio is still only sitting at a modest 14:1.  With the CAPE ratio on the S&P 500 now at nose-bleed levels and the CAPE ratio on the Emerging Markets at bargain levels, the disparity between their valuations have become glaringly obvious.

But that’s not gonna help us out with the timing.  We need to see some price action to accomplish that.

Ratio Action

The S&P 500 has outperformed the MSCI Emerging Markets Index since 2010.  However, technical action suggests that this trend could finally be coming to an end.  We are going to look at the ratio between SPY and EEM to determine this.

A near perfect double top pattern in the ratio may have formed on the weekly chart between the multi-year high of 6.60:1 that was posted in early January 2016 and the mid-December 2016 high of 6.58:1.

To confirm that a double top has indeed been established, the SPY/EEM ratio needs to break the lowest point between the two highs.  That level is located at the mid-October correction low of 5.69:1.

The ratio is within spitting distance of the October correction low right now.  Any trader who’s interested in shorting the SPY/EEM spread better have their finger on the trigger and be ready to squeeze it at the drop of a hat.

Early Warning Shot

One could make the argument that the SPY/EEM ratio has already signaled a bearish trend change, despite the fact that a double top has not yet been confirmed.  This occurred back in mid-March when the ratio closed below technical support at the rising 100-week moving average.

In 2011, the ratio broke about above the 100-week moving average and closed above it every single week for five years straight.  (I wrote a post that explains my process for ending up with the 100-week moving average).  The bullish trend was a classic pattern of higher highs and higher lows, making it an easy pairs trade (long SPY and short EEM) to hold for anyone aware of what was going on.

In October, the ratio sank to a one-year low and closed just below the 100-week moving average.  It was a do-or-die moment.  As it turned out, this marked the bottom of the correction.  In just a couple of months, the swift recovery that immediately followed catapulted the ratio almost back up to the early January multi-year high.

After failing to clear the January 2016 high, the ratio rolled over again and started its descent.  Technical support at the 100-week moving average was breached again in mid-March, but this time the SPY/EEM failed to recover.  By this metric, it’s time to be short or be out.  Being long is currently not an option.

Buy, Sell, Switch

Even if you don’t intend to put on a SPY/EEM pairs trade, knowledge of how it’s performing is still valuable knowledge for the average investor.

From the perspective of diversification and/or marketing timing, knowing about the wide spread between the S&P 500 and the MSCI Emerging Markets Index CAPE ratios and tracking the trend in the SPY/EEM ratio can help one enhance returns and manage risk.

Since the case has been made that Emerging Markets should start to outperform the US market, an investor could use this information as a reason to lighten up on US equities and get a little heavier in the to the Emerging Markets.

If you’re an absolute return kind of guy, you could even say that this is a good reason to switch altogether from being invested in US equities to being invested in the Emerging Markets.

Better Risk/Reward

Not only does the recent change in the SPY/EEM trend suggest a regime change in market leadership, but the CAPE ratio also tells an investor where to go for lower risk.

Most people assume that the Emerging Markets carry the higher risk because of political risks, higher volatility in the currencies, less-developed economies, etc.  These are valid concerns.  But the price of Emerging Markets relative to what they actually earn indicates that they are a lot closer to being a good value than what the US market is.

Not to suggest that they can’t decline from here, but the Emerging Markets have much less further to fall than the US market does before getting to what has been an historically an undervalued level.

If there’s a global bear market lurking around the corner and you get caught wrong-footed, don’t you at least want to be invested in the market that drops the least instead of the one that drops the most?

Emerging Markets Have Emerged

Let’s forget this whole relative value play for just a moment and take a look at the Emerging Markets on their own merit.  For a few years the outlook for EEM was bleak.  But things have changed considerably over the last several months.

Back in the summer of 2015, the MSCI Emerging Markets Index broke out of a multi-year trading range…to the downside.  Not a good omen.  Once support at the October 2011 low was breached, there was no reason to try catching a falling anvil.

