Crude Is Rude

by: Andrew Hecht


Contango is huge.

EIA and API reports conflict and Baker Hughes says less rigs.

OPEC comments still affect price.

Refining spreads say demand is weak.

The one-way street has been bad news for equities.

Crude oil was a wild ride last week. Early in the week the price headed south; by Wednesday, the energy commodity made new contract lows when it fell below $27.56 per barrel on the active month NYMEX futures contract. On Thursday, crude was downright rude when it fell to the lowest level since May 2003 at $26.05. The price bounced hard after that low and on Friday, crude exploded higher. The relief rally did not come as a surprise; the market had gotten itself very short. Open interest rose to over 1.88 million contracts during the week, a historical high. A short-covering rally was certainly in order as speculative positions covered, many with a profitable result. Friday's rally was fierce; crude oil peaked at $29.66 - $3.61 or almost 14% above the lows of less than one day before. Crude oil closed the week at $29.44 on the active month March NYMEX futures contract. However, the rally was not enough to cause crude to close positive on the week. Alas, it fell by $1.45 on the week by the time futures settled on Friday afternoon. Daily historical volatility exploded on the market action; it closed the week at over 95%, a reminder of the danger and treacherous trading conditions in this market.

Meanwhile, despite the recovery on the last day of the week, the same issues that confront crude oil and continue to drive it to new lows remain intact. Supply is enormous and that is a fact that is not changing any time soon.

Contango is huge

Term structure in crude oil continues to put a spotlight on the issue that has caused the bear market in the commodity. The fundamental equation remains tilted in favor of supply. That supply continues to grow as the price falls and contango, the premium of oil for deferred delivery over nearby delivery, continues to rise.

The daily chart of the NYMEX crude oil March 2016 versus March 2017 futures spread illustrates that this one-year contango peaked on Thursday at $12.01 per barrel. That means that the cost of carrying crude oil for one year on Thursday amounted to an astonishing 45.8%. As of the close of business on Friday, contango fell to $11.77 or 40%, a level that still reflects massive oversupply.

The Brent crude oil one year, April 2016-April 2017 spread closed last Thursday at $8.15 or 27%. The differential between contango in WTI and Brent arises from a continuation of huge U.S. production and rumors about OPEC production cuts. Brent is the benchmark pricing mechanism for Middle Eastern crudes. As such, it is possible that lower Brent contango at least partially reflects the political risk in the region.

EIA and API reports conflict and Baker Hughes says less rigs

Early last week, the Energy Information Administration reported that the global oil glut is even bigger than expected with 250,000 barrels of additional daily output. The American Petroleum Institute reported an increase in inventories of 2.4 million barrels of crude oil for the week of February 5 with total inventories rising to 503.4 million barrels; this sent prices lower. However, the Energy Information Administration later reported that inventories fell by 800,000 barrels as of February 5, contributing to the volatility in the crude oil market. Regardless of the weekly figures, crude oil supplies continue to be massive in the U.S. and around the world.

Friday's strength in crude came as the latest report from Baker Hughes said that oil rigs in operation in the U.S. fell by 28 last week to 439 in operation. This is 617 less than last year. U.S. production remains at around 9.2 million barrels per day. Lower rig counts will eventually translate to lower daily output in the U.S., but the lag has taken a lot longer than many analysts expected. Oil production continues to flow in the U.S. depressing price. When it comes to the rest of the world, OPEC nations and Russia continue to pump.

OPEC comments still affect price

Comments out of the UAE, whose oil minister said they would cut production if everyone else does, sparked Friday's rally. The problem with the statement from the UAE is that Iran is not likely to cut production as they have stated on many occasions that it is their "sovereign right" to sell as much crude as they wish. The only way that Iran will agree to a cut is if pressure from the Russians and the rest of OPEC becomes intense. That is only likely to happen at even lower prices.

