by Brynne Kelly

July 24, 2017

What Does An ‘OIL GLUT’ really mean?

The terms “glut” and “oil” have become almost inseparable the past 18 months.  Fueled by an obsessive focus on inventory and production levels, it has become an easy narrative.

The Cambridge English Dictionary defines a ‘glut’ as:

A supply of something that is much greater than can be sold or is needed or wanted.

A glut is often associated with low prices, or an expectation of low prices.  An extreme example of a supply ‘glut’ can be seen in the electricity markets through real-time electricity prices.  Whereas most commodity markets exist with a storage system under-pinning them,  this is not the case for electricity markets (but for limited battery and hydro storage).  As a result, when power has been generated in excess of demand, market prices have to move low enough to clear this excess supply.  As a matter of fact, this market clearing price can even be less than zero (negative), meaning the producer has to PAY the consumer to take the product off their hands.  The negative price reflects the ‘cost’ the consumer incurred to accommodate that supply into their system.  Without a storage system in place, market regulations require utilities to hold enough generating capacity to cover the highest projected demand for the year plus a reserve margin.

A robust storage system helps to smooth day-to-day and seasonal differences in supply and demand and reduces traditional production capacity requirements.  In this way, storage acts as an alternative form of supply and demand by allowing product injections during times of over-production for use in times of under-production.  The natural gas market in the US is a good example of this.  Total natural gas production capacity exceeds total demand in the summer, but isn’t enough to meet total demand in the winter.  Using storage however, production can continue at a relatively stable level throughout the year, with excess being injected into storage in the summer for use in the winter.

Storage levels then become the ‘glut’ indicator, unlike the electricity market which doesn’t have a buffer between differences in supply and demand.  At the extremes, conventional storage systems either become too full to accommodate additional supply, or too low to accommodate projected future seasonal demand.  In either case, price signals emerge in an attempt to rectify the situation.

Perceived versus Real “Glut”

An inventory shortage or excess can be either perceived or real.  Real inventory issues show up in the spot market.  Perceived inventory issues are based on assumptions.  These assumptions are anticipated as threats to the spot market at some point in the future and are expressed via the futures market.  If these assumptions don’t manifest into the spot market over time, assumptions regarding the ‘future’ will ultimately be revised.  Think of flowers delivered on Valentine’s Day.  A month in advance, the market establishes a clearing price for flowers delivered exactly on February 14^th.  There are even discounts offered for flowers delivered the day before or the day after February 14.  These are based on perceived value.  Come Valentine’s day, those who forgot to place their order and need flowers are now forced into the ‘spot’ market and may be willing to pay multiples of the original price for delivered flowers, or they may luck out and find an overzealous store stuck with too much delivery capacity.

With that in mind, let’s circle back to the aforementioned ‘glut’ in the oil markets.  The prevailing narrative is that there is too much supply for the current level of demand.  The evidence being used to support this narrative is inventory levels.  High inventory levels are perceived as a threat to the spot market.  As long as there is still room to fill conventional storage, producers have the option of storing their barrels or selling them.  In this way, spot prices are linked to futures prices.  In a perfect world, the difference (spread) between the spot price and the next futures price should reflect the cost of storage capacity.  Of course, the cheapest storage options will be used first.  As these fill up, spreads may widen to value the next most economic form of storage and so on.  This is why it has been traditionally assumed that a widening spread, or contango, may be signaling a market oversupply.  On the other hand, if spot prices are higher than futures prices, those with barrels in storage will withdraw stored barrels to capture a higher spot price and eliminate storage costs.

Take a look at the 1-month price spreads in WTI futures since the beginning of 2017:

At the beginning of the year, the front of the futures market was trading at a slight contango from one month to the next (the black line above).  However, starting with the Dec-17 contract, the market had moved into ‘backwardation’.  This market structure makes the decision to store barrels uneconomic and should have induced producers to sell their barrels into the spot market.  You can see that by June, the backwardation in the futures curve had been pushed back 3 months (the grey line) and by last week that backwardation was gone.