By January of 2016, EEM was trading at the lowest price since early 2009 and the CAPE ratio had returned to the Financial Crisis low.  At that point, one would not be surprised to see “Abandon all hope, ye who enter here” scrawled on their brokerage confirmations for any purchases of Emerging Markets equities.

But it’s always darkest before the dawn.

A mere two months later, EEM closed back above the October 2011 low.  This negated the downside breakout and triggered a Wash & Rinse buy signal.

Three months after that, the MSCI Emerging Markets Index closed above its 50-week moving average for the first time in over a year.  This signaled a bullish trend change.

Here we are nearly a year later and EEM is still going strong.  It’s stayed above its 50-week moving average this entire time and it’s now trading at the highest price in nearly two years.  Furthermore, the Emerging Markets Index is now trying to crack through trend line resistance (as drawn across the 2007 bull market high and the 2011 secondary top).

Add the current technical picture to the fact that the CAPE ratio has spent the last year and a quarter recovering off a double bottom at the 2008 and 2016 lows and you can see there’s plenty of fuel to keep the rocket going.  Buying the dips and riding the rips is currently the way to trade the Emerging Markets.

Leveraged Bet

Gundlach recommends doing this ETF pairs trade with leverage of 2-to-1.  If you’re a conservative investor, you might want to do this without the leverage.  But if you’re really confident in this trade, that’s fine.  Go ahead and use the leverage he recommended.

But if you’re really, really confident in this trade…

You could step on the accelerator and put on the same spread trade position with futures contracts.

Now, perhaps Gundlach doesn’t understand the insane amount of leverage that’s available to futures traders to execute this idea.  More likely, though, he knows.  He just doesn’t want to be held responsible for telling the rest of the world to go out and trade futures contracts.

The leverage offered on futures contracts can give the typical novice investor way too much fire power.  Think 20-to-1 leverage instead of 2-to-1 leverage.  It’s like the difference between driving a Prius and a Ferrari.  If you’re gonna go for a drive, you had better know in advance how much horsepower you can safely handle.

If you’re conformable with the futures market, you can easily trade the E-Mini S&P 500 Index futures contract against the Mini MSCI Emerging Markets Index futures contract.  Conveniently, they both have the same multiplier of $50 times the index.

Given the fact that the value of the E-Mini S&P 500 is worth more than double the value of the Mini MSCI Emerging Markets Index (the ratio is currently 2.35:1), a trader who wants to lower the volatility might consider using a more dollar neutral position of spreading two Mini MSCI Emerging Markets Index contracts against one E-Mini S&P 500 contract.

The Market Is Master

If you are looking to make a play on the SPY/EEM pairs trade, or any trade for that matter, is very important that you take your instructions from the market’s action.  Put your trust in the price, not in the prognosticator.

For example, what if you’d gone short the homebuilder ETF (XHB) when Jeff Gundlach picked it in May of 2014?  Initially, it dropped about 12% over a five month period from when he made the recommendation.

But then XHB rocketed to new multi-year highs just a couple of months later.

In May 2013, he absolutely hated Chipotle (CMG) stock –even though he said that he likes their burritos- and said it was a short sale.  He didn’t like the chart, the P/E ratio, the low barriers to entry for the competition, etc.

Guess how that one turned out?

From the close of May 2013 through the end of the year, the stock actually increased in price by about 48%!  That wasn’t the end of the run, either.  The stock more than doubled in price in the months and years that followed his presentation.

Would you have stayed short on that?!

Not if you had any leverage.  Even if you did, it took nearly three and a half years before CMG finally dropped back down to the price where it had closed in May 2013.

The point of this is that Gundlach should not be your Guru.  While you may get some good ideas from some of the big traders and investment managers from time to time, it’s important that you overlay all of it with your own research as well.

More importantly than getting in a trade, you have to determine where you will get out of a trade.  A thorough examination of the price behavior will be able to provide you with those exact parameters.  You can’t rely on the other guy to tell you when to bail out of their big trade idea if it goes south.

