Prospects For The Oil Market - What Is Market Structure Telling Us As We Head Into 2016?
Summary
- Market close to December 2008 lows.
- Term structure.
- Refining spreads.
- Quality/location spreads.
- Divergence with XLE.
It has been a rough year for the energy markets in 2015. Crude oil opened in January of this year at over $50 per barrel on the active month NYMEX crude oil futures contract. There was some wild volatility in the oil market throughout the year. Crude oil got down to $42.03 in March and then rallied for two months, in a straight line, to highs of over $62.50 per barrel. Selling then returned to the market and by August 24, the price made a new low at $37.75. The new low brought buying back to the energy commodity and it quickly reversed and appreciated to just over $50 by the first week of October. Since then, the price turned south again, making yet another new multiyear low at $33.98 per barrel at the end of December.
Market close to December 2008 lows
On Thursday, December 24, the price of active month February NYMEX crude oil futures settled at $38.10 per barrel. While the price traded only $1.50 above the December 2008 lows early last week, it closed slightly higher but remained below the $40 level.
High levels of global inventories and a continuation of output from OPEC, Russia and the United States continues to weigh on price. Although rig counts in the United States have fallen to 538 in operation as of December 23, a decrease of 961 rigs from the prior year, U.S. production continues to be strong. One of the reasons that crude oil bounced last week was an unexpected drawdown of 6 million barrels in the U.S. as reported by the Energy Information Administration last Wednesday. This drawdown may have been window dressing for year-end as oil companies seek to reduce state tax liability in some storage areas. The bottom line is that the price of crude oil remains close to the lows and key support dating back to 2008. 
Those 2008 lows were the lowest price since early 2004. As we head into the New Year, there are many projections out there as to what the price of crude oil, perhaps the most important and closely watched commodity, will do next year. After all, the price of crude oil is extremely important when it comes to the direction of the stock market, so many oil related companies are in indices that serve as benchmarks for equity prices.
Meanwhile, the price of crude oil is so much more than a simple number on the screen. Most investors and traders watch the daily gyrations in the price of crude oil. The nominal level of the energy commodity, reported each day in the press, is only a small part of the story for oil. When it comes to price forecasting, market structure in crude is an important tool in understanding the ever-changing fundamental state of the market.
Term Structure
One of the most important indicators of market direction in crude oil is term structure or the shape of the forward curve. When deferred prices are below nearby prices, a condition of backwardation exists. This tells is that the market is tight, that demand is greater than supplies in the short-term. When deferred prices are above nearby prices, a condition of contango exists. In this situation, there are plenty of nearby supplies ample to satisfy demand. The later is the case in the crude oil market today.
The contango in crude oil spreads has been making higher highs and higher lows over the course of 2015. The level of these spreads is highly sensitive to movements in underlying price. Most of the time, the spread follows price but sometimes, the opposite occurs and 'the tail wags the dog'. When this happens, it often signals a coming shift in fundamentals for crude oil and other commodities as the forward curve is an important indicator for all raw material markets. The daily chart of the February 2016 versus February 2017 NYMEX crude oil chart shows the price action in the forward curve dating back to 2014. 
As you can see from the chart, this one-year spread was in a state of backwardation throughout much of 2014 and when the price of oil started to fall it shifted to contango. Since then, it has been making a series of higher lows and higher highs. The most recent high came on December 11 when crude oil was heading to new lows. The spread peaked at $8.11 per barrel, which equates to a contango of around 22%. The spread closed last Thursday at $6.66 per barrel. This ominous level implies a contango of 17.5%. These are very high levels of contango considering that one-year interest rates are a fraction of the current contango. The cost of storing oil has increased as the price has decreased because traders entered into cash and carry trades where they buy nearby oil, put it in storage and finance the energy commodity. If the total cost of financing, storage and insurance is less than the contango, they lock in a profit.
Contango is a sign of ample supply in a market. Even though crude oil contango has moved lower over recent weeks, the level on a percentage basis reflects a market in oversupply. This continues to be bearish for the price of the crude. Keep in mind that term structure is often very volatile as the price of these spreads move dramatically on a percentage basis over time.
