The two major crude oil futures contracts lost values yesterday and time spreads also weakened prior to today’s Brent expiry, nonetheless, it was a spirited performance led by the CME products that was greeted with a sigh of relief after Tuesday’s bruising session. The recovery from the day’s lows was encouraging. Not even a quite downbeat weekly Petroleum Status Report from the EIA was able dent confidence. The morale of the fable of the past two trading sessions about bulls and bears is that a.) the sell-off on Tuesday was chiefly the result of the spike in Treasury yields because of inflation worries and the resultant day trip out of equities and b.) there has been no change in the underlying expectations and continuous depletion in global and OECD oil inventories is still widely anticipated.

OPEC and its non-OPEC friends are expected to stick to the original plan when ministers get together next week to decide the way forward. Another increase of 400,000 bpd is pencilled in for November, which is, in the light of the supply disruption caused by Hurricane Ida is viewed as price supportive as it would likely guarantee declining oil inventories for the rest of the year provided demand growth holds up well. For next year, the group’s Joint Technical Committee, under its base case scenario, now expects supply exceeding demand by 1.4 mbpd, down from the previous forecast of 1.6 mbpd, a presentation seen by Reuters suggested.

The resilient price action is all the more impressive in spite of an unexpected build of 11 million in US commercial oil inventories. The chief culprit is crude oil, which went against forecast and swelled 4.6 million bbls. As production is normalizing -it jumped to 11.1 mbpd last week suggesting a full recovery from the hurricane-related disruption- PADD 3 saw an increase of 3.9 million bbls in its crude oil inventories. Although refiners, again led by those located in the Gulf of Mexico, increased runs by 0.6% both distillate and gasoline stocks remained effectively unchanged. Weekly combined oil demand data showed a fall of 750,000 bpd.

The recovery in equities and in bond prices also helped oil stay stable yesterday. The ongoing saga surrounding the US debt ceiling and growing concerns about Chinese economic growth due to the power crunch (September factory activity contracted) are both hanging above the oil market like the sword of Damocles. They will inevitably cause future turbulence but when oil is left to its own device re-testing the $80/bbl level and higher is very much feasible.

Undervalued Heating Oil

The recent rally in flat price suggests a tight market for the fourth quarter of the year that will further deplete global and regional oil inventories. Struggling growth in oil supply, the result of Hurricane Ida and production limits from some OPEC+ members, coupled with a healthy rise in demand as the world is slowly leaving the Delta variant of the coronavirus behind are expected to provide solid support for oil prices. This month’s report on global oil balance from the IEA saw OECD inventories having fallen by 329 million bbls between 3Q 2020 and 3Q 2021. Total commercial stocks in the US are currently 188 million bbls below last year’s level and 65 million bbls lower than the 5-year average.

Of course, the movements in global, OECD or US oil stocks include product inventories, as well. Although US distillate and gasoline inventories were the integral parts of the decline in US and OECD stocks, a closer look at the changes reveals that the price reaction of CME Heating Oil was somewhat muted. It did not fully reflect the decline in stocks, at least this is what its structure and its price differential to the RBOB contract implies.

US distillate stocks are low. A comparison to last year’s level is probably misleading due to the unprecedented circumstance the coronavirus caused, nonetheless the annual deficit of 43 million bbls clearly implies that the stock depletion is happening in front of our eyes. It is slightly below the comparable week of 2019 and is 12 million bbls lower than the 5-year average. Yet, what we see in the futures market going into the last quarter of the year is that that the average monthly backwardation is not deeper than the one we saw in 4Q 2019. To be consistent, it has to be pointed out that in the last quarter of 2020 the structure was uncharacteristically in contango, but again, the stock build caused by the pandemic had not started to reverse in earnest back then yet. The point is that there is a good chance of the structure of the Heating Oil contract strengthening in coming months, especially if natural gas and LNG remains sought after. Additional support could come from the demand side. Distillates supplied, the proxy for US demand, is now around 4 mbpd (4-week average), up by 500,000 bpd on last year and 100,000 bpd more than in 2019.

The RBOB structure for 4Q matches the 2019 level for the corresponding period. Whilst it might come as surprise since US inventories are some 9 million bbls below the 4Q level, it is probably the function of sluggish demand. Current consumption is nearly 200,000 bpd lower than in 4Q 2019. Throw in that the EPA recommended a lower-than-expected Renewable Volume Obligation (RVO) targets or biofuel mandate for this year and next leading to a significant fall in RIN D6 prices, which highly correlates with gasoline. RIN D6 price has more than halved since the beginning of June and at one point last week it was as low as 90 cents. Yet, the premium Heating Oil commands over the RBOB contract at around 16 cents/gallon is nearly half as much as it was two years ago when the US distillate market was less tight than it is now. Heating Oil also seems to be relatively cheap to WTI: the crack spread for the upcoming quarter at around $15/bbl pales in comparison with the spread value of $24.82/bbl in 4Q 2019.

Despite the wobble on Tuesday outright oil prices are likely to remain resilient for the balance of 2021 – the fundamental backdrop looks supportive. Based on the comparison with 4Q 2019 Heating Oil might easily outperform WTI and RBOB under this scenario resulting in tighter Heat crack spreads and higher premium to RBOB.