The energy sector posted a small loss during the third quarter of 2018 because of a downdraft in the price of ethanol futures.
In 2014, the energy composite fell by 36.59% due to the swoon in crude oil, petroleum product, and natural gas prices. A composite of energy commodities fell 25.14% in 2015 making it the worst performing sector of the year.
The energy sector finished 2016 42.57% higher than it was on December 31, 2015. In 2017 the sector moved 3.35% higher adding to gains. In Q1, energy commodities continued on their bullish path adding another 4.02% on the upside for the first three months of 2018. In Q2, energy posted an 8.21% gain, and in Q3 a minor loss of just 0.15%. Energy commodities were 12.24% higher over the first nine months of 2018. Crude oil continued to rally despite a strong dollar as worldwide demand increased. OPEC increased production at their most recent June 22 meeting, but the output hike was lower than the market had expected leading to new highs in the NYMEX crude oil futures market. At the most