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Brent Spreads Tell The Truth About Saudi Oil Disruption

Rig 2

Trump/China relations finally took a back seat in oil market headlines this week. All it took was a massive drone strike knocking out about half of Saudi Arabia’s oil production creating the largest intraday crude jump ever.

In case you missed it, Iran-backed Yemeni rebels (important: Iran was widely believed to be involved but this is still unsubstantiated) attacked one of Saudi Arabia’s largest facilities- the Abqaiq- over the weekend and have taken out an estimated 5.7m bpd of production.

Price action was obviously haywire on Sunday night open and into mid-week trading. After closing last Friday near $60, Brent crude printed up to $71.95 on the open before settling down towards $68 in late Monday trading and falling to $64 on Tuesday. For now, traders seem to be working to answer two questions about the attack to figure out where prices are going. First, how long will the outage last? Second, will the attacks lead to a broader escalation of conflict in the Middle East?

On the first question, we think a reasonable way to measure the duration of the supply outage is to look at Brent spreads which we view as the expression of gathered intelligence from the world’s most informed physical oil traders. In the front of the curve, the prompt 1-month Brent spread is trading at 96-cents backwardated, suggesting that the outage will certainly last at least a few weeks. The 2month/3month spread is trading at 85-cents backwardated, the 3month/4month spread is trading at 62 cents backwardated and the 4month/5month Brent spread is trading at 52 cents backwardated. We have to go all the way out to the 7month/8month spread to find a diff that is trading at less than 30-cents of backwardation. The key signal to us here is that the world's largest refiners and trading merchants seem to think the outage will last for a few months- not just weeks.

On Tuesday Saudi officials announced they had restored Abqaiq to 2m bpd of production and that exports wouldn’t suffer in the short term. Regarding exports, the Kingdom plans to draw on reserves and reduce their own consumption by 1m bpd in order to serve customers instead. They also claimed the facility would be back to producing about 5m bpd by the end of September. Beyond that information, traders will have to play wait and see with respect when the Saudis can fully resume exports. The Kingdom is obviously more optimistic than the world’s traders for the time being.

On the second question, we’re slightly skeptical the Iran-lead attack will lead to broad military aggression or war. Saudi Arabia- clearly unable to protect their own most lucrative assets- would not benefit from war and it’s hard to see how Iran’s sanction-strangled leadership would benefit from escalated belligerence. Of course, President Trump will also play a large role in determining where things go from here playing ally with Saudi Arabia while using Iran as a foil to score points with his base voters. It would seem odd to us if Mr. Trump found a hawkish groove one week after firing his national security advisor John Bolton for being overly hawkish. The two men never seemed to be on the same page with respect to the application of the US military and Trump was clearly frustrated by Mr. Bolton’s seemingly endless rationalization of war. In short, we expect Trump to Tweet tough and remain ‘locked and loaded’ on social media while taking a dovish posture that strives to remove- not add- US troops in the The Middle East.

For now, oil markets seem to be taking the news largely in stride with Brent crude up a mere $5 from its Friday close. This weekend’s attacks obviously add upside risk in the short term, but we think the market is correct in taking a slightly bullish adjustment rather than drastic action.

Quick Hits



- Crude oil has obviously been on a hell of a ride since the Sunday open. After closing near $60 on Friday Brent’s first print of the week was just under $72. Oil then sank back to $65 on Monday before spiking back up to $69 on Tuesday morning but eventually sank to $64 on Tuesday night.

- The first question on every trader’s mind was How Long Will It Last? According to spreads, this issue won’t be resolved overnight. The difference between the 2nd month Brent contracts and 3rd month Brent contracts spiked from +60 cents to +120 then down to +90. We’re taking this to mean that Brent markets should remain tight for at least the next few months.

- Iran fully denied involvement in the attacks this week and rejected the idea of talking with the Trump administration despite overtures to meet without preconditions.

- FedEx- seen by many as an economic bellwether- saw its shares drop 8% after cutting its outlook this week. The company’s executives blamed a slowing economy and the US/China trade war for the darkening outlook.

- President Trump floated the idea of tapping US emergency reserves to calm prices on Monday but had changed his tune by Tuesday after prices calmed The President seemed to echo the IEA’s last note saying “Oil has not gone up very much. There’s a lot of oil in the world.”

- Option markets also went haywire on the weekend’s news. For the first time in years call options traded at a premium to put options as traders frantically went to cover short-call positions to stem losses. On Tuesday the 25-delta call option at the front of the Brent curve implied 51% volatility while the 25-delta put priced at 49% volatility. At the money options (50 delta) implied 48% vol, which is up more than 10-vols from last week.

- In macro news, the US REPO market received some well-documented stress this week as rates in the ultra-short-term market spiked. The US Fed responded by adding $75b worth of liquidity to calm markets and said they stood prepared to double that amount if remains stay elevated. Bond traders took the sign as a dovish signal and even bought bonds at late dated maturities as well with the yield on the US 10yr sinking from 1.9% to 1.8%.

DOE Wrap Up



- US crude stocks fell nearly 7m bbls to 416m last week. Inventories are higher y/y by 6% over the last four-week period and have actually managed to have a very bullish seasonal inventory draw moving lower by about 70m bbls since mid-June versus a decline of just 35m bbls during the same period last year.

- The US currently has 23.8 days of supply of crude oil on hand which is its lowest level of 2019.

- Net imports of US crude continued to move at low levels and help drive the inventory draw. Last week the US imported 6.7m bpd and exported 3.3m bpd for net imports of 3.4m bpd. For comparison, net imports averaged 5.9m bpd in 2018.

- US crude production as flat w/w at 12.4m bpd and has averaged 12.1m bpd in 2019.

- Cushing, OK crude stocks also moved lower in line with the overall inventory draw. Supplies in the mid-continent delivery hub fell to 39.3m bbls- below 40m for the first time since December of ’18.

- US refiners input 17.5m bpd last week for a w/w improvement of 120k bpd. Refiner demand has averaged 17.50m bpd over the last four weeks which is lower y/y by 300k bpd (1.6%) over the last four weeks.

- US gasoline stocks dropped by 600k bbls last week to 229k and are higher y/y by 1% over the last month.

- The US currently has 23.6 days of gasoline supply on hand.

- Meanwhile, distillate inventories increased by more than 2.5m bbls and are higher y/y by 2%.

- Implied US gasoline demand printed 10.4m bpd last week which is in line with its four-week average. Demand is higher by 120k bpd (1.1%) y/y.

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