Also, you need to have your risk management plan totally dialed in.  You shouldn’t ever put on a position that’s so big that one bad trade can wipe you out.  If you’ve caught a tiger by the tail and you’ve picked a big winner, you should have ample opportunity to add to it as the trend unfolds.

But until a trade proves itself, you need to be concentrating on playing good defense.  Remember, Emerging Markets have spent plenty of time acting like submerging markets.  If that happens again, you don’t want to go down with the ship.


More Articles by Jason Pearce:

Profiting From Failure: The Wash & Rinse Trade, Part II

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

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by Brynne Kelly

[email protected]

May 18, 2017

 

Is there more to OPEC’s strategy than meets the eye?

When oil prices soared to $100 plus for a sustained period of time, the ‘capability to produce more’ was born.  The US and other producing nations rushed to unlock technologies that had previously been uneconomic and unnecessary.  Was OPEC watching as that last barrel came on-line and broke the camel’s back or did they severely underestimate the innovation that soaring prices would create?

Sustained higher prices fueled innovation in drilling and extraction and also fed the renewable enthusiasts.  The subsequent fall in prices then led to cost cutting and production efficiency.  At $100 a barrel for oil, it was easier for ‘green’ technologies to get their foot in the door using the economic argument.  We then saw stricter fuel efficiency mandates, government subsidies that encouraged ‘switching’ to renewable sources, and the idea of energy ‘choice’ became more mainstream as electric vehicles and solar panels gained momentum.  This left the world with a slump in organic demand for oil and oil products and consumers with the idea that they can ‘choose’ the type of energy they buy.

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When OPEC finally announced production caps at the end of 2016 the substance was interesting from two perspectives.  One is the bulk of them came from members exporting medium and heavy sour oils, another is the impact the light/heavy spreads are having on the economics for global oil movements.

It has now been telegraphed that OPEC may agree to extend the production caps at their upcoming meeting.  Is there something more to this strategy than meets the eye?  As they face growing competition from other producers like the US, OPEC’s motives may extend beyond just general price support.  Meaning, is their strategy intended to support their ‘brand’ of crude over lighter brands and will that lead to more disparity in light/heavy crude spreads.  How will that impact the growth of US exports?

Let’s look at the price impact of reducing the supply of heavier crude grades from the market so far this year:

ASCI Sour Crude, Canadian Heavy

The value of WTI relative to both USGC Sour and Canadian heavy crude fell.  We know that refineries are specifically configured to process the most economic grades of oil available to them.  This is how they work their strategic advantage.  For example, since the US has historically been a net importer of oil, and heavier grades were the cheaper option to import (from Canada, Mexico and the Middle East), many US refineries were configured accordingly over time. In addition, many of Asia’s new refineries are designed to run on medium and heavy crude that has a higher diesel yield.  With their proximity to the Middle East’s supply of heavier production, this made sense.

In the mean-time, new supplies of US shale production are now ready to hit the global market and it’s primarily light, sweet oil.  The US has invested heavily in and around the Gulf Coast to accommodate exporting their new-found supplies as slowing local demand has spurred a search for new markets.  They are now juggling the task of importing the slate of crude grades that meet local refiner specifications along with exporting excess production of those that don’t.

Of the 3 main benchmark oil futures contracts, WTI, Brent and Oman/Dubai, WTI is the ‘lightest’ and Oman/Dubai is the ‘heaviest’.  With OPEC cutting the supply of heavier grades from the market at the same time lighter supply is growing, spreads between benchmark oils continue to reflect that.

The loss of premium of WTI over the OPEC basket price can also be seen in the spot market.

 

The question is, how much of this can be attributed to the heavy US refining maintenance season this past spring and how much is attributed to tighter supply of heavier grades?

Even with the rally in outright prices this week, WTI was the weakest performer.

