Preparing for the Inevitable before the Inevitable Happens.....
Author: Brynne Kelly 4/10/2022
The International Energy Agency announced last week that member states have agreed to a coordinated release of 120 million barrels of crude oil over the next 6 months beginning in May. In total, combined with continued monthly production increases from OPEC+ countries we would see an additional 1 million bpd of oil per month of additional supply as seen on the table below (far right column).
One could say releasing inventory now is in anticipation of the inevitable problems Russia will face bringing it's oil to market amidst sanctions. It is believed that Russia could soon be forced to curtail crude oil production by 30% (or ~3 million bpd), subjecting the global economy to the biggest supply crisis in decades.
Yet, Russian oil is still making it's way to market due to severe price discounts being offered and the inability of European countries to halt purchases from Russia immediately as they have no viable alternative at the moment. Making the recent inventory releases look like a chess move to reduce oil prices. Pondering a silly question: What if Russian oil isn't fully banned from reaching the market until AFTER all of the recent SPR inventories have been released??? For now, the additional inventory is seen as nothing more than weakening the front of the market relative to the back when reserves will need to be replaced.
There are a few unknowns surrounding this latest inventory release however, such as (1) how much sweet crude oil and how much sour will be released, (2) where the pipelines connected to the four SPR sites could take that oil, (3) whether those pipelines have sufficient capacity to absorb the incremental flows out of SPR, and (4) what the ultimate market impacts of the SPR releases will be. What is different about this latest inventory release is that it is apparently all in the form of outright sales rather than an inventory loan to be paid back at a future date by the buyer. This latest round of SPR releases are in the form of outright sales. Meaning that it is up to local governments to repurchase barrels in the open market in the future to replace the most recent inventory draws rather than an obligation by the buyer to repay barrels.
As a reminder, below is the table we included in a previous report detailing the specifics of the US 32 million barrel SPR loan program announced at the end of last year. The detail worth noting from this is the repayment terms. The black arrows below indicate the latest month at which loan repayments can begin and still allow for enough time to pay the loan back in full.
You can see that the loan volumes from Big Hill (2nd column above) will need to begin repayment in September 22, at the latest. This is right when the most recent SPR inventory releases will end.
To make matters worse, US shale producers, once thought to be able to produce as much crude as needed, seem completely resilient to the latest price rally. After a decade of persistent losses in the pursuit of growth, the shale oil industry received clear warnings from banks, equity and bond markets. Thus for the past year, the US shale oil industry focused solely on profitability, which meant to stick to production guidance even as prices doubled. And they seem determined to not continue on this path in 2022. At $60/bbl expectations were that US shale companies grow production in 2022 by about 700-800kb/d. At $100/bbl, those expectations are still largely unchanged. It seems the days of >2mb/d production growth per year are gone forever.
Of course, the release of global inventory reserves is meant to combat the expectation that the IEA expects Russian oil production shut-ins to reach 3 million bpd if they are unable to find buyers amid the US embargo and as western energy majors have shunned Russian barrels in fears of reprisals, it said in its monthly report published two weeks ago.
Until such shut-in happens, oil markets need to grapple with the additional supply coming online and the eventual need to replenish said inventory.
Market Impact
Given the schedule presented above regarding the timing of supply additions, it makes sense that front spreads have been collapsing relative to back spreads in WTI futures. Butterfly spreads like the one shown below (June/Dec/June) made new highs as the war risk premium was moved to the front of the market. One could argue now that with the timing of SPR releases, the risk premium might need to move further out on the curve to reflect replacement risks. If we don't refill the reserves, we could be in trouble because there are other disruptions in the world. Houthis are attacking Saudi facilities; Libya is unstable. If we don't replenish that emergency reserve in the coming years, we will be even more vulnerable to price spikes when, new geopolitical disruptions occur.
Calendar Spreads
The impact (of SPR inventory being brought to market) continues to be felt in relative calendar spreads like butterflies. Pressure is building on the front of the market relative to the back as a result of SPR inventory releases.
In a look at continuous one month WTI calendar spread futures below, note the weakness in the front spread (gold line). While once the high flying leader, it is now the laggard of the bunch.
We also see a similar impact in butterfly spreads. Butterfly spreads reflect the relative value of a front calendar spread versus a further out calendar spread. A negative butterfly implies relative weakness in the front vs the back. We see examples of this in the two charts below: on the left we have the June/Dec/June WTI butterfly and on the right we have the Dec/June/Dec butterfly. In both cases, historically the spread has been weak into expiration. In fact the front spread has 'expired' weaker than back spreads in almost every case over the last 8 years!
Until such time that Russian oil truly faces an embargo from EU countries, the front of the market will be weighed down relative to the back as a result of additional supply from the SPR hitting the market and the current state of Omicron related lock-downs in China.