The effect of the shape of the term structure seems to have had the desired effect on inventories, as storage has been drawn down significantly since April:

Total Petroleum inventories have been reduced by over 50 million barrels since the beginning of April, 2017.  This is significantly higher than inventory withdrawals in the prior 3 years.  As a result, total inventory levels are now slightly below where they were at this time last year but still above levels of the prior 3 years:

Once the incentive to store barrels was reduced, they were instead pulled out of storage and moved to market.  Pulling over 50+ million barrels out and selling them into the market put pressure on the front of the futures curve relative to the back (seen in the chart below):

As a result, the December 2018 contract is now close to $2.00 over the December 2017 contract.  While that may sound like a lot, it’s just a little over $0.15 a month compensation to defer payment on your production.  Since the seller of oil doesn’t receive payment until after the oil is delivered, holding it in inventory doesn’t generate cash.  As a matter of fact, holding oil in inventory costs money (via the tank storage cost).  With all the news coverage this past year regarding the need for cash, it’s no surprise producers would rather sell now versus hold inventory.

Days of Supply

Oil inventories are often expressed as “Days of Supply”.  This is essentially total inventories divided by daily demand.  Over the past 10 years, we have gone from just under 25 days of supply to a little over 30 days as production has increased and demand has flattened (as seen below).

This assumes oil inventories can transported to refineries to be processed as they are withdrawn.  I use ‘days of supply’ to put the phrase ‘inventory glut’ into perspective.  Is just over a month’s worth of crude oil held in inventory to meet our current demand needs something you would consider excessive?  Since we still rely on imports for over half of our crude oil needs in the US, this doesn’t scream ‘excess’ to me.  But, as in any business, holding inventory is expensive and it’s a delicate balance to determine the optimal balance between margin and cost.  Assuming there are decent margins to be made, it would be logical to assume more inventory would be held at low prices versus high prices.

What is The Signal?

As Nate Silver discussed in his book “The Signal and the Noise” (2012), we seek to extract signals and eliminate noise when building models with historical data to
predict the future.  However,  while the final outcome of an event is subject to influences that will repeat themselves in a foreseeable way in the future, it is also subject to a great deal of noise that will not repeat itself in the future in a predictable manner.

I believe the ‘signals’ we have been receiving from the oil market have moved from ‘price’ signals to ‘volatility’ signals.

Increased production and storage capacity in the US have reset oil prices from $90 to $45 in the past 2 years. As a result, production costs have been targeted and optimized.  What remains is a larger, more efficient system with a lower convenience yield that may be less prone to significant price moves in either direction.

However, low volatility also makes it more difficult to justify new assets as it reduces projected returns (all other things being equal).  With long lead-times to build new assets like pipelines and export infrastructure, a sustained period of low volatility will have impacts not realized for many years in the future.

by Brynne Kelly

brynneKkelly@tfabk.com

June 2, 2017

Is there a case to be made for relative value?

Selling energy at the beginning of April was a great trade.  However, where do we go from here?  Since prices don’t exist in a vacuum, I thought this would be a good time to take a look at how energy inputs have performed relative to energy outputs.

Think of Crude Oil, Natural Gas and Coal as the three major inputs used to produce energy in a consumable form. Their prices are heavily dependent on the demand and price of the products they can be converted into.  The spread (or margin) between the cost of inputs and the sales price of the outputs not only drives investment in these conversion capabilities, but also indicate supply versus demand.

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With all of the focus this past week on OPEC cuts, inventories and demand worries, let’s take a look at the price movements of the three major inputs.

Inputs

The entire WTI crude oil curve has fallen more than 6.5%  since the beginning of April, 2017.

The front of the natural gas curve has fallen more than 8% since April.

Meanwhile, CSX coal futures have increased over 6% since the beginning of May, 2017.

Outputs

To get a feel for the relative value of energy inputs, it makes sense to see how consumable energy products have performed.

First off, we have electricity.  Coal and Natural gas are two of the primary inputs used to produce electricity in the US.  While natural gas prices have fallen significantly in the past two months, the “heat rate” has moved higher.  This means that electricity futures prices are not falling as much as natural gas prices.