Brent crude lost value relative to the heavier Dubai grade, but gained slightly relative to the even lighter US grades.  This has been the general trend all year, but has gained some momentum as talks of continued output cuts emerged.

However, it’s interesting to note that while December 17 vs 18 spread in both WTI and Brent futures dipped into contango territory briefly when the market sold off early this month, Dubai(Oman) didn’t follow suit.

I take this as a sign that the market realized any tightness created by summer seasonality and production cuts will be short lived.  Said another way, inventory levels are still high and the market doesn’t want to create incentives to store more via contango.  At this point, any rally in outright prices needs to be led by the front of the market in order to disrupt the mind-set that historically high inventory levels equals low prices.

It’s worth noting that crack spreads moved higher this past week in tandem with the oil price rally.

Spot gasoline prices have been lackluster so far this month with the exception of the West Coast which is still experiencing refinery outages and are now well above levels seen this time last year.

Turning to EIA Inventories.  Was a small draw of (0.4) in gasoline inventories this week all it took to change sentiment?

With this week’s crude draw of (2.5), the total change in inventory over the past 6 weeks have been impressive relative to the same 6 weeks in prior years:

Gasoline inventories, however, remain a net injection over the 6 week period.  The picture is quite different from this period last year which points to the difference in the refinery maintenance season year over year.  Now that the Gulf Coast refiners are mostly back on-line (as seen in the refinery utilization rate for PADD 5 in the inventory table above), it remains to be seen if summer gasoline demand (plus exports) will outpace production and draw down inventory.

We have watched the increase of oil storage capacity over the past year as the market caught up to growing production and the desire to have export facilities.  Growth in both storage capacity and the inventory to fill it has weighed on the market heavily.  Take a look at a comparison of WTI prices to ending inventory levels over time:

Does adding more capacity to store automatically mean lower prices once it has been ‘filled up’?  The success of our ability to absorb this storage capacity as the ‘new norm’ seems to hinge on the viability of the export market.  As noted above, for now, OPEC cuts have been more helpful to heavier crude markets.  But, might it be reasonable to think that with this expanded capacity comes a higher base level of oil in storage to support an export system?  If so, prices have room to move higher.

For now, the US is brimming with light, sweet crude oil in a global market dealing with OPEC’s attempts to tighten heavy and sour oil supplies, but it’s a long way from where we were this time last year before any cuts and still just getting our feet wet with crude exports.

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Read More Brynne Kelly Research

Global Oil Spreads Are the Key to Balancing US Oil Inventories

Is a Rotation Out of Oil Into Equities Underway?

Putting Gasoline Inventory Build Into Perspective

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by Brynne Kelly

May 12, 2017

Just like the delicate balance between a strong versus weak currency, oil prices between OECD and non-OECD regions need to strike a balance.  US Exports to Non-OECD regions will be the key to balancing growing US production versus slowing US demand growth:

Since the last OPEC cuts were announced, WTI crude oil has gone from trading at a $2.50 premium to the OPEC basket price to discounts of up to $2.00 (see Figure 1).  With the export ban lifted, the US is now positioned to take advantage of a weak relative ‘currency’ (oil price) by moving US production to more expensive global markets.

 

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Figure 1.  Prices before vs after OPEC cuts

This is certainly the dilemma that OPEC faces going forward, starting with the upcoming May 25 meeting.  OPEC used to be the Gold Standard to which world oil prices were pegged.  As in 1971 when the world moved off the gold standard, so too is the world now slowly moving off the ‘OPEC-Standard’.  The shifting of the supply/demand picture between regions is forcing producing nations into ‘currency’ (oil price) wars.  At this point in the game, OPEC production cuts only strengthen their relative ‘currency’ (oil) in the short-term making ‘currencies’ (oil) from other countries more attractive to buyers.  The path to outright price inflation is becoming less clear.