Inventory
Crude oil inventories in the US have continued to retreat against a backdrop of backwardation (red line vs black line below). Huge premiums in the front of the market provide zero incentive to store barrels. Hence, barrels continue to be drawn out of inventory.
The blind assumption that we can draw inventories down to uncomfortably low historical levels because conditions will improve in the future is not one that is overly rooted in fact. Unless perhaps it is a recession that saves us down the line in regards to 'demand'?? Just a thought.
Yet longer-dated prices have broken significantly out of their $50-65/bbl range they have been trading for the past seven years. While short term price fluctuations are usually simply a function of fluctuating inventories and supply disruptions, long term prices reflect the industry’s marginal cost of future supply. Meaning the market is betting that we face higher replacements costs in the future (due to regulatory risk - aka loading energy prices with increasing environmental costs).
Total inventory balances seem like they will have a tough time growing from here considering that there will be withdrawals out of the SPR for the next 6 months that would offset any builds in commercial inventory. We are pulling 'supply' forward without concrete evidence that it will be easier to replace in the future. Fingers crossed???
Crack Spreads
While oil has pulled back significantly from its highs over the last 2 weeks, the same can not be said for refined product cracks. Over the last 10 days, both gasoline and distillate crack spreads versus WTI continue to make new highs even as outright oil prices retreat. It's never bearish when end-use products (gasoline and distillate) outpace raw material inputs (crude oil).
While the oil complex has strengthened this year on the back of the Russia-Ukraine war, it is middle distillates that have stood out. Over the first quarter of the year, ICE gasoil has rallied by 59%, compared to ICE brent strengthening by almost 39%. ICE gasoil prices hit record highs of $1,665/t at one stage in early March.
Whether we look to Europe, the US, or Asia, middle distillates stocks are low. In the ARA (Amsterdam-Rotterdam-Antwerp) region, gasoil inventories have fallen to their lowest levels since 2008 for this time of the year. It is a similar story in Singapore, where middle distillate stocks are also near a 14-year low, while in the US, distillate fuel oil stocks are at their lowest levels since 2014 for this stage of the year. Tight inventories coupled with plenty of uncertainty over supply has meant that middle distillate cracks have seen significant strength, along with volatility. Clearly, this is unlikely to change until we see a de-escalation in the war.
There are several reasons for this tightness and strength in the middle distillate market:
Firstly, Russia is a key exporter of refined products. In fact, after the US, it is the second-largest net exporter of product.
Secondly, the export of gasoil from China has continued to decline this year, which has helped to tighten up regional Asian markets. The decline in exports is a result of reduced releases of export quotas to state refiners, and this is a trend that is likely to continue.
Finally, The natural gas market has also provided support to middle distillates in two forms. Higher natural gas prices in Europe have increased refining costs, particularly when it comes to desulphurization.
Futures Curve Shift and Structure
Taking a more macro look at futures curve shifts, we compare how they have moved since the beginning of 2021 (red lines below) in outright WTI futures, RB gasoline futures and HO distillate futures below.
Most notable is the shift in heating oil cracks (left chart below) which continue to post new highs regardless of what outright oil prices are doing. Gasoline cracks aren't too far behind (right chart below). When product cracks remain high regardless of what oil prices do, it's a clear sign that demand, rather than supply is the foundation of current market strength. Said another way, while adding more oil to the market via SPR inventory releases might put a lid on outright oil prices, it does little to alleviate end-use product demand. Therefore, refining margins continue to increase. This is not indicative of a bearish oil market, rather it is indicative of inadequate refining capacity.
Meaning, while it seems that Western governments have the ability to boost supply by adding more raw materials (aka, crude oil) into a refining system with fixed processing capacity. Cheaper raw materials don't always lead to cheaper refined products. Especially if refining systems are already running at max capacity. In the latest EIA inventory report through April 1, the refinery utilization rate stood at 92.50%. This is 8.5% higher than this time last year and 16.90% higher than 2 years ago. In other words, crude oil IS being processed. Clearly not at a fast enough rate to meet growing end-use demand, especially when you factor in the military need for gasoline and diesel.
Bottom Line
The initial shock of Russia's attack on Ukraine has passed. Western nations have responded not only with economic sanctions but also with additional oil supply from their strategic coffers. Barring something new, we now have to contend with elevated risk premiums that coexist alongside tapping emergency oil reserves. The effect of this is to roll positions further out on the curve to a time period when oil reserves will need to be replaced and the flow of oil will once again move INTO inventory (SPR to be specific) instead of OUT of inventory.
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EIA Inventory Recap - Week Ending 4/01/2022
Weekly Changes
The EIA reported a total petroleum inventory DRAW of 2.50 for the week ending April 1, 2022.
YTD Changes
YTD total petroleum EIA inventory changes show a DRAW of 43.00 through the week ending April 1, 2022.
Inventory Levels
Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years are have gone from way above historical levels to surprisingly below historical levels and should continue to draw as long as backwardation in the market persists.
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