Uri Is Behind Us, The OPEC Meeting Is In Front Of Us

Author: Brynne Kelly 2/28/2021

The impact of last week's storms on the production and refining of crude oil was significant. The scarcity of electricity in Texas and the surrounding area left refiners and producers without power or needing to conserve power. What resulted was a drop in refinery utilization rates that rivals that seen at the onset of the pandemic when lock-down orders were initiated. Prior to that, refinery utilization rates followed seasonal patterns ranging between 85-95%, with the exception of the disruption caused by hurricane Harvey in 2017.

The same pattern can be seen in the US supply of crude oil (defined as production plus net imports). The key difference between this year and last year's drop in utilization rates is that last week the refinery outages and production losses were simultaneous. The result was lower crude oil production and therefore, lower inventory builds.

Based on EIA inventory data, the complimentary nature of production and refining losses have, at least initially, had little impact on US crude oil inventory levels. Both Cushing and USGC PADD 3 inventory levels have not yet seen the builds to inventory reminiscent of Hurricane Harvey or pandemic lockdowns. Basically, we have returned to normal operating levels in US oil inventories.

But, it's not just oil inventories that matter. If refined products aren't being cleared out of inventory, a backlog is sure to ensue. Moving the excess from the oil side of the ledger to the refined product side of the ledger isn't a big win. Hence, we go one step further and look at combined inventory levels (crude oil, gasoline and distillate). On balance, we are not in warning territory here either. Per the last EIA inventory report, the combined inventory comes in at just slightly above its 5-year average (black line vs gold line).

In any event, we acknowledge there is nothing necessarily alarming about current inventory levels. Still, there is much uncertainty out there, ranging from the duration and extent of last week's storm damage to predictions about production increases out of OPEC+ at their upcoming meeting on March 4. Thus, oil markets are on edge and not only have outright prices rallied (left chart below), but calendar spreads (right chart below) have also continued to widen.

Over the last several days, we have seen 2021 futures prices soar to an almost $5.00 premium over calendar 2022 prices (green line vs navy line, right chart above). Nevertheless, this recent surge in backwardation took a bit of a breather last week as the WTI cash 'roll' into month-1 futures failed to get above flat. Consequently, length in the front of the market sought shelter further out on the curve, keeping a lid on backwardation.

The real concern here is whether or not the petroleum complex is in good enough shape, going forward, with gradual supply increases out of OPEC+ and elsewhere - without a significant spike up or down in prices. The damage beset upon the oil complex over the last year was broad and far-reaching. The expectation of over-supply has become the norm these days, against a backdrop of outright prices moving higher since last year.

This leads us to question whether the assets that underpin the market are loaded with scar tissue by virtue of the pandemic. What happened in Texas last week was no doubt an eye-opener. Together with the focus last year on capital preservation and ESG, have we taken our eye off the ball when it comes to maintaining key assets? Has the complex become less resilient to a sudden 'blow' as a result?

The structure of calendar spread futures certainly seems to suggest this. On a rolling 1-month spread basis, both WTI and Brent continue to reward owning barrels today vs barrels in the future despite the fact that, by many accounts, the future production story looks anything but robust. Contrarily, the narrowing of 1-month calendar spreads (beyond July in WTI, left; and June in Brent, right) is a nod to the expected cumulative reduction in OPEC+ supply cuts over time. This suggests that the market is tight, but unwilling to commit.

We know that next week will be full of headlines leading up to the OPEC+ meeting. At the moment, it's reasonable to assume that they will stick to their original game plan of incremental monthly supply increases not to exceed 500k bpd a month. It's also reasonable to assume that Saudi Arabia will let their stop-gap 1 million bpd production cuts expire at the end of March. It is worth considering, though, what a deviation from that expectation might signal, in the same manner that equity markets often react in the opposite direction expected after a change in interest rates (before monetary policy became so loose, that is).

Would 'higher than expected' production increases be a sign that those 'in the know' fear the market is tighter than anyone expected and therefore, crude oil rallies? Conversely, would a 'lower than expected' production increase suggest that those same "in the know" people believe the market is still to fragile to absorb more production and, as a result, crude oil sells off? Another possibility is that the market has the events of last year in the rear-view mirror and will continue it's bullish run (underpinned by low interest rates and the USD), regardless of what OPEC+ decides.

All of this aside, we give you a few other distractions to focus on until the dust settles after the OPEC meeting. Are there still some over- or under-valued pockets in the market that deserve a second look?

Ethanol vs Gasoline (aka, the CURL)

Iowa Gov. Kim Reynolds on Feb. 8 introduced a bill that aims to speed the statewide adoption of higher biofuel blends, including E15 and B20. Representatives of the ethanol and biodiesel industries are speaking out in support of the bill. For ethanol, the bill would make E15 the standard fuel option by 2025. It would also update the E15 promotion tax credit to 3 cents per gallon year-round. Growth Energy estimates that over the first five years, the legislation would increase ethanol demand by more than 117 million gallons.

The rally in US gasoline futures this month has finally pushed the CURL spread into negative territory (black and purple lines below).

However, the bull market gripping hold of agricultural commodities right now is one driven by not just tight supplies, but monster demand. Add blending regulations like the one noted above and an uptick in gasoline demand and both markets could become very tight this summer. According to Pay with GasBuddy data, US gasoline demand last Friday was the highest of any day since Oct. 30 and the third highest single day since the pandemic started.

"Summer" Crack spreads (April-October)

Building on the ethanol to gasoline relationship, and the potential underlying support stronger ethanol prices could have on gasoline prices we turn to the more significant relationship of gasoline to WTI.

The spread between Summer 2021 and summer 2022 gasoline cracks (to WTI) has finally moved into slight backwardation in an attempt to follow-suit with the curve structure in oil markets. On an outright basis, the summer gasoline crack strips finally regained pre-pandemic levels last week. Given the impaired level of refinery utilization noted earlier and the upcoming seasonal expected draws in gasoline inventory, these spreads could be poised for another run to the upside.

Yet, while summer gasoline cracks moved into slight backwardation, the same cannot be seen in US ULSD markets. The summer 2021 spread to WTI is currently trading at an almost $4.00 discount to summer 2022 ULSD cracks.

One narrative that could be keeping ULSD cracks in contango is the fear that a quick ramp in refinery gasoline output ahead of the summer driving season could overwhelm ULSD inventory. This is a valid concern, however, on a seasonal basis, distillate inventories continue to draw for another month. Add to this an increase in air travel into the summer and the impact of increased production could be offset by an increase in jet fuel demand.

WTI/Brent Spread

The spread between WTI and Brent futures has some interesting dynamics of it's own. We heard from Platt's last week that they will be adding US WTI Midland crude to its Dated Brent benchmark beginning in July, 2022. This added a bit of lift to the spread in the back of the curve by the end of the week. Beyond that, when considering the tepid production forecasts out of the US, the spread could continue to tighten if the US becomes more dependent on import barrels to round out their demand needs.

Next week should be interesting. However, the outcome of the OPEC+ meeting isn't the only game in town.

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EIA Inventory Statistics Recap

Weekly Changes

The EIA reported a total petroleum inventory DRAW of 3.70 million barrels for the week ending February 19, 2021 (vs a draw of 10.10 million barrels last week).

YTD Changes

Year-to-date total inventories in 2021 are DOWN by 12.40 million barrels, with crude oil inventory now down 22.40 million barrels for the year (vs 23.70 last week).

Inventory Levels

Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years continue to show signs of recovery.

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