• In recent weeks the oil market has seen negative sentiment drive prices lower based on expectations of heightened output (some of which have been realized) from recent problem areas including Canada, Nigeria and Libya while refining margins have collapsed and Brexit has added to macro/demand concerns. Over the last two months speculators have trimmed net length by 32 percent in NYMEX WTI and reduced net length in ICE Brent by 21 percent. During WTI’s rally from $26.05 to $51.67 many traders assumed that a gasoline demand boom and falling non-OPEC+Russia production would accelerate a clearing of the global crude supply overhang and lead to higher prices. Instead, traders are looking at a more negative macro picture, a global glut of gasoline is weighing on the entire complex and fear of another move into the $30s is gaining momentum.
• In our view, however, a protracted move below $40 for oil would probably require a sharp selloff in the EUR/USD (which is certainly possible, but could be difficult given the Fed’s unspoken mandate of keeping a harness on the $, more on that later) and could ultimately prove to be a good buying opportunity as the global daily supply surplus continues to shrink. High inventories aside, the market is still gradually moving towards balance and peak daily oversupply is behind us. According to the most recent IEA data, the peak in the oversupply cycle occurred in 2Q’15 at 2.2m and supply/demand will flip into deficit either in 2H’16 or 1H’17. The EIA and OPEC see similar trends believing that the market is moving towards balance before reaching a daily supply deficit next year. We would even view a market with a daily surplus of 500k bpd (a much more bearish assumption than any of the above forecasts) as a thin margin of error when the IEA sees 96-97m bpd of demand in 2H’16, production has yet to bottom in many parts of the world and massive geopolitical risks persist in Libya, Nigeria and Venezuela. More broadly, the budget stress shared by exporting nations, commercial producers and the odds of an OPEC supply cut would only increase if prices make another aggressive shift south.
• While we aren’t in the camp arguing for +$60 oil in 2016 based on the above trends, we do see trending market balance as limiting the downside risk for oil and would most likely look to own 35-25 delta $5-$10 wide call spreads with 4Q16 maturity, sell $35-$30 puts or own WTI structure such as WTI Z16/Z17 if an FX driven sub $40 crude oil move materializes in the coming weeks.
Oil adjusts to new era of central bank easing
For most of the QE era, equity investors have attempted to answer two questions, 1) will central banks deliver more monetary support? and 2) will the monetary support actually push multiples higher in a low growth environment?
As of this week, the answer to both has clearly been yes. The party in equity markets continued with record high prints in S&Ps, a 1-month high in the Nikkei, an 11-month high in the FTSE, and a 3-month high in the Shanghai Composite. The primary driver of the recent equity strength in our view has been accomodation from the ECB and BoJ and expectations of a dovish course from the U.S. Fed.
In Japan, key events included election results, which should allow Abe to pursue more supportive policies including a potential $130 billion fiscal stimulus package. Additionally, a meeting between Ben Bernanke, Abe and BoJ head Kuroda occurred over the weekend and it is widely believed that helicopter money was discussed. In FX markets the result was a rally in the USD/JPY from 100.00 to 104.99. Meanwhile the ECB has accelerated its asset purchases while increasing its focus on corporate bonds as a growing percentage of negative yielding soverign debt becomes ineligable for purchase. The ECB has increased its balance sheet by 16 percent so far this year including a 3.4 percent jump from June 24th through July 8th.
Our main concern for oil when interpreting recent central bank activity is trying to gauge their impact on EUR/USD and USD/JPY. While the recent easing abroad has been positive for the USD and driven risk-taking via USD/JPY flows into energies and equities, a strong USD would obviously be bearish for oil over a longer horizon.
However, given the Fed’s increasing interest in keeping a harness on USD strength and the market’s belief that the Fed is more likely to ease over the next nine months than tighten, we don’t see very high odds of the dollar reemerging as an overwhelmingly bearish influence on crude oil in the coming months. In a potential signal of the Fed’s next effort to talk down the USD, Cleveland Fed president Loretta Meester gave a speech this week suggesting that helicopter money “would be sort of the next step if we ever found ourselves in a situation where we wanted to be more accomodative.” It’s hard for us to imagine a runaway USD if Fed officials continue to discuss helicopter money in this fashion.