Over recent weeks, any whiff of even the consideration of a cut in production from the oil cartel has caused volatility in the oil market. OPEC remains at odds within itself. The poorer nations continue to lobby for a production cut. Venezuela already suffers the highest rate of inflation in the world due to the fall in the price of crude oil. Nigeria, Angola, Ecuador and Algeria continue to suffer. Even the richer members have had to tighten belts. However, at the top of the oil chain within the organization, Saudi Arabia and their allies continue to be at odds with Iran on every issue from oil to Syria and Yemen. The divide within the cartel transcends the economics and political, and religious divisions are the root of hatred and mistrust that is deeply ingrained. Therefore, it is unlikely that the cartel will ever agree on anything without the influence of the Russians at this point. Meanwhile, the lower the price slips, the more member nations need to sell to capture revenues.

As the price of oil continues to make lower lows and lower highs, OPEC rhetoric is likely to continue to cause price movement in a market that is volatile and hungry for news on a daily basis. However, only a change in OPEC policy and agreement amongst members will have a lasting impact on price.

Refining spreads say demand is weak

On the demand side of the fundamental equation for oil, product prices have followed raw crude oil lower. At the end of last week, the price of heating oil and gasoline was just above the $1.00 per gallon level. What is good news for consumers at the gasoline pump and for those who heat their homes is not so great for refiners as margins are lower than last year at this time. The profitability of a refinery depends upon its ability to buy crude oil and sell products at an attractive relative margin. Refineries crack raw crude into products - it is the crack spread that determines their economic results.

The weekly chart of the gasoline crack spread highlights the differential in this important processing spread from early February 2015. The active month March NYMEX RBOB gasoline crack spread closed last Friday at around $14.34 per barrel. During the same time last year, the same spread was at around the $15.50 level. In what could be a positive sign for the weeks ahead, the weekly chart highlights a key-reversal trading pattern last week. The gasoline crack spread made a lower low than the previous week and then closed above its highs. This could mean that the gasoline refining spread is in for more gains in the weeks ahead. Last year, this spread rallied all the way up to $33.75 per barrel by the end of February.

The picture for heating oil is not as positive as it is for gasoline at this time. While the crack spread has rallied from multi-year lows at $8.06 per barrel in mid-January, it remains at half the level it was trading at last year at this time. The weekly chart of the NYMEX heating oil crack spread shows that it closed last week at around $15.50 per barrel. Last year at this time, the price was at the $30 per barrel level. While an overall warm winter across the United States decreased demand for heating oil, this crack spread also represents the economics for the production of diesel fuel, a year-round oil product. The low level of the crack spread this year is a reflection of slow economic activity.

The one-way street has been bad news for equities

The stock market in the U.S. has been following the price of crude oil like a little puppy in 2016. On Thursday, as crude oil moved to new lows, the Dow Jones Industrial Average sank over 250 points. On Friday, the recovery in oil sparked a 300-point rally.

Overall, lower oil has been bad news for the stock market. Even if the oil price finds a level and goes to sleep, stocks are likely to show further weakness. There are so many oil-related companies in major equity indices in the U.S. that contagion from the "new" price level in crude oil will take some getting used to. Additionally, many of these oil companies are the beneficiary of financing from banks and institutions around the world. With prices so low, it is a real stretch to think that they will be able to service debt loads. This is likely to lead to bankruptcies and write-offs for many banks. The contagion from oil is just another reason that equity prices will continue to be weak in 2016.

Finally, I find it a bit ironic that crude oil has totally divorced itself from the influence of the U.S. dollar over recent sessions. Since January 29, the dollar has moved 3.9% lower. A weak dollar is historically bullish for commodity prices. During the same period, the price of oil has declined by 12.4%. The decline would have been much worse had it not been for Friday's recovery rally in oil. The energy commodity is not alone in ignoring recent dollar weakness; other commodities such as copper and agricultural commodities have moved lower in spite of dollar weakness. Only precious metals have moved higher, which could be a sign of fear and flight to safe havens in market conditions that are volatile and problematic.

Crude has been on a one-way path lower since June 2014. After last Fridays' powerful rally, it remains below $30. There is certainly room for more of a recovery in the energy commodity and the current level of big speculative short positions could be just what the market needs to make that happen. Open interest stood at 1.876 million contracts on NYMEX crude oil futures as of the close of business last Friday. However, supply issues and product prices could be telling us that crude will continue to be rude and that we have not yet seen the lows.

As a bonus, I have prepared a video on my website Commodix that provides a more in-depth and detailed analysis on crude oil and other commodity markets to illustrate the real value implications and opportunities.

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.