Another relative value product to look at is ethane.  While it is not normally thought of as an ‘output’ of natural gas liquids, it does take further processing to get it to market which differentiates it from raw production value.

For the past several years, ethane has routinely been ‘rejected’ into the natural gas stream since the outright price of ethane hasn’t been enough to cover processing costs.  From the chart below, you can see that ethane futures have not experienced nearly the drop that natural gas has this year (at least in the front of the curve).

Another obvious consumable output is gasoline.  Gasoline futures have also fallen less than their underlying ‘input’ falling less than 6% compared to oil’s greater than 6.5% decline.

This relative value play can be seen in the rebound of the gasoline crack from its lows in May.  Meaning that while crude oil prices continued to decline, relative gasoline prices increased.

The same is true for ultra-low sulfur diesel (HO).  As oil prices continued to sell-off, distillate cracks actually started to rebound off their May 1 lows.

What does this mean?  Is this a signal?

Oil Spreads

Another place to spot relative value is in oil spreads.

Relative value of oil in one geographic area to another is similar to input/output economics in that differences in prices can impact the movement of production from one market to another.

Key relationships impacting these movements are US prices versus Europe and Asia.  In the past month, US prices (LLS oil in the gulf coast) through the end of the year have gained value with respect to prices in Europe (Brent), yet European prices have lost value relative to Asia (Dubai).  This is not good for US exports.

However, the spread between US and Asian prices has continued to widen.  Meaning that while the economic incentive to move US oil to Europe hasn’t increased, the incentive to move oil to Asia has increased (as seen in the WTI/Oman spread below).

This points to where the market pins their demand hopes.  As long as global oil demand increases, production to meet that demand can come from anywhere as long as the economics support moving oil from one market to another.

Weekly Inventory

This brings us to the weekly inventory changes.

For the week ending May 26, 2017 total stocks declined by (9.9) per the EIA figures below:

The most important part of this week’s inventory draw is seen in the cumulative change in this “summer” totals versus prior years:

The rate of crude oil stock draw-downs this year relative to the last 3 years is certainly impressive, especially considering that oil inventories posted a net build during this same period in 2016 and 2014.

One contributing factor to this draw-down is the growth in US oil exports:

The chart above definitely highlights what could be considered a ‘trend’ of increasing exports and decreasing net imports.  But, it also highlights the fleeting nature of this dynamic from week-to-week.  However, it’s a positive sign to see these export volumes continue to make new highs.

Speaking of inventory levels, we are approaching that time of year when heating oil (distillate) inventories should start to build in preparation for winter heating season (just as natural gas inventory summer builds in preparation for winter).

With all the focus on gasoline inventory and prices, might it be time to take a look at heating oil prices? Spot prices are half what they were at these same inventory levels 5 years ago.

From a relative-value perspective, there is a lot to think about.

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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

It’s easy to get caught up in the daily grind of price action and market sentiment.  Sometimes it’s good to take a step back and look at the week in review to bolster your conviction for the week ahead.

Inventory Overview and Discussion:

The net change in overall inventories for the week ending April 7, 2017 was a Draw of 8.0 (as seen in Figure 1 below).  For comparison, the net change for this week last year was a Build of 2.9 and 2 years ago was a Build of 1.3.

Ok, so let’s take a look at where we are.

From the Utilization Rate, you can see that we are slowly exiting refinery maintenance season.  The decrease in Gulf Coast utilization rate can be attributed to a higher increase in Operable Capacity numbers relative to gross inputs, which obviously decreased the utilization rate (see Figure 2 below).

The Operable Capacity is based on the ‘latest reported monthly operable capacity’ to the EIA.  Since the prior EIA report week ended on March 31, it would reflect reported capacity levels for March, whereas this weeks’ report would be updated with April  levels.  The reported Operable Capacity for April most likely includes updated capacity expectations that may not have fully taken place yet, which is why it ‘appears’ that the Utilization Rate went down in this latest report.   This could also account for the slight build to Cushing inventories.  I would look to see this ‘catch up’ in the next two week, meaning more inputs of oil into the system.  Continue to keep an eye on this.