Refining Spreads
Consumers do not buy raw crude oil; they buy gasoline, heating oil, diesel fuel, jet fuel and other petroleum products. When an oil refinery processes crude oil into these products there is a margin between the price of the input, crude oil, and the price of the resulting oil product. This margin is the crack spread. Crack spreads are real-time indicators for the profitability of those companies involved in the refining of crude oil into oil products. The higher the level of the spreads, the more profitable refining is and vice versa.
We can glean many important fundamental signals from these refining spreads. When they move higher, it signals increasing demand and falling inventories of oil products. When they move lower, the converse is often the case. The price action in refining or crack spreads often translates to buying or selling in the ultimate input, crude oil itself.
We are now in the winter season. Seasonality plays a role in the price of crack spreads. During the spring and fall, gasoline crack spreads tend to move higher. Demand for gasoline increases and peaks during the heart of driving season, which is the summer vacation period in the U.S. The monthly chart of the gasoline crack spread shows the price action over recent years in this refining spread. 
As the pictorial highlights, the February gasoline crack spread settled at the $15.42 per barrel level last Thursday. This is a strong level for the spread. In December 2014, it only reached highs of $11.40. In December 2013, the highs were a touch over $20. I attribute the mild strength in the gasoline refining spread to three factors. First, the price of gasoline has dropped to under the $1.30 per gallon wholesale level. Considering that gasoline was over $3 per gallon wholesale a year and a half ago, cheaper gasoline is resulting in drivers putting more mileage on their cars. The second factor is that it has been a very warm late fall and early winter across the most populous regions of the United States. The lack of snow and ice and great weather has caused an increase in driving during recent weeks. Finally, refineries tend to make more heating oil during the weeks and months before winter. When they refine more heating oil, they make less gasoline. Therefore, demand for gasoline has been unusually strong during a period of the year when inventories are at their lowest levels. The action in gasoline crack spread is moderately positive for the price of crude oil at its current level.
The price action in the refining spread for heating oil is a very different story. Heating oil futures also serve as a proxy for diesel fuel since the characteristics of the oil products are similar. Therefore, there tends to be less seasonality in heating oil than in gasoline crack spreads. 
The monthly chart of the NYMEX active month heating oil crack spread shows that it settled at $9.79 per barrel last Thursday. This is the lowest level for this processing spread since August 2010. Moreover, the last time that the heating oil crack spread traded this low in December was in 2009 when it made lows of $8.21 per barrel. In December 2014, this spread traded to lows of $21.91, in December 2013, the low was $26.86 and in December 2012, its nadir was $35.21. As you can see, the heating oil crack spread is trading at a very low level even though the nominal price of the oil product is at the lowest level in years, closing last week at under $1.15 per gallon wholesale. High levels of inventories and warm weather have caused these multiyear lows in the price of heating oil and the level of the crack spread. While the gasoline processing spread is mildly supportive for the price of crude oil, the heating oil crack negates that support and overall the signal from refining spreads is negative for the price of crude oil at this time.
Quality/Location Spreads
Price differentials between the same commodity that are of different grades/quality or at different locations can tell us a great deal about supply and demand. The most important quality/location spread in the world of crude oil is the price differential between Brent crude and West Texas Intermediate crude. The later trades on the New York Mercantile Exchange and is the delivery grade for the NYMEX futures contract. Brent is the pricing mechanism for crudes that emanate from Europe, Africa and the Middle East. WTI is the pricing mechanism for North American crudes.
Brent crude has higher sulfur content than WTI crude, the later is sweeter crude. This means that it is cheaper and easier to refine WTI into gasoline while Brent is a better solution for heating oil, diesel fuel and some other refined products.
Over the past forty years, WTI has typically traded at a premium of between $2-4 to Brent crude, as gasoline is a more ubiquitous oil product. However, in late 2010 and early 2011, the Arab Spring that brought sweeping political change to the Middle East increased the political premium for Brent crude. In 2011 and 2012, Brent crude rose to a $25 premium to WTI as fears related to supplies and logistical routes through waterways like the Straits of Hormuz and Persian Gulf caused worries about securing oil from the region. Since the price of oil began to drop in the second half of 2014, the Brent premium over WTI has moved progressively lower. The deal with Iran put additional pressure on Brent crude oil prices as the nation has stated they intend to increase production by one million barrels per day in 2016. Additionally, in the latest U.S. budget deal, the government lifted the ban on U.S. oil exports meaning that inventories of WTI are likely to start to drop in the year ahead. This has provided some strength to WTI crude relative to Brent.
