Analys
Trade war today and oil market balance tomorrow
Brent crude lost 7.2% and closed at $60.5/bl with also the three year contract loosing 4% with a close of $56.02/bl. Neither equities nor oil were satisfied with ”mid-cycle rate adjustment” cut by the Fed earlier in the week and were already on a weak footing. Yesterday’s announcement/tweet by Donald Trump that an additional $300 bn worth of trade with China would get a 10% import levy totally pulled the plug on oil.
The thing is that the global oil market balance is not too bad right now and so far this year. IEA announced in its July Oil Market Report that OECD oil inventories had been rising during the first part of the year. It is true that the OECD inventories are up 34 m bl in May versus December last year but normally (2010 to 2014 average) they increase 45 m bl during this period. So if inventories are the proof of the pudding then the global oil market was pretty much in balance from Jan to May this year. Since then the US crude oil inventories have fallen sharply and the Brent crude oil forward curve is still in backwardation signalling a market which is on the tight side of the scale.
The sell-off yesterday is thus about concerns for the oil market balance for tomorrow, for next year and not so much for the current balance and the balance in 2H-19.
The forward Brent crude oil curve is still in backwardation, US crude inventories have been falling sharply since early June and continue to do so, US shale oil production growth is slowing quite sharply, European overall spot refining margin is close to the highest level over the past 2-3 years, OPEC+ is cutting and supply from Iran and Venezuela is just plunging.
Thus the bearish take on oil is not so much coming from the front end (spot) of the oil market. It is all about slowing global growth, slowing oil demand growth, US-China trade war, too little proactive stimulus from the US Fed and deep concerns for the oil market balance of tomorrow.
If we remember correctly Saudi Arabia commented earlier this summer that it might be difficult to cut yet deeper in 2020 than what they are doing now. So if the oil market is running a surplus in 2020 then the oil price and not OPEC+ will have to do the job of balancing the market.
If we look at where oil prices are trading on the forward curve it is very clear that the main job of the oil prices at the moment is about holding US shale oil production growth in check. The three year WTI price yesterday closed at $50.12/bl while the three year Brent crude oil contract closed at $56/bl. Thus the oil price right now is all about controlling US shale oil production growth.
Four new pipelines channelling oil out of the Permian will come on-line in 2H-19 and early 2020 with a total capacity of 2.3 m bl/d. What this mean is that local Permian oil prices will move much closer to US Gulf seaborne oil prices and Brent crude oil prices. Oil will be drained out of the Permian and allow Permian oil producers to ramp up production without crashing the local Permian oil price. The flow of oil from Permian to Cushing Oklahoma on the Sunrise pipeline will slow to a halt. US Cushing stocks will decline much more easily and the WTI Cushing price will also move closer to Brent crude.
So, again, will WTI move up to Brent or will Brent move down to WTI when the pipelines open up? The 670 Cactus II from Permian to Corpus Christi at the US Gulf opened for service on 1 August. Since one year ago the Brent June 2020 contract has declined by $10.2/bl while the comparable WTI contract has declined by only $7.5/bl and the spread between the two has declined from $8.5 to now $5.8/bl. So over the past year at least we see that it is the Brent contract which has moved down to the WTI price and not the WTI price which has moved up to the Brent price. The interim transportation cost on the Epic II pipeline has been lowered from $5/bl to only $2.5/bl and pipelines from Cushing to US Gulf are lowering tariffs in competition. In a slowing shale oil production growth situation coupled with a large increase in pipeline capacity we should expect to see a further strong convergence between the Brent crude oil price curve and the WTI price curve. In general the Brent prices should move down to the WTI prices but the initial reaction will be declining US crude oil inventories both in general and in Cushing Oklahoma. This will drive WTI prices higher initially and drive the WTI crude curve into full backwardation.
The only reconciliation we can envisage for an oil market where the current situation is tight, refinery margins are strong and IMO 2020 is coming on top coupled with deep rooted market concerns for the oil market balance for 2020 is very weak 2020 forward prices together with spiky and backwardated front end prices. So expect WTI curve into full backwardation (strong spot prices), weak 2020 prices and tighter Brent to WTI spreads with forward Brent prices moving down towards the WTI prices.