The move in spread relationships among the various futures curves this past week (Figure 2 below) highlights the uncertainty in relative prices as the market awaits the upcoming OPEC meeting.   Will production in the US continue to find a home in growing global markets or will production from other countries be more price-competitive?  Notice that the back-end of the WTI and Brent curves gained relative strength to their Oman counterpart in the Middle-East and are actually up week over week.

Figure 2.  12 month futures price relationships

Is this an anomaly or a lack of confidence that US exports are viable at these levels?  For now, the price ‘wars’ will continue to search for a balance.

Inventories:

Weekly EIA Inventory figures posted a net Draw of 7.5 for the week ending May 5, 2017 (Figure 3).  The market finally got its much-anticipated draw in gasoline inventories of (0.40).

Figure 3.  Weekly EIA Inventory Statistics

EIA Inventory

To provide context, Figure 4 takes a look at inventory changes for this week over the past 3 years.

Figure 4.  Comparison of this week’s inventory change to prior years

With total inventory levels still at the top end of the historical range, it will take a lot more than this one week’s draw to change the overall picture.  If we simply take the average summer inventory draws over the past 3 year, September-end total inventory levels still look historically high:

Figure 4.  Comparison of this week’s inventory change to prior years

2017 end of summer crude oil inventory projection

Bottom-line, inventory statistics still aren’t providing a catalyst to break us out of the $45-$55 range.

What do Futures Curves tell us?

Crude oil futures prices for the balance of 2017 fell just under 1.0% this week and were essentially unchanged in the gasoline and distillates.  While gasoline cracks continued to hold their ground, Ultra Low Sulfur Diesel(ULSD)/Heating oil cracks also found a bit of a bottom.

In-line with things outside of the US gaining relative value, note that it was the non-US ULSD cracks that moved higher relative to their local crude oil market.  This makes sense given relative overall demand growth ‘US versus non-US’.  As WTI is the least expensive of the 3 benchmarks right now, US refiners are the winner in the product markets.

These relationships are helping move oil through the ‘system’.  The question is how much price incentive OPEC is willing to provide to non-OPEC producing nations.

With the next OPEC meeting 2 weeks away, markets appear relatively ‘status quo’ rather than ‘bracing for impact.’

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Read More Brynne Kelly Research

Is a Rotation Out of Oil Into Equities Underway?

Putting Gasoline Inventory Build Into Perspective

Crude Oil Market Not Willing to Pay for Storage

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by Brynne Kelly

[email protected]

May 5, 2017

Rotation from Oil to Equities??

As the upside picture for crude prices is called in to question in light of the deteriorating supply/demand picture, ‘capital’ may be moving to markets with greater upside potential. Could that be what we are seeing in the chart divergence above?

Equities aren’t the only market holding relative value this week.   Crude Oil is losing ground everywhere you look.

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WTI versus Natural Gas

While there is no real direct correlation between WTI and Henry Hub, they are both part of the ‘energy complex’ and you can see below that the ‘spread’ is now lower than it was at this time last year.

WTI versus NGL’s

In addition, the NGL components, that are often considered to follow the price of oil, fell a combined 2.33% for the June contract compared to WTI’s 8.26% decline for the same period.

WTI versus Gasoline

Even the front months of the gasoline crack held steady amidst the continued slide in petroleum prices during the May 4 trading session.

So the question is:  Will oil pull the above-mentioned markets lower, are they signaling a bottom or is oil on a path of its own?

This week’s EIA statistics

Weekly Oil Inventories showed a net DRAW of 2.7 for the week ending April 28, 2017; Crude draw overshadowed by a slight BUILD of .2 in Gasoline stocks (see detailed stats in Figure 1)

This week’s gasoline build of .2 brings the 4 week total to a build of 2.1.

How the 1 and 4 week-cumulative inventory changes stack up

Looking at the EIA report (below) of total gasoline supplied alone, nothing stands out.  However, the conclusion of the market is that due to the builds in gasoline the demand-side of the equation is where the problem lies.

