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Can Oil Continue To Rally?

- WTI registered its best week of the year on strong fundamental data, OPEC progress and currency tailwinds. The physical market is showing signs of health with sharp inventory draws on a global level in crude oil and refined products which have been cheered by tightening differentials and time spreads to their highest levels in months.

- OPEC developments continue to support prices in the near term with little promise of delivering a long term bull market. On the bullish side this week’s commitment from Saudi Arabia to cut exports to 6.6m bpd (Bloomberg estimates their exports at 7.7m bpd in 2016) beginning in August has at least some teeth due to recent export cuts into the US. Over the last six weeks the US has imported 840k bpd from the Saudis after averaging 1.1m bpd in the prior six week period. On the geopolitical front we also see a set of circumstances which skew risk transmission to the upside as Nigerian and Venezuelan output have extremely small odds of increasing in the near future. On the bearish side Iraq’s continued insistence on increasing output to 5m bpd continues to weaken OPEC’s hand in the long term and limit the potency of the group’s efforts to manage the market beyond protecting the low end of the price range.

- We’re still looking to US production data for signs of stress and are seeing mixed results with an operating environment that will likely continue to keep prices in their current range. This week showed more flattening of the rig count and more news of rising breakevens due to labor and fixed costs in key shale areas. Anadarko and Continental also announced CapEx cuts this week which were applauded with higher stocks prices on the pursuit of higher returns over market share. On a more bearish note, lower 48 production continues to increase steadily (this week’s US production decline was due to Alaska) and the recent climb in prices has been followed by a 3% increase in gross shorts held by merchants and producer firms. Today’s 2-month high in the Calendar ’18 WTI swap at $50.13 invited considerable producer hedging into the market which should obviously increase if prices continue to rally. We’ve also observed a collapse in rates across high yield energy bonds with the Barclay’s Bloomberg Energy High Yield index moving from 5.2% to 4.75% over the last two weeks suggesting credit stress in the sector is mild.

- Away from the oil market the EUR/USD continues to underwrite strength in crude touching a 2.5yr high this week over 1.1730. This week’s FX fuel came in the form of a Fed statement which characterized sub 2% inflation as a structural phenomena rather than a transient blip. Recently dovish Fed speak has pushed the odds of another rate hike at the FOMC December meeting down to 48.5% from 54.4% one month ago. On the more bullish USD side the Fed reiterated plans to shrink their balance sheet ‘relatively soon.’ The Fed’s balance sheet is roughly flat YTD while the ECB’s is higher by about 16%.

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WTI spreads show near term strength, raise long term questions

Prompt WTI spreads rallied to roughly 10 cents contango this week on the back of a drop in Cushing stocks below 56m bbls. In the front of the board the prompt WTI 1-month spread traded to a 4-month high of -8 cents on Friday for a 10 cent improvement on the month. In longer dated maturities WTI Z17/Z18 briefly traded 3 cents backwardated on Friday with help from producer deals as the WTI Cal ’18 swap reached $50/bbl. Going forward it seems like prompt WTI spreads may have more upside potential if Saudi export discipline keeps barrels out of Cushing, but the flood of Cal ’18 hedging we expected to see with swaps over the $50 mark in addition to continued US production gains should limit rally risk in spreads.

US producer data was mixed this week beginning with a weekly increase in rigs by 2 to 764. We continue to be interested in flattening rigs which have expanded by 44 over the last ten weeks after growing by 89 over the previous ten week period. US production has yet to reveal the stress however, and it’s important to note that last week’s w/w production decline was entirely driven by Alaskan output while lower 48 production expanded for the 24th time in 28 weeks this year. Producers/merchant gross shorts have increased by 3% over the last two weeks on rising prices which we think will expand on this week’s rally in swaps. Related: Barclays: Oil Could Rise By $7 If U.S. Sanctions Venezuela

In overseas markets brent spreads suggested a rapidly tightening market abroad. Brent V17/Z17 traded near 12 cents contango / month and dated brent vs. the front line swap traded to a 2-month high at -46 cents. Further back in the curve Brent Z17/Z18 traded -65 cents on Friday for a two month high and approached its 100-DMA for the first time since May. Bloomberg estimated global floating inventories at 169m bbls early in the week representing a decline of 40m bbls since late June.

