Uneven economic growth due to the spread of the Delta variant of the Covid virus and the inequality in vaccine rollouts is a very clear and present danger that is likely hinder unabated march higher in risky assets. Yesterday, however, these fears were on the back burner thanks to the weekly EIA report on US oil inventories and to the Fed’s view on interest rates hike.
The US economy, despite stuttering vaccinations, is alive and well, at least this is what yesterday’s inventory report implied. Stocks have fallen in every major category – crude oil -4.1 million bbls, gasoline -2.3 million bbls and distillates -3.1 million bbls. Consequently, commercial oil inventories dived 6.5 million bbls and they show a 2.9% deficit to the 5-year average. Demand figures also suggest a booming economy. Total weekly consumption broke over the 21 mbpd mark last week and at 21.1 mbpd US demand is only 400,000 bpd below the peak of the last 19 months reached four weeks ago.
No wonder that oil prices generally edged higher yesterday also supported by the weaker dollar, which, in turn, was at the mercy of the US central bank. The Fed’s FOMC acknowledged the progress it has made towards its target of full employment and an average inflation of 2% but it was quick to emphasize that the underlying conditions do not warrant action in tightening the current loose monetary approach. In other words, no rate increase is imminent. Yesterday’s sanguine mood is being carried over to today. Chinese regulators have rushed to re-assure international investors that despite the regulatory crack-down on tech companies and on the private tutoring industry the world’s second biggest economy is still the place to trust and invest.
Cyclical WTI spreads
We touched on the topic of market structure in Tuesday’s note. We concluded that the picture is quite rosy as time spreads have been generally strengthening in recent months. Brent is the bellwether of the flock whilst the deep backwardation of the RBOB contract is understandable since we are in the middle of the US driving season. Heating Oil and Gasoil are also performing well despite the seasonality of these two contracts and their structures are expected to strengthen as summer in the northern hemisphere is slowly drawing to an end.
Every now and again WTI tries the challenge the healthy backwardation of its European peer but keeps failing to dominate on the front-end. As a matter of fact, an interesting phenomenon can be observed on the front-month over the last couple of months. On several occasions as the front contract edges closer to expiry its premium to the second month narrows (or its discount widens as it was the case last year) whilst the price differentials further down the curve remain resilient. Last month the front spread dropped from +72 cents/bbl to +7 cents/bbl. April started with a slight backwardation and by the expiry the first month displayed a discount of 23 cents/bbl to the second one. In February a 16 cents/bbl backwardation turned into a 21 cents/bbl contango.
There is no single explanation for this occurrence, it is probably a combination of factors. Firstly, funds that invest in oil usually roll their positions from one month to the next at the beginning of each month. As WTI expiry approaches around the 20th of the month traders might join this activity by typically selling the M1/M2 spread and buy the M2/M3 spread. The relative strength of WTI -the WTI/Brent arbitrage rallied from over -$4/bbl in April to around -$1/bbl at the beginning of the month- could have also made prompt barrels unattractive occasionally.
Whilst these developments might have contributed to the cyclical weakening of the nearest WTI spreads the underlying fundamental picture ensured that the backwardation remains resilient. After all, US oil demand is rising, we are in the midst of the US summer driving season and refiners are pumping as much gasoline as possible further supporting the domestic crude oil market. Under these circumstances nationwide as well Cushing crude oil inventories have been declining. It is the latter that catches the eye.
Crude oil stocks at the NYMEX delivery point are close to 35 million bbls, the lowest since the beginning of 2020. Tank capacity utilization rate has dipped below 50%. Last time it happened was in 2Q and 3Q of 2018 when front WTI spread was more than $1/bbl in backwardation. It is anyone’s guess whether it would happen again, but it is worth noting that out of the 35 million bbls around 8-10 million bbls must stay in storage due to operational purposes. The remaining 25-27 million bbls equates to 25,000-27,000 futures contracts of crude oil on the CME, not exactly a massive amount given that 10-15 times as much oil changes hand in the font-month every day. Should Cushing stocks keep draining and open interest in the front-month remain relatively high as the next expiry approaches (it is on August 20 with current OI in the September contract at 463,000 lots) those who remain short in futures would find it impossible to secure physical barrels to make deliveries from Cushing after the September contract goes off the board. Of course, this is nothing more than an implausible scenario as concerns about regulatory action in case of an adverse price spike is a good enough reason not to embark on such an adventure.
The other question is what the future holds beyond August. As thirst for gasoline declines with the end of the summer and as US refiners go into maintenance from September will demand from abroad be sufficient to keep US crude oil stocks depressed? Will a cold winter create enough Heating Oil demand to prevent an increase in crude oil inventories that could put downward pressure on the WTI structure? Instead of answering these riddles it is best to look at the bigger picture. The hopefully successful containment of the coronavirus and the consequent economic recovery should be sufficient to ensure healthy US oil demand, which in turn, is likely to keep the WTI structure backwardated for the balance of this year and possibly at the beginning of 2022.