How Tight Are Physical Oil Markets? Time Spreads Offer Hints

Macroeconomic concerns pushed oil lower this week as the recent rise in interest rates spilled bearishly into the stock market and ultimately pushed risk assets lower across the board. In the U.S., the spike in the 10yr yield to 3.25% (7-year high) instigated a drop in S&Ps of 232 points from its all-time high on October 3rd through its weekly low on October 11th representing an 8% decline. While macro pressure could persist as a bearish factor for oil in the near term, we're thinking the more powerful influence on oil prices in the short term will be the ability (or inability) of Russia, Saudi Arabia and the U.S. to replace lost Iranian barrels as sanctions are scheduled to take hold on November 4th in an already undersupplied market.

In gauging the status of the supply/demand balance there are certainly market participants among us who think that oil's risks are very much skewed to the upside. IEA chief Fatih Birol made his concerns clear at a conference this week pleading with OPEC and non-OPEC producing nations to do what they can to increase supplies as the oil markets "are entering the Red Zone." Mr. Birol is concerned that more bullish momentum in oil prices will eat into global economic growth. Hedge funds have also increased bullish bets on oil in recent weeks with net length in ICE Brent contracts jumping 50% from August 21st to October 2nd.

On the other side there are more temperate forecasts available including- very notably- a call this week for $65 oil in 2019 from Vitol CEO Ian Taylor who credited cooling demand for his bearish outlook. Meanwhile Goldman Sachs's head of commodities research told Bloomberg TV this week that calls for $100 oil are unjustified because "fundamentally today the market is well supplied." OPEC's chief also joined the bearish chorus this week predicting that markets will flip back into oversupply in 2019.

Perhaps more important than any individual forecast, however, is the behavior of crude oil time spreads which seem to insist that the oil market will remain tight but not overwhelmingly so. In Brent, the contract for December '18 delivery is trading at a $1.50 premium to the June '19 delivery contract and in WTI the December '18 delivery contract is trading at a 45-cent premium to the June '19 delivery contract. Those two differentials are 25 cents and $1.50 below their 1yr averages, respectively, and while both backwardated structures imply that oil supplies will continue to shrink, neither level suggests that the world's largest physical oil traders are not in panic mode when it comes to sourcing barrels. It's also important to note that WTI and Brent spreads are both significantly lower than their YTD peaks which both occurred in May. We will continue to watch spreads for hints on how large trading houses feel compelled to deal in the market, but for now their temperature seems best described as lukewarm bullish and trending towards neutral.

Looking ahead, we'll certainly keep a close eye on rising interest rates and worsening US/China trade relations as bearish influencers from a macroeconomic angle on oil. Global growth concerns continue to flash bearish headlines and this week we saw more of that as the IMF cut their global GDP forecast for 2019 and OPEC cut their crude demand forecast for 2019. In the near term, however, we feel that the most important story impacting prices will be the fight to replace Iranian barrels and on that front time spreads are clearly saying to us- don't panic just yet.

Quick Hits

- The most important story for crude oil prices this week wasn't about oil. It was about stocks. The damage in global stock markets (lead broadly by the decline in technology and emerging market stocks) cascaded across global risk assets and oil prices were not immune. In US markets the S&P 500 index fell a whopping 232 points from October 3rd to October 11th for a decline of roughly 8%. In Europe, the Euro Stoxx 50 fell to an 11-month low and in China the Shanghai Composite fell to its lowest level since 2014. This week served as a harsh reminder that oil prices are inseparable from the health of the global economy- which many are questioning.

- The impact of the global equity rout was rough on oil. Brent crude futures fell from a recent peak of over $86 on October 3rd to $80 on Thursday. In the US, WTI futures sank from $76 to $71 during the same period. Crude oil futures also fell from a weak DOE report on Thursday which reported a larger than expected US oil inventory build and profit taking from hedge funds who've benefited from oil's recent strength. It's also likely that oil suffered from a technical pull back as futures had simply rallied too far above their 50-Day Moving Average and had to come back down to earth

- Crude oil options are revealing heightened bearish concerns. This week the 25-delta put option for Jan '19 WTI futures priced near 29% implied volatility while the 25-delta call option priced at 27% volatility. We suspect that the premium being paid to own downside risk is being driven by long-positioned traders who are hedging their position and producers who are buying puts to protect cash flows from future output.

- Oil markets have been understandably obsessed with gauging future output from Iran and Saudi Arabia. Meanwhile the growth in U.S. production has been astonishing. U.S. output has reached a record of 11.2m bpd last month and is averaging 10.6m bpd in 2018. The EIA expects U.S. suppliers to pump a previously inconceivable 11.7m bpd on average in 2019. US companies are furiously working to build takeaway capacity in West Texas where supply growth has been particularly strong. Much of the new supply can be expected to serve markets away from the U.S. as exports have grown from 975k bpd on average in 2017 to more than 1.8m bpd in 2018.

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DOE Roundup

- U.S. crude oil stocks rose by a surprisingly large quantity w/w adding downward pressure to oil prices

- The build was primarily driven by elevated production and the seasonal slowdown in consumption as refiners perform fall maintenance and get ready to make winter fuels

- Rising gasoline supplies across U.S., rising crude supplies in the Cushing trading hub and tepid gasoline demand growth should all help keep a lid on near term strength

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On the demand side of things, U.S. refiner inputs fell by more than 300k bpd w/w to 16.2m bpd and are in line with last year's seasonal levels. On a YTD basis the U.S. has seen significant y/y growth in refiner demand of 500k bpd. Unfortunately, refined product demand growth hasn't shown the same level of excitement with U.S. domestic gasoline consumption + exports higher y/y by just 1.5% so far for 2018.