Up until the release of the US oil inventory data yesterday the mood was gently positive – crude oil was resilient, but products came under pressure. Then the sentiment turned, or one might say that a small change in assumption led to a significant change in conclusion. Although the headline figures were more on the negative side the crude oil build of 2 million bbls is deceptive. True, the 2.6 million bbls rise in distillate stocks and the 11 million bbls jump in commercial inventories were somewhat disheartening, but attention shifted to crude oil and gasoline. The 8 million bblds build in USGC crude oil inventories was the function of another 7 million bbls release from strategic reserves, which takes SPR stocks to 519 million bbls, more than 100 million bbls lower than during the same week of 2021. In the light of this development the 2 million bbls nationwide increase is actually viewed as constructive.

The small change in assumption was the 800,000 bbls decline in gasoline inventories, which went against the expectations of an increase of 1.1 million bbls. Add to that a healthy increase in gasoline demand and Tuesday’s sell-off and the morning weakness turned into a decent rally. No doubt that the RBOB strength greatly motivated crude oil bulls and by the close WTI was $2.70/bbl higher whilst front-month RBOB gained 642 points on the day.

The medium-term demand outlook is also deemed supportive, especially when it is compared to stock levels ie. the days of cover. They paint a tight inventory picture. Total US commercial stocks would last for 58 days based on the latest weekly demand figures compared to 73 days a year ago. Distillate inventories would satisfy 30 days of demand versus 40 days last year whilst gasoline stocks would cover 24 days of consumption as opposed to 28 days at the beginning of June 2021. Admittedly, weekly changes both in stocks and consumption could be erratic, therefore these figures might not be convincingly indicative or reliable, however, the year-to-date weekly averages also imply tight inventory levels compared to the corresponding period of last year. When OPEC and the IEA publish their latest monthly oil balance reports next Tuesday and Wednesday probably the same picture will emerge about OECD stocks.

Light at the end of the liquidity tunnel?

Russia’s invasion of Ukraine has been causing pain globally. Economic growth is stuttering, inflationary pressure is increasing and there is actual food shortage appearing, especially in the developing part of the world that could easily lead to social unrests with catastrophic consequences. Financial markets are no exception, the Ukrainian crisis has inflicted significant strain on them that is manifested in rising margin calls and illiquid trading conditions.

Relatively small orders can trigger sizeable swings in assorted asset classes. The liquidity crisis is so acute that even US central bank officials felt the need to address the issue during last month’s policy meeting. There are rising concerns that weak liquidity will adversely impact the operation of stock, bond, and commodity markets. Of course, tighter regulations introduced both in the US and Europe after the 2008 financial crisis have had a tangible impact on liquidity, but the situation has considerably worsened since Russia has attacked Ukraine. The US government bond market, the most important in the world, is in its worst condition since March 2020, the height of the panic caused by the outbreak of the coronavirus. And the situation is no better in the oil market.

Average daily volume (ADV) in the five major oil futures contracts has taken a substantial hit after the conflict broke out nearly four months ago. A total of nearly 4 million contracts changed hands a day in February. Trading volume actually shot up towards the end of that month because market players were quick to re-adjust their portfolios as Russian tanks rolled into Ukraine and the talks of sanctions got louder. At the same time the two major oil exchanges, the CME and ICE were understandably forced to take action and increased initial margins. Trading became more expensive, and this is reflected in the fall in ADV.

The decline in March was relatively small as combined ADV still stood as high as 3.41 million contracts. The situation, however, meaningfully deteriorated in April and May when ADV dived to 2.45 and 2.49 million contracts. It is a contraction of around 38% from the pre-invasion level, probably unheard of in the history of futures markets. One interesting, and retrospectively logical, consequence of the ongoing liquidity crisis in the oil market is the re-alignment of the market share of the individual components. The two crude oil futures contracts, generally the most actively traded ones, have increased their influence as trading conditions have worsened. WTI and Brent made up 74% of the total ADV in February. The pie has gotten smaller, but the slice of crude oil has grown to 78% in April and 77% in May. The change is understandable. Those who usually follow products might have found it easier and more effective to use crude oil to increase or reduce their exposure in oil futures.

Whilst liquidity is still under pressure the good news is that the anxiety seen in the immediate aftermath of the Russian attack and as measured by volatility, has greatly subdued. Volatility in front-month Brent, for example, that averaged around 66% in March and April, occasionally spiking over 90% on some days, fell back to 48% in May and is currently at 36%. It is still high by historic standards (the 2021 average was 31%) but if one believes in the inverse correlation between prices and volatility, he or she can conclude that oil prices are unlikely to come significantly lower and if the recent relative calmness persists margin calls might be lowered once again providing much needed liquidity that might result in the revival of trading volume. Right on cue, a Twitter post from yesterday afternoon claimed that ICE has cut Brent margins by 10.3% (it was increased by 19% at the end of March). Although we were not able to find the original circular on the ICE website, if true, it could be the first step towards a more liquid futures market.