Nothing bullish in crude | FT Alphaville

Nothing bullish in crude

Stephen Schork of the Schork report makes an excellent point regarding recent large US inventory crude draws.

As he explains, with reference to contango:

In other words, the market is paying you to build supplies by virtue of the discount on nearby material. If the recent run-up in price was based on real demand for wet barrels, then this discount would disappear, i.e. the market would be moving from contango toward backwardation. That is not the case at this time. Thus, the ongoing drawdown in U.S. crude oil supplies (outside of Cushing) is not demand driven, but rather a function of lower domestic production and fewer imports. In other words, refiners, as any good grocer would tell you, are aggressively emptying the shelves, as it were, of surplus material.

He goes on:

Thus, what is so bullish about the current string of crude oil draws in the U.S.?

Not much.

Which leads us to the conclusion that the current uplift in prices to about $65 per barrel is more likely the result of a little rational exuberance in connection with the equity stampede than a fundamental turnaround (yet again).

This is somewhat confirmed by Tuesday’s API data, which showed a reversion to large crude stockbuilds in the last week alongside further refinery run cuts, and a larger than expected build in gasoline stocks.

The point is that in the much longer term, yes,  fundamentally the view is bullish. In the shorter term, until we are on our way to definitive recovery, there’s nothing much fundamental supporting crude prices. This was well expressed by former US government adviser Philip Verleger last week when he predicted crude prices could even collapse to $20 per barrel this year. As Bloomberg reported:

“The economic situation is not getting better,” Verleger, 64, a professor at the University of Calgary and head of consultant PKVerleger LLC, said in a telephone interview yesterday. “Global refinery runs are going to be much lower in the fall. If the recession continues and it’s a warm winter, it’s going to be devastating.” 

“OPEC don’t realize the magnitude of the cuts they need to make,” which would total about a further 2 million barrels a day, Verleger added. “Storage is going to become tight. It’s not clear if there’s going to be enough storage available.”

We would be cautious on being quite so bearish (bar another financial meltdown), but we do understand where Verleger is coming from. The two key aspects he raises in our view are a) beware the end of driving season — if refineries are already cutting runs what’s it going to be like come September — and b) beware the flattening of the curve.

To explain the curve issue: if contango is generally the reflection of a well supplied market with the side-effect that the incentive to stockpile underpins short-term prices, and backwardation is the reflection of an undersupplied market, with side-effect that spot demand supports short-term prices — what’s the worst possible scenario for the current market?

Well, we guess that would be the rather rarer phenomenon of a mostly flat curve either on a lengthy transition towards backwardation or the prolonged stagnation of the light-sweet crude market especially in light of most global demand now stemming from Asia– something definitely manifesting itself via the premium currently appearing in the market for sour crudes like Russian urals, a reflection of the tightening in supply of Middle Eastern sour crudes.

As Reuters reports, the fact the market is happy to pay more for Russian crude than for Brent is highly unusual. Brent is a much better grade. Accordingly, this has to be reflective of an oversupply of light sweet crudes in the marketplace.

Meanwhile, if you compare the DME Oman front-month prices — the best representation for Middle Eastern crudes — with that of the Nymex WTI prices, you’ll see not only are the two grades trading at their narrowest differential for a very long while (see chart below courtesy of the DME), you’ll also note the Oman curve is currently trading much flatter than the WTI curve. The Oman curve was even backwardated earlier this week. As JBC Energy note on the phenomenon:

In Asia, Dubai took a step back, falling by around $1 per barrel. The crude, which had been in persistent backwardation in contrast to Western benchmarks, flipped into contango on Monday and the Dubai 1st Mth/2nd Mth spread was last seen at -65 cents per barrel. The weaker market for prompt Dubai has also brought Brent back to its usual premium over Dubai.

The Brent/Dubai cash spread was last seen slightly over $2 per barrel according to Platts, the highest level since mid-April, while the Brent/Dubai EFS has also returned to positive territory at 95 cents per barrel. Part of the reason behind Dubai’s sudden weakening could be realignment with fundamentals although Dow Jones quoted some traders mentioning short-covering and hedging as contributing factors. In any case, the Brent/Dubai spread has already encouraged considerable flows of Brent-related crude including medium-sour Urals to head East of Suez. 

(Click to enlarge)

DME Oman prices vs global crudes - DME

Any reversion to DME Oman backwardation should therefore be closely watched.

Related links:
Demand is in the toilet
– FT Alphaville
Commodities correction
– FT Alphaville