Ch1: Rising OECD inventories by IEA. But those rises are very close to normal seasonal trends. From Jan to March inventories usually drop by 32 m bl (2010 to 2014 average seasonal trend). This year they only dropped by 16 m bl. From March to May however they normally increase by 46 m bl while this year they only increased by 39 m bl. In total from Jan to May they normally increase by 14 m bl while this year they increased by 23 m bl. So yes OECD inventories increased by 9 m bl more than the seasonal trend from Jan to May. That is pretty close to noise as it gets. So if OECD inventories are anything to go by we’d say that the OECD-inventory implied supply/demand balance was pretty much in balance from Jan to May
Ch2: US crude stocks have fallen sharply since early June. Here seen in days of consumption where it has fallen from 28.9 days to only 25.4 days in the latest data. We expect US crude inventories to fall further
Ch3: US crude oil stocks in barrels have fallen sharply since early June and now only stands some 9 m bl above the 5 year average. Also if we look at total US crude, middle distillates and gasoline we see that these US inventories in total are only 9 m bl above normal (2014 – 2018).
Ch4: What worries the market is this: Global economic growth and thus oil demand growth. Here depicted through the lense of Bloomberg’s calculated now-cast indices. What stands out here is that it is worse in the rest of the world than in the US but maybe more importantly that the US economy now is cooling faster than the rest of the world. Though this is a very qualitatively assesment from the graph. This week’s quarter percent US Fed rate cut is probably far too little to counter this cooling trend.
Ch5: Agregating Bloomberg’s individual country now-cast indices to one “global now-cast” index shows that the global economy is cooling and cooling and will soon be down to the trough in 2015/16. Graphing this global index versus the Brent crude 6m/6m change in prices we see that from a demand/macro view point Brent has moved counter to the cooling macro trend and a deteriorating global demand back-drop. It has risen on the back of OPEC+ supply cuts and Iran issues.
Ch6: Huge loss in supply from key producers since primo 2017 not enough to lift prices
Ch7: Aggressive cuts by Saudi Arabia neither enough to lift prices. It is very hard to lift prices through production cuts amid a deteriorating global growth
Ch8: European spot refining margins are very strong and close to the highest level over the last 2-3 years
Ch9: Speculators are not feeling very bullish in the face of the deteriorating global macro picture
Ch10: Forward crude oil curves. Ydy close vs end of June. Brent down more than WTI. Brent is moving lower and closer to WTI.
Ch11: Spreads between the forward crude oil curves have moved lower since late June
Ch12: US shale oil production growth has slowed to a growth rate of only 0.6 m bl/d on a marginal, annualized rate. Sharply down from around 1.5 – 2.0 m bl/d in 2017/18 period. Shale oil players are signalling further slowdown during the autumn. The shale oil well completion rate only needs to be lowered by some 100 to 200 wells per month in order to drive US shale oil production growth to close to zero
Market is starting to take US/Iran headlines with a pinch of salt. Brent crude rose $2.8/b yesterday to an official close of $112.1/b. But after that it traded as low as $108.05/b before ending late night at around $109.7/b. Through the day it traded in a range of $106.87 – 112.72/b amid a flurry of news or rumors from Iran and the US. ”US temporary sanctions during negotiations” (falls alarm). ”We will bomb Iran” (not anyhow),… etc. While the market is still fluctuating to this kind of news flow, it is starting to take such headlines with a pinch of salt.
We’ll see. Maybe, maybe not. The Brent M1 contract is trading at $110.2/b this morning which very close to the average ticks through yesterday of $110.4/b.
Trump with bearish, verbal intervention whenever Brent trades above $110/b it seems. What seems to be a pattern is that Trump states something like ”very good negotiations going on with Iran”, ”New leaders in Iran are great,..”, ”Great progress in negotiations,…”, ”Deal in sight,..” etc whenever the Brent M1 contract trades above $110/b. An effort to cool the market. These hot air verbal interventions from Trump used to have a heavy bearish impact on prices, but they now seems to have less and less effect unless they are backed by reality.