Bearish DOE’s spark another round of selling
• Declines in U.S. crude stocks and PADD IB mogas stocks were the only two somewhat positive components of an otherwise disappointing round of EIA stats
• Most notably, U.S. refiner inputs reported a seasonally abnormal w/w decline as multi year lows in margins continue to take their toll. Total inputs at 16.54m bpd represent a 3yr seasonal low in demand.
• Overall mogas stocks also suffered a seasonally surprising build of 1.2m bpd suggesting to us that refiners have a lot more slowing down to do before margins can recover
U.S. crude stocks fell 2.54m bbls w/w and are higher y/y by 13 percent. PADD II stocks added 500k bbls (+8 percent y/y) and PADD III stocks dropped by 1.6m bbls (+17 percent y/y.) Changes in PADD II and PADD III inventories were largely driven by import volumes which increased by 230k bpd in PADD II and decreased by 751k bpd in PADD III. Overall imports at 7.84m bpd (down 522k bpd w/w) are higher by 11 percent y/y over the last four weeks. Stocks in the Cushing hub fell by 232k bbls to 63.9m bbls and production jumped to 8.49m bpd due entirely to Alaskan output.
Poor margins continued to take their toll in refiner inputs with overall demand dropping by 143k bpd to 16.54m bpd. On a regional basis the east coast and Midwest were the hardest hit with w/w drops of 88k bpd and 90k bpd, respectively. As of Wednesday afternoon prints in the RBOB/brent crack at $11.70/bbl, WTI 321 crack at $13/bbl and gasoil brent crack $9/bbk all represented multi-year lows.
A seasonally abnormal build in U.S. mogas stocks was another bearish component of this week’s stats. On a regional basis PADD II added 540k bbls, PADD V added 760k bbls and PADD III stocks fell by 514k bbls. PADD IB stocks fell by 500k bbls but are still higher y/y by 29 percent. Overall stocks are higher y/y by 10 percent. Domestic mogas demand fell for the 2nd time in 3 weeks to 9.67m bpd and is higher y/y by 1.6 percent over the last month.
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Distillates also did their part in adding to the bearish DOE report with an overall inventory build of 4m bbls with +1m bbl additions in PADDs I, II and III. Overall stocks are higher y/y by 8 percent and PADD IB stocks are higher y/y by 19 percent following a 934k bbl w/w build. Domestic distillate demand fell by an alarming 727k bpd w/w to 3.2m bpd bringing overall to demand to 4.5m bpd for its worst seasonal level since 2012.
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Profit taking lifts spreads despite bearish news flow
WTI U16/Z16 and Brent U16/Z16 moved sharply lower to begin the week (low prints of -2.17 and -1.97, respectively) before profit taking from funds and trade groups eventually moved spreads higher. For flows, the most notable development of the week in our view was a massive liquidation of WTI CSO puts on Tuesday with nearly 34,000 contracts of open interest eliminated on -100, -75 and -50 strikes from 4Q’16 through 1H’17. We’re interpreting this as one component of smart money taking profits following the sharp selloff that spreads have experienced over the last six weeks.
Oversupply of crude oil and refined products in addition to the weak demand outlook from refiners on a global level kept pressure on spreads this week and helped limit their Tuesday-Wednesday relief rally. In the U.S. the flattening rig count, glut of crude oil from Chicago to Houston and massive oversupply of gasoline on the east coast remained as major concerns. In Brent, weak refiner demand in Europe and China in addition to elevated OPEC output persisted as bearish inputs. Evidence of cooperation towards opening long-shuttered export terminals in Libya and a quickly resolved labor strike in Nigeria also added pressure to spreads.
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By SCS Commodities Corp.
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