The Big Oil Bet That Went Bad

1. Exploding distillate glut

- U.S. distillate stocks are soaring, jumping from 136 million barrels in mid-April to 174 million barrels at the end of May.

- Distillate stocks are only 1 percent below a record high last reached in 2010.

- “The latest inventory build happened even more quickly than during the 2008/09 economic crisis, as stocks soared now by 52 million barrels, i.e. 43%, in just two months,” Commerzbank said in a note. “This is attributable first and foremost to extremely weak demand, which at 2.7 million barrels per day has fallen to its lowest level since April 1999.”

- At the start of the pandemic, it was gasoline that was dragging down refiners. Now it is diesel and other distillates.

- Cracks for diesel in Europe have collapsed to an all-time low. “The situation looks awful,” an executive at a big European refiner told Reuters.

2. Petrochemical sector facing a bust

- The oil majors have made a large bet on plastics and petrochemicals as a hedge against long-term demand. But the market for polyethylene is facing overcapacity and narrowing margins.

- The buildout of petrochemical facilities in the U.S. over the past decade has led to a wave of new facilities, but prices for polyethylene – the building block of plastic – have nosedived.

- PE prices traded at about $1 per ton in 2011-2012 when Royal Dutch Shell (NYSE: RDS.A) planned its petrochemical complex in Pennsylvania (now under construction). Prices are now between $0.40 and $0.60 per ton, and 2021 futures are trading at just $0.20 per ton.

- Collapsing oil prices have also zeroed out the cost advantage that U.S. polyethylene producers had over Asian competitors.

3. U.S. LNG exports declining fast

- The global market for LNG is buckling under a supply glut, and U.S. exporters are shouldering the burden of the “rebalancing.”

- “[T]his process implies a softening of US balances, be it through US LNG cancellations or by a TTF capitulation making the US a destination for spot LNG,” Goldman Sachs wrote in a note. TTF is the benchmark price in Europe. “We now see evidence both are happening.”

- Goldman says that the U.S. will suffer from LNG cancellations on the order of 4 Bcf/d in the summer months.

- Canceled cargoes hit upstream natural gas production. Goldman lowered its Nymex gas prices for July through October to just $1.75/MMBtu, down $0.35/MMBtu from its previous forecast.

- The sharp decline in the volume of gas flowing to export terminals (see chart), “if sustained without any offset, would create a scenario where [coal-to-gas] substitution alone could not balance the market and US gas production shut-ins would be required this summer.”

4. China rebound drives bullishness for aluminum

- China’s manufacturing PMI surprised on the upside with a 55 reading for May, compared to a consensus of 47.3. The reading suggested a sharper rebound in manufacturing.

- But that is not the only reason for the newfound bullishness for aluminum. “Aluminium stocks on the SHFE in Shanghai have declined from nearly 550,000 tons at the end of March to below 300,000 tons now, while those in China as a whole have plunged from almost 1.7 million to below 900,000 tons according to SMM,” Commerzbank said in a note.

- But with abundant bauxite on hand, China ramped up aluminum production and exports, which Commerzbank said is the main driver behind LME stocks (London) rising.

- “From a low of around 970,000 tons in mid-March they have meanwhile soared to a four-year high of over 1.5 million tons,” Commerzbank said. “Chinese aluminum exports are thus likely to achieve a new record of over 550,000 tons, which is why we remain skeptical as far as aluminum prices are concerned.”

5. Oil market could flip to deficit, but huge inventory buildup remains

- Global oil production fell by 9.3 mb/d in May, and demand rebounded by 4.7 mb/d, according to Standard Chartered. That brought the 19.6 mb/d surplus in April down to just 5.6 mb/d in May.

- By July, the surplus will disappear.

- But there is a cumulative inventory build up of around 1,083 million barrels from March to June.

- Under the current OPEC+ arrangement (assuming no extension) it would take until March 2022 to run down the surplus inventories.

- For 2020, only about 20 percent of the surplus would be burned off. But if the current 9.7 mb/d OPEC+ cuts were extended through the end of the year, it would erase 60 percent of the inventory hangover.

- However, OPEC+ appears only set to extend for a month or two, leaving a large inventory buildup to work off.

6. U.S. shale shut-ins come back

- In North America, oil producers shut in around 2.5 mb/d of production. But relief is already on the way.

- “Since many of these plans were unveiled, oil prices have strengthened to levels where shutting-in no longer makes sense and should actually encourage producers to quickly restore production,” Bank of America Merrill Lynch wrote in a note. “For this reason, we expect June curtailments, particularly in the US, to be a fraction of the previously announced levels.”

- But the dynamic is not as simple as production coming back. Output may rise temporarily, but because of the deep capex cuts that have already been announced, the steep decline rates from shale wells will overtake the returned output from shuttered wells.

- “Shut-ins have captured the headlines recently, but the lack of new shale wells is also hurting output and will become more apparent as the year progress,” Bank of America said. Year-on-year production by the fourth quarter could be down by 2 mb/d.

7. Refined product exports focused on Latin America – Covid-19 could wreck that

- Refineries were hit hard by the downturn, but gasoline and diesel inventories remain elevated, despite recent drawdowns.

- Upstream production has started to come back, but refineries have yet to ramp up again. “This could cause Cushing inventories to stagnate in the coming weeks, but we think sluggish drilling and completion activity will eventually pull production lower again in the coming months,” Bank of America said.

- One of the problems for American refiners is that one of their main markets has been exporting to Latin America.

- Mexico and Brazil are suffering from skyrocketing cases of COVID-19, which could “weigh on US refined product exports and slow the recovery of refining activity,” Bank of America said.