Last week, the Brent premium over WTI crude turned into a discount for the first time in years as it head towards historically normal levels. On Thursday, February Brent crude oil futures were trading at a 23-cent discount to the price of February NYMEX crude oil futures. Brent moving to a discount to WTI is bearish for the price of the energy commodity in two senses. First, it highlights the high levels of inventories and production from Middle Eastern nations and Russia. Secondly, it means that the political premium for crude oil has decreased dramatically. Therefore, the signal from this quality and location spread is bearish for the price of crude oil as we head into 2016.
Divergence with XLE
While all fundamental signals continue to point to lower prices for crude oil, the Energy Select Sector SPDR (XLE) has outperformed the price of crude oil. 
XLE closed last Thursday at $61.57 per share. It got down to lows of $58.21, which is just below the August lows and recovered. However, crude oil remains right around those August lows. At $38 per barrel, with the price of Brent dropping relative to WTI, contango wide, and heating oil crack spreads at the lowest level in years, XLE remains relatively strong. Consider this; crude oil is at the lowest level since February 2009. At that time, XLE was trading in a range between $40.28 and $50.77. At over $60, the energy companies that comprise XLE have yet to feel the effects of lower revenues due to lower prices. Perhaps hedges have helped them out. Perhaps memories of big rallies off recent lows in March and September have kept them from keeping pace with the price of oil. The bottom line is that there is a divergence between XLE and the price of oil as we move into 2016. The longer oil stays below the $40 level or if it makes another new low, things could get very ugly for oil companies and XLE could catch up quickly. I believe that this is one of the most important divergences going on in markets today. A pairs trade, crude oil versus the XLE could present an excellent opportunity for the beginning of 2016.
Meanwhile, market structure in the global crude oil market continues to show few positive signs. Keep your eyes on market structure, as it will alert you to fundamental changes in crude oil throughout 2016. Also, remember that the political premium on crude oil is now at the lowest level in years. With over half of the world's reserves in the Middle East, this is surprising considering the turbulent nature of the region. While the price of oil is likely to continue to trickle lower due to increasing output and growing inventories, price shocks in the New Year are most certainly on the upside. Any increase in tensions in the Middle East will reverberate through the oil market. The lower the price of crude oil falls, the more potential there is that we will wake up one morning and see a price on the screen that makes us do a double take. Next week I will publish my quarterly/annual report on crude oil and energy as well as on other commodity markets on Seeking Alpha.
As a bonus, I have prepared a video on my website Commodix that provides a more in-depth and detailed analysis on crude oil to illustrate the real value implications and opportunities.
This article was written by
Andy spent nearly 35 years on Wall Street, including two decades on the trading desk of Phillip Brothers, which became Salomon Brothers and ultimately part of Citigroup.
Over the past two decades, he has researched, structured and executed some of the largest trades ever made, involving massive quantities of precious metals and bulk commodities.Andy understands the market in a way many traders can’t imagine. He’s booked vessels, armored cars, and trains to transport and store a broad range of commodities. And he’s worked directly with The United Nations and the legendary trading group Phibro.
Today, Andy remains in close contact with sources around the world and his network of traders.
“I have a vast Rolodex of information in my head… so many bull and bear markets. When something happens, I don’t have to think. I just react. History does tend to repeat itself over and over.”
His friends and mentors include highly regarded energy and precious metals traders, supply line specialists and international shipping companies that give him vast insight into the market.
Andy’s writing and analysis are on many market-based websites including CQG. Andy lectures at colleges and Universities. He also contributes to Traders Magazine. He consults for companies involved in producing and consuming commodities. Andy’s first book How to Make Money with Commodities, published by McGraw-Hill was released in 2013 and has received excellent reviews. Andy held a Series 3 and Series 30 license from the National Futures Association and a collaborator and strategist with hedge funds. Andy is the commodity expert for the website about.com and blogs on his own site dynamiccommodities.com. He is a frequent contributor on Stock News- https://stocknews.com/authors/?author=andrew-hecht
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.