Which is exactly what we see in the weekly US Gasoline demand stats (below)

This reminds me of natural gas inventories heading into the winter season. Everyone is full of anticipation waiting for the demand (weather) to show up to use all of the production that has been stored away.  If the weather doesn’t show up, the market moves on and focuses on the next demand season.

If we don’t see the gasoline demand materialize, a similar thing will happen in the oil complex.  The market will move on from “driving” season to the next demand season, which in this case is heating (heating oil) season.

Perhaps they already are.  You can see below that the heating oil cracks sold off more this past week than gasoline cracks did.

 

Crude Oil Prices and Spreads

There was a mixed bag when it came to the crude oil spreads (arbs) this week.  Both the Brent/WTI and Brent/LLS spreads fell slightly versus last week in the front of the curve, but actually increased over last week in the back of the curve.  That was not the case for the Brent/Dubai spreads in which the entire spread curve shifted lower.

 

Demand-willing, the spreads still favor US crude oil moving towards Europe and Asia.  The tighter Brent/Dubai spread also increases the competitiveness of North Sea crude against Middle Eastern grades, meaning we should see a widening of the Brent/WTI spread.   Any increase in shipping rates at this point would throw a wrench in all of these movements.

Crude oil prices (Figure 2 below) fell an average of 3.2% since last week’s report with gasoline prices down another 4.6% and distillates down 7.3% (Figure 3 below).  The Dec7/Dec8 spread held on to its slight backwardation in oil with the Jun7/Dec7 spread contango widening by $0.14, not a ringing endorsement for short-term oversupply. Rather, it points to a general expectation of current conditions to persist throughout the rest of the year.

 

 

 

 

 

 

 

 

 

 

 

 

 

Due to seasonality, the Jun7/Dec7 in gasoline is almost $7.00 backwardated while The same spread in heating oil is $1.20 in contango.

This, unfortunately, will incent refiners towards gasoline production in the short term since it carries the highest premium to crude oil prices in the market.

Comparing this week’s production and inventory levels to the same week in 2016, 2015 and 2014, the percentage change in US oil prices are certainly reacting negatively by varying magnitudes to the percentage that current inventories exceed those in prior years.  Keep an eye on these year over year percentages going forward.

 

What to look for in the coming week:

  • Entry point into any of the ‘one-off’ spreads (ES/WTI, NG/WTI, NGL/WTI) mentioned above if you believe they will revert to the mean.
  • RB and HO cracks.  Front month gas cracks are at 4 year lows  for this time of year, but if demand doesn’t materialize relative to supply, refining margins will have to get ‘punitive’.

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Putting Gasoline Inventory Build Into Perspective

Crude Oil Market Not Willing to Pay for Storage

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by Brynne Kelly

April 28, 2017

Weekly Oil Inventories showed a net BUILD of 1.7 for the week ending April 21, 2017; Crude draw overshadowed by a BUILD of 5.9 in Gasoline and Distillate stocks combined:

This week’s gasoline build of 3.3 flips the 3 week total to a net build of 1.9 as seen below making for a dismal comparison to the same 3 weeks in 2015 and 2016 (see detailed stats in Figure 1).

The Fundamentals:

While the 3 week changes are more reflective of the end of refining maintenance season when crude oil inventories begin to draw down and product inventories increase, the continued build of gasoline is the bottleneck and a point of contention for a balanced market.  Until there is evidence of increased demand drawing down this inventory, gasoline cracks will be under pressure.  The refining incentive to produce gasoline has been high and will continue to favor gasoline unless near-term spreads retreat.

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The term structure of RBOB gasoline crack futures week over week reflects the pressure on near-term margins:

RBOB, Curve Shift, RBOB Crack Spread, Refining Margin

The shape of the curve also represents the seasonality of gasoline demand and refinery outages.  If stocks continue to build at current rates, we should expect the front month cracks to shift lower until production responds.  Watch the June7/June8 RBOB crack spread which moved from $0.50 backwardation last week to almost $0.70 contango this week.

