Oil’s Biggest Fear

The biggest oil headline in the last week- and perhaps the biggest headline in any other periodicals you might read- has been the growing US/Iran conflict. To recap, Iran has been behaving in an increasingly feisty manor since May 1 when the Trump administration ended the waiver for buyers of Iranian crude oil in an effort to get the nation's exports down to zero. The Iranian leadership has obviously been displeased with this move and has been accused by the U.S. and its allies of the recent attacks on oil infrastructure in the Persian Gulf. Things got even more heated last weekend when the Iranian military claimed responsibility for shooting down a $125m US drone which, according to the Iranians was surveilling their territory while US forces have claimed the device was flying over neutral territory. This escalation was met by the US military- and hawkish voices within the White House- with plans for air strikes on the facilities which may have planned and executed the attack on the US drone. However, President Trump, ten minutes prior to the US retaliatory strike, called off the attack believing that the response was overly aggressive.

Newspaper headlines and op-eds have focused intensely on this story and for good reason. US/Iran relations have been on a negative path for decades and the Trump administration's renewed emphasis on 'dealing' with Iran has talking heads understandably concerned that we are on the path to a more intense conflict. The story has captured the imagination of every financial and political newspaper we monitor as it has the potential to negatively reshape the lives of millions of people.

Oil wires have obviously taken an interest in the story too, but there seems to be an intense disconnect between the amount of press the story is getting in commodity analysis versus the impact it's having on prices, market sentiment and positioning.

For starters, let's look at old-fashioned flat price crude. Brent futures are trading near $65/bbl this week down from $72/bbl on May 1 when the Trump administration ended their waiver program. Prompt brent spreads- while strong- are also trading at non-panicked levels and are sharply lower over the last two weeks suggesting a lack of fear among refiners that the conflict will make it difficult to source barrels. Hedge funds were massive sellers of oil contracts in May and have been again in June. Lastly, in options markets, while volatility is obviously trading at elevated levels, implied vols on put options (downside insurance) are trading at a comfortable premium to call options (upside insurance) suggesting the real fear in the market is a bearish move.

To be clear, we aren't suggesting that traders shouldn't be worried about a US/Iran conflict. They should be. We also aren't saying that heightened tensions and rhetoric aren't impacting prices. They are. But we'd add that markets seem more concerned with the risk of further decay in global oil demand growth than in the decay of Washington/Tehran relations. While headlines are screaming about Trump's actions in the Middle East, commodity traders seem more concerned with what may or may not occur between Trump and Xi at the G20 in Japan later this week.

Quick Hits

- Brent traded near $65 this week holding recent gains on US/Iran tensions that are being capped by global demand concerns.

- Vladimir Putin and MBS are set to meet at the G20 later this week amid increased concern that the Saudis are losing Russian support in their effort to cooperate and tighten oil markets. We still think the most likely scenario is that Russia will agree to continue to cut supplies in the second half of the year, but teamwork between the two countries is far from guaranteed as Russia can balance its budget with $40 oil and the Saudis need crude north of $80.

- As we mentioned in our opening piece, put options are trading at a healthy premium to call options despite the elevated risk of conflict in the Middle East. This week 25 delta put options traded at 40% implied volatility while 25 delta call options only grabbed 37%. Yes, volatility is higher across the curve as recent price action has been sharp, but the continued put-premium that traders are willing to pay reveals a large amount of bearish concern. The current skew structure also implies a hefty amount of hedging activity from producers who are eager to lock in the recent jump in prices.

- Brent spreads also continued to moderate this week signaling that physical traders are not having a difficult time sourcing barrels for refiners. This week the spread between the 2nd month and 3rd month brent contract sank to just 40 cents backwardated from a recent high of nearly 70 cents. In our judgment, this is yet another strong signal from the market that sentiment is not overwhelmingly bullish despite the heated rhetoric between Washington and Tehran.

- US stocks moved slightly lower this week as traders felt inadequately reassured that the US Fed will move to lower rates at their next meeting. S&Ps traded near 2,925- up by about 16% YTD. The Shanghai Composite traded near 2,980 which is higher by about 22% YTD.

- Hedge funds were net sellers of NYMEX WTI and ICE Brent last week for the eighth consecutive week. Speculators were net buyers of NYMEX WTI by about 18k contracts last week but it was outweighed by selling in ICE Brent to the tune of 21.5k contracts. Combined net length between the two contracts is lower by 40% since late April.

DOE Wrap Up

- US crude stocks fell 3.1m bbls last week with help from upticks in demand and exports. Overall crude stocks feel to 482.4m bbls and are higher y/y by 11% over the last four-week period.

- Unfortunately, crude inventories in the Cushing trading hub jumped by more than 600k bbls to 53.6m which is their highest level since November of '17. Prompt WTI spreads continued to trade in contango- with front contracts trading at a discount to later-dated contracts due to soft fundamentals in the US.

- The US currently has 28.4 days of crude oil supply on hand- higher y/y by about 2.5 days.

- Traders imports 7.5m bpd of crude last week and exported 3.4m bpd.

- US refiner demand increased by 200k bpd to 17.26m bpd and is lower y/y by 400k bpd over the last month.

- US refining margins continued to fall this week which is concerning given the already-bleak demand data we're seeing on a weekly basis. This week the WTI 321 crack sank to $21/bbl with the RBOB/WTI crack near $20/bbl while Heating Oil / WTI yielded $23/bbl.

- US gasoline stocks fell 1.7m bbls last week to 233m and are lower y/y by 2% over the last month.

- Gasoline demand + exports printed 10.56m bpd last week and has averaged 10.3m bpd over the last four weeks which is lower y/y/ by about 40k bpd. Implied gasoline demand has averaged 9.95m bpd so far in 2019 which is lower versus 2018 by 45k bpd.

- US distillate stocks fell 550k bbls last week to 127.8m and are higher y/y by 10%.