Prompt option vols rally on flat price recovery

Crude options did something unusual this week which was rally across the skew in a rising flat price environment. As of Thursday we saw WTI U17 ATM vol near 29% representing a 1.5 vol w/w rally which we attribute to a push higher in 20-day realized vol from 27% to 30%. The skew maintained its newly bullish stance with 25d calls trading at a slight premium to ATM and 25d puts. Away from the oil market the VIX printed 8.84 on Wednesday for a +15yr low mark while EUR/USD 1-month vol rallied to 7.4%.

Fund positioning normalizes, retail throws in the towel

After building a substantial bearish position on WTI’s drop to $42.05 funds are now returning to a historically average stance on crude oil. Last week funds were net buyers of NYMEX WTI and ICE BRENT contracts for the third straight week largely due to short covering. Rather than looking bullish, however, current fund positioning looks very lukewarm on oil and probably reveals greater than normal uncertainty on where the next move might be. As of July 18th, NYMEX WTI net length stands at 215k contracts which is 6% above its 3yr average while ICE BRENT net length at 262k contracts is within 2% of its 3rd average.

Refined product flows from hedge funds were mixed last week looking bullish in RBOB while Heating Oil flows stay negative. On the gasoline side, net length jumped to 15k contracts representing a 13-week high while HO’s net short increased to 12k contracts. On the retail side the USO experienced a third straight outflow last week- this time for a cool $84 million. Total outflows over the last three weeks have reached $534m and are +90m YTD.

EIA data continues to surpass expectations

- US crude oil data began with a headline draw of 7.2m bbls and also included better than expected draws in Cushing, gasoline and distillates alongside strong demand
- US production growth is at least temporarily slowing which we think is a key piece of the bullish short term puzzle
- Trade flows also look bullish in the US on falling USGC imports and elevated exports

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US crude oil stocks fell more than 7m bbls last week and are now lower y/y by 1.5%. PADD I inventories were flat w/w and are -11% y/y, PADD II stocks fell 1.7m bbls and are flat y/y and PADD III inventories fell by 4.5m bbls to a y/y deficit of 1%. Cushing inventories also fell by 1.7m bbls w/w to 55.8m bbls for a 21-month low. Imports were flat near 8m bpd this week with a sharp increase into the east coast while PADD II and PADD III imports fell. PADD III imports are lower y/y by 18% over the last month. Exports jumped to 1m bpd for a 2-month high. Related: Shell Posts 700% Rise In Earnings, Prepares For ‘Lower Forever’ Oil Prices

US refiner demand was also bullish last week printing 17.3m bpd. Overall inputs are higher y/y by 3% over the last month and flat y/y in PADD I, +4% y/y in PADD II and +5% y/y in PADD III as USGC refiners have busily exported products to Latin America. Refiner utilization printed 94.3% last week and is +1.5% y/y. Refiner margins continued to trade at healthy levels that should support medium term demand including a YTD high in the gasoil/brent crack over $12.50/bbl. In the US, the WTI 321 crack fell to $18.30/bbl.

Gasoline data was also much more bullish that expected last week beginning with an overall stock draw of 1m bbls. Overall gasoline inventories in the US are -5% y/y with help from aggressive exports to LatAm. On a regional basis PADD I inventories are now lower y/y by 14% following last week’s 2.2m bbl draw. PADD II inventories fell 1.7m bbls and are +2% y/y while PADD III inventories added 2.9m bbls and are +2% y/y. Refiners continue to stay busy producing gasoline and at 10.4m bpd domestic production is +3% y/y. Domestic consumption printed 9.8m bpd last week and is flat y/y while exports at 600k bpd are +31% y/y.

US distillate inventories fell by more than 1.8m bbls last week and are now lower y/y by 1.2%. PADD IB stocks fell by 867k bbls and are lower y/y by 10% while PADD II inventories fell 315k bbls and are higher y/y by 8%. PADD III stocks fell by 879k bbls and are higher y/y by 3.5%. US distillate production continues at elevated levels and at 5.1m bpd is +3% y/y. On the demand side domestic consumption printed 4.4m bpd and is +14% y/y while exported at 1.2m bpd are -9% y/y.

By SCS Commodities Corp.

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