Compare the EIA chart below to the shape of RBOB futures curve. Historically, gasoline inventories tend to level off or decline at a slower pace during the summer until building again towards the end of the year.  To date, we are sitting at the top of historical 5 year ranges.

EIA historical gasoline inventories, EIA inventory projections, Distillate Inventory

Gasoline build, Distillate Build, Inventory glut

Prices across the Petroleum complex fell another 2.5% week/week in response to Inventory report:

What’s most notable this week is the relative shift in US prices (LLS and WTI) versus European and Mid-East prices (Brent and Oman (see Figure 3 for detailed price curves).

WTI, Brent, OMAN, USGC Sour, LLS, WTI Oman spread, LLS Brent Spread

Bottom-line, incremental demand for US crude will come from Asia and the Middle East.  Like all refiners, they are interested in the most competitively priced grade of crude oil.  There won’t be a massive outpouring of US crude oil from the Gulf Coast unless price spreads support it.  We have seen an expansion of pipeline and export infrastructure into and around the Houston/Corpus Christie area to enable export demand.  Since the majority of USGC refineries are still consumers of medium to heavy sour crude oil, finding a home for US light shale oil is key.  Any relative weakness of US prices can be viewed as a competitive advantage. 

Speaking of competitive advantages, the much-anticipated Dakota Access Pipeline is scheduled to begin operations in May.  This offers an alternative to oil transported by rail out of the Bakken area.  Rail transport costs to the Gulf Coast average between $7.50-$11.00.  Transport rates on the new pipeline are  in the $5.50-$7.50 range depending on service level.  This basically cuts the delivered price of Bakken oil into the USGC by an average of $2.00 and makes it more profitable to move barrels south versus by rail to the East Coast.  Now it’s just up to spreads like LLS/Brent to provide the export economics.

The OPEC cuts at the beginning of this year were focused on sour grades, which have since garnered a premium to lighter, sweeter grades.  This is forcing the hand of refiners around the world (including in the USGC) to enhance their ability to process the cheaper, lighter oil grades.  These type of changes take time, but speak volumes regarding economics.  If light, sweet shale is here to stay and OPEC cuts have made heavier crude grades more expensive, the long-term impact could be that refiners will shift their operational capability in favor of lighter oil.  We know that Japanese and other Asian refineries have been testing their capability to refine US shale oil in anticipation of a cheaper supply source.

With all the talk of growing US crude oil production, it’s easy to lose sight of OPEC cuts versus US growth.  As of the last production figures, OPEC production cuts have been greater than US production increases.

OPEC cuts, US production

This is why the May OPEC meeting is important.  Will they continue to limit production of the heavier crude grades that current refining capacity craves at the expense of impacting a long-term shift in refining preference for cheaper, light shale oil?

Crude oil futures, weekly price change, LLS WTI spread, USGC Sour Crude oil, Brent Dubai spread, Dubai futures

Refined product prices also took a hit this week.

The build in gasoline inventories led to a decline of 7.5% this week of gasoline cracks while the blended gasoline and heating oil 3:2:1 crack spread fell a bit less at 6.7% (See Figure 4).  Any relative increase in distillate demand could help support overall refining margins and take the pressure off of gasoline production.

Another component of the summer gasoline season is ethanol blending.  So far, the selloff in crude oil and gasoline prices haven’t translated to ethanol prices:

Ethanol futures, ethanol blending, rbob futures

With 2017 blending mandates already in place, the ratio of ethanol to gasoline prices is a dynamic to keep an eye on.  This past week, we saw the ratio move above 1.0 in parts of the term strip meaning ethanol prices are higher than gasoline prices.

ethanol vs rbob

 

Week Ahead – Expectations and Wild Cards:

As noted above, the key items to watch in the upcoming week are:

  • US term structure vs Europe and Asia and the LLS/Brent spread
  • Gasoline Demand and the crack spread term structure
  • Distillate margins
  • Discussions surrounding the May OPEC meeting.

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