The expected is greeted with a rally these days as was the case yesterday. One of the major events of the week, the Fed’s interest rate decision, did not rock the boat. Although the central bank’s aggressive modus operandi is tangible indeed, the fact that it lived up to expectations and hiked interest rates by “only” 0.75% was reassuring enough for equity bulls with itchy fingers to pull the trigger. Does it mean that the clouds of inflation and recession are disappearing? Hell no, and that much the Fed’s chair admitted. The tightest monetary conditions of the past 40 years are being implemented despite struggling economic growth but as it has been advertised that for months the priority is to bring inflation under control. Current data suggests that this goal can only be achieved by gradually increasing the cost of borrowing to 3.5% by the end of the year, the inevitable consequence of which will be further slowdown in economic expansion.
Although the outlook is gloomy risk was back on yesterday. Equities rallied and the dollar weakened. The falling greenback encourages buyers in our segment of the market and when it is coupled with a constructive US inventory data oil is bound to rally. Major categories all registered drawdowns. Crude oil stocks were down by a combined 10.1 million bbls (4.5 million bbls commercial and 5.6 million bbls SPR) and gasoline and distillate stocks also declined. Consumption in these two products have picked up significantly – by 700,000 bpd in the former and 50,000 bpd in the latter, however total products supplied dumped by more than 1 mbpd due to the 1.5 mbpd fall in the ”other product” category. Net product exports were 4.2 mbpd. Draining US oil inventories, “as-expected” Fed rate hike together with falling gas deliveries on the Nord Stream 1 pipeline by Gazprom provided a decent tail wind for risk assets but in the current uncertain and turbulent geopolitical and economic climate prevailing winds of fortune can change direction fast.
Spreads hold the crystal ball
It has now turned into a boring cliché, but it does not make it less true: the market is torn between economic/demand fears and supply worries. Another way to put it is that immediate production shortage clashes with perceived economic malaise. The reasoning from both sides is well publicized. Those with bullish inclinations point to reduced Russian exports, although the extent of it is not entirely clear. They would also argue that one of the biggest sellers of energy products is more than willing to weaponize its oil and natural gas resources in order to achieve its political ambitions. Further support comes from the continuous under achievement of the OPEC+ producer group, which produces more than 2 mbpd below its allowed ceiling. Scarce spare capacity is also a significant factor and so is the roughly 5 mbpd production outages from Iran, Libya, Venezuela and Russia due to heightened geopolitical tension and political infighting. Lack of refining capacity should be the last nail in the bear’s coffin.
Do not get your hopes up high though, says the pessimist in the opposing corner. Limited availability of oil is only concerning when it leads to a tight oil balance that is manifested in depleted oil inventories. Rising consumer prices have started to have a notable impact on aggregate demand globally, including oil. Call it fears of recession, stagflation or inflation the fact of the matter is that the global and regional economies are struggling, especially in the developed part of the world. Central banks have no choice but hike interest rates, which makes borrowing more expensive. This, in turn, acts as a break on expansion. Do you need proof? Just open yesterday’s newspapers. The IMF slashed its global growth forecast for this year and next by 0.4% and 0.7% from three months ago. Chinese growth will be 3.3% this year, 1.1% less than estimated in April. The US economy will only grow by 2.3% this year and 1% in 2023. These are worrying signs that simply cannot be ignored and will ultimately result with global oil demand dipping below supply – if it already has not done so.
As for oil prices the question is which of the above proves to be the dominant factor in months to come. The recent bullish edge has clearly been taken off the market; outright prices are considerably below the March peaks. On the other hand, assorted price differentials are proving to be stubbornly resilient. And it is the latter that holds the clue to an irrevocable turn in sentiment. Take the European benchmark, Brent as the shining example. The front months contract has dropped $32/bbl or around 23% since the middle of March. At its peak, on March 7, the front-month commanded a premium of $4.34/bbl over the second one. The backwardation is now nearly $5/bbl although it is noteworthy that the M1/M6 spread has narrowed $8/bbl. The Brent CFD market, which provides us with an estimated value of dated Brent for the nearby weeks, is also buoyant. The physical benchmark was around $10/bbl above its forward peer in March for the closest week, it still trades more than $8/bbl above it. The Nigerian grade of Bonny Light has tripled its premium over forward Dated Brent since March 7 and Saudi premium over its benchmark for Asian customers is close to record highs.
Healthy backwardations imply robust demand for crude oil, and it does so with a good reason. The collective impact of reduced Russian product exports and severely diminished refining capacity are forcing refiners to ramp up runs in their efforts to produce as much product as physically possible. This supports the backwardated nature of the crude oil market but ultimately products have gotten an even bigger boost. Although both the ICE Gasoil/Brent and the CME 3-2-1 crack spreads have eased some from the stratospheric peaks observed at the beginning of June they are still at elevated levels compared to historic norms and much higher than pre-invasion. The Gasoil crack is more than twice as much as in February and is worth six times more than a year ago. The 3-2-1 spread is currently just over $150/bbl. It was $69.50/bbl a year ago and around the same level in the first half of February. We believe that a reversal in these spreads will be the harbinger of a considerable downturn in consumption. A weakening of crude oil structures will be the first sign of waning refinery demand, which should couple with declining crack spread values and margins. Whenever it happens bears will feel more encouraged than now to start firing from all cylinders, possibly sometime after the driving season. Until then the volatile and somewhat range-bound nature of the oil complex is expected to persist.