Price Overview and Discussion:

This week we saw roughly a 3.60% average rally across the board in crude oil prices,building on last weeks’ 3.25% increase (see Figure 3 below). In addition, there was a slight narrowing of the Brent/Dubai spread for the balance of 2017.

As noted last week, the Brent/Dubai spread is an indicator of crude oil movements.  For example, Middle Eastern and Russian Crudes tend to be priced relative to Dubai, and West African crudes tend to be priced relative to Brent.  Since Middle Eastern crudes (Dubai and Oman) are viewed as lower quality (less ‘sweet’) than Brent and WTI, the narrower the Brent/Dubai spread, the more likely Brent, WTI or even West African crudes will be chosen as an option by Asian and other refiners.  These market-driven global flows of oil ultimately impact the ‘supply’ available to any individual region.  Of course, freight rates are a key factor as those with access and ability to these logistics will ultimately ‘arb’ out any market disparities.                                                                                                                         

This is worth noting due to the upcoming OPEC meeting in May.  As you know, the cuts that OPEC put in place at the beginning of this year translated to tighter sour crude supply in the Middle East.  This is because the bulk of the cuts have come from members that produce and export medium and heavy sour oils.  This resulted in a collapse of the “Light/Heavy” oil spreads.  Futures spreads between Brent and Dubai/Oman were $6.00+ last year and are now well under $2.00.  Watch this spread as we near the May meeting for any big moves indicating market sentiment/positioning.

Many refineries blend light and heavy crude oil to achieve the optimal blend for their refinery.  In the US this has been achieved by blending heavier Canadian crude with lighter Bakken oils in an aim to create a cheaper barrel than the price of sour crude in the Gulf Coast.  This might be a good time to remind everyone that back in 2009/10 the Saudi’s and other Middle Eastern countries dropped WTI as a benchmark and replaced it with US Gulf Coast Sour (“ASCI”).  Couple that with the recent OPEC cuts focused more on heavier crude, and it’s a good time to ponder the REAL strategy and how that might play out in light/heavy spreads if the cuts continue.

Spreads to watch:

1. Brent/Dubai spread.
2. WTI/LLS spread (as an ultimate destination for WTI Cushing barrels is the Gulf Coast)
3. Light/Heavy spreads

Moving on to refined product and related markets (Figure 4 below).

The past week, we saw benchmark Distillate prices for the balance of 2017 increase an average of 3.30% while Gasoline (the leader as of late) increased roughly 2.50% for the same time period.  Gasoline prices have been enjoying a combination of seasonal strength coupled with refinery outages.  Those refining outages are beginning to wind down, so it’s now up to global demand to do the heavy lifting.

There are so many grades of global refined products that the amount of logistical movements of products to/from the best priced markets are too many to cover in one report.  Needless to say, there is a lot going on.  There are more than 50 unique spreads related to Gasoil alone listed on exchanges.

One item I will point out this week is the Heating Oil/Gasoil (HOGO) spread.  Gasoil futures dropped briefly from around $500/MT at the beginning of March to around $450/MT towards the end of the month.  However, since then prices have regained the $500/MT level.  Strong demand from Latin America and other counties is diverting US distillate away from Europe.  Demand was forecasted to recede the first quarter of 2017, however, in the last EIA report that includes US exports through Jan, 2017, there was no sign of that as of yet.  Watch for a widening of the HOGO spread to indicate the potential for steady to increased distillate exports.  Things could also get interesting if we start to see an increase in Freight rates.

Week Ahead – Expectations and Wild Cards:

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

1. Refinery Utilization rates, gasoline demand and Oil inventories
2. Crude spreads (WTI/LLS, Brent/Dubai, Light/Heavy)
3. Distillate spreads (HOGO)

We should expect to see support for WTI above $50 unless there is a material shift in one of the above items.

Implied volatility is LOW across the complex.  As noted last week, the Open Interest in WTI options is almost twice that of the underlying futures.  Add to all of this the amount of OTC structured ‘costless collar’ type of hedges that have been written out there that never hit the exchange numbers.  With prices remaining in a narrow range, low volatility and option strikes being written closer and closer to the money, one has to keep looking for the catalyst that will veer us off this long, narrow road.