As far as we can see there has been no real progress in the negotiations between the US and Iran with both sides still standing by their previous demands.
Iran is getting stronger while the cease fire lasts making a return to war for Trump yet harder. Iran is naturally in constant preparation for a return to war given Trump’s steady threats of bombing Iran again. Iran is naturally doing what ever is possible to prepare for a return to war. And every day the cease fire lasts it is better prepared. This naturally makes it more and more difficult and dangerous for the US to return to warring activity versus Iran as the consequences for energy infrastructure in the Persian Gulf will be more and more severe the longer the cease fire lasts. Israel seems to see it this way as well. That the war is not won and that current frozen state of a cease fire gives Iran opportunity to rebuild military and politically.
Global inventories are drawing down day by day. How much? In the meantime the Strait of Hormuz stays closed. There is varying measures and estimates of how much global inventories are drawing down. Our rough estimate, back of the envelope, is that global inventories are drawing down by at least some 10 mb/d or about 300 mb/d in a balance between loss of supply versus demand destruction. Other estimates we see are a monthly draw of 250-270 mb/d. The IEA only ’measured’ a draw in global observable stocks of 117 mb in April with oil on water rising 53 mb while on shore stocks fell 170 mb. But global stocks are hard to measure with large invisible, unmeasured stocks. As such a back of the envelope approach may be better.
Oil products is what the world is consuming. Oil product prices likely to rise while product stocks fall. Strategic Petroleum Reserves (SPR) are predominantly crude oil. Discharging oil from OECD SPR stocks, a sharp reduction in Chinese crude imports and a reduction in global refinery throughput of 6-7 mb/d has helped to keep crude oil markets satisfactorily supplied. But global inventories are drawing down none the less. And oil products is really what the world is consuming. So if global refinery throughput stays subdued, then demand will eventually have to match the supply of oil products. The likely path forward this summer is a steady draw down in jet fuel, diesel and gasoline. Higher prices for these. Then, if possible, higher refinery throughput and higher usage of crude in response to very profitable refinery margins. And lastly sharper draw in crude stocks and higher prices for these. But some 6 mb/d of oil products used to be exported through the Strait of Hormuz. And it may not be so easy to ramp up refinery activity across the world to compensate. Especially as Ukraine continues to damage Russian refineries as well as Russian crude production and export facilities.
Watch oil product stocks and prices as well as Brent calendar 2027. What to watch for this summer is thus oil product inventories falling and oil product premiums to crude rising. Another measure to watch is the Brent crude 2027 contract as it rises steadily day by day as the Strait of Hormuz stays closed and global oil inventories decline. The latter is close to the highest level since the start of the war and keeps rising.
The Brent M1 contract and the Brent 2027 prices and current price of jet fuel in Europe (ARA). All in USD/b
Our back of the envelope calculation of the global shortage created by the closure of the Strait of Hormuz. Note that 3.5 mb/d of discharge from SPR is also a draw. Note also that ’Forced demand loss’ of 2.5 mb/d is probably temporary and will fall back towards zero as logistics are sorted out leaving ’Price demand loss’ to do the job of balancing the market. Thus a shortfall of at least 9 mb/d created by the closure. More if SPR discharge is included and more if Forced demand loss recedes.
Brent is climbing higher. Front-month is at USD 106.3/bl this morning, close to a weekly high and a USD 9/bl jump from Mondays open. This is the move we flagged as a risk earlier in the week: the market shifting from ”a deal is around the corner” to ”this is going to take longer than we thought”.
Analyst Commodities, SEB
During April, rest-of-year Brent remained remarkably stable around USD 90/bl. A stability which rested on one single assumption: the SoH reopens around 1 May. That assumption is now slowly falling apart.
As we highlighted yesterday: every week of delay beyond 1 May adds (theoretically) ish USD 5/bl to the rest-of-year average, as global inventories draw 100 million barrels per week. i.e., a mid-May reopening implies rest-of-year Brent closer to USD 100/bl, and anything pushing into June or July takes us meaningfully higher.
What’s changed in the last 48 hours:
#1: The US military has formally warned that clearing suspected sea mines from SoH could take up to six months. That is a completely different timescale from what the financial market is pricing. Even a political deal tomorrow does not immediately reopen the strait.
#2: Trump has shifted his tone from urgency to ”strategic patience”. In yesterday’s press conference: ”Don’t rush me… I want a great deal.” The market is reading this as a president no longer feeling pressured by timelines, with the naval blockade running in the background.
#3: So far, the military activity is escalating, not de-escalating. Axios reports Iran is laying more mines in SoH. The US 3rd carrier strike group (USS George H.W. Bush) is arriving with two countermine vessels. Trump yesterday ordered the US Navy to destroy any Iranian boats caught laying mines. While CNN reports that the Pentagon is actively drawing up plans to strike Iranian SoH capabilities and individual Iranian military leaders if the ceasefire collapses. i.e., NOT a attitude consistent with an imminent deal!
Spot crude and product prices eased off the early-April highs on a combination of system rerouting and deal optimism. Both now weakening. Goldman estimates April Gulf output is reduced by 14.5 mbl/d, or 57% of pre-war supply, a number that keeps getting worse the longer this drags on.
Demand-side adaptation is ongoing: S. Korea has cut its Middle East crude dependence from 69% to 56% by pulling more from the Americas and Africa, and Japan is kicking off a second round of SPR releases from 1 May. But SPRs are finite.
Ref. to the negotiations, we should not bet on speed. The current Iranian leadership is dominated by genuine hardliners willing to absorb economic pain and run the clock to extract concessions. That is not a setup for a rapid resolution. US/Israeli media briefings keep framing the delay as ”internal Iranian divisions”, the reality is more complicated and points toward weeks and months, not days.
Our point is that the complexity is large, and higher prices have only just started (given a scenario where the negotiations drag out in time). The market spent April leaning on the USD 90/bl rest-of-year assumption; that case is diminishing by the hour. If ”early May reopening” is replaced by ”June, July or later” over the next week or two, both crude and products have meaningful room to reprice higher from here. There is a high risk being short energy and betting on any immediate political resolution(!).
Down on Friday. Up on Monday. The Brent June crude oil contract traded down 5.1% last week to a close of $90.38/b. It reached a high of $103.87/b last Monday and a low of $86.09/b on Friday as Iran announced that the Strait of Hormuz was fully open for transit. That quickly changed over the weekend as the US upheld its blockade of Iranian oil exports while Iran naturally responded by closing the SoH again. The US blew a hole in the engine room of the Iranian ship TOUSKA and took custody of the ship on Sunday. Brent crude is up 5.6% this morning to $95.4/b.
The cease-fire is expiring tomorrow. The US has said it will send a delegation for a second round of negotiations in Islamabad in Pakistan. But Iran has for now rejected a second round of talks as it views US demands as unrealistic and excessive while the US is also blocking the Strait of Hormuz.
While Brent is up 5% this morning, the financial market is still very optimistic that progress will be made. That talks will continue and that the SoH will fully open by the start of May which is consistent with a rest-of-year average Brent crude oil price of around $90/b with the market now trading that balance at around $88/b.
Financial optimism vs. physical deterioration. We have a divergence where the financial market is trading negotiations, improvements and resolution while at the same time the physical market is deteriorating day by day. Physical oil flows remain constrained by disrupted flows, longer voyage times and elevated freight and insurance costs.
Financial markets are betting that a US/Iranian resolution will save us in time from violent shortages down the road. But every day that the SoH remains closed is bringing us closer to a potentially very painful point of shortages and much higher prices.
The US blockade is also a weapon of leverage against its European and Asian allies. When Iran closed the SoH it held the world economy as a hostage against the US. The US blockade of the SoH is of course blocking Iranian oil exports. But it is also an action of disruption directed towards Europe and Asia. The US has called for the rest of the world to engaged in the war with Iran: ”If you want oil from the Persian Gulf, then go and get it”. A risk is that the US plays brinkmanship with the global oil market directed towards its European and Asian allies and maybe even towards China to force them to engage and take part. Maybe unthinkable. But unthinkable has become the norm with Trump in the White House.
Oil product price pain is set to rise as the Strait of Hormuz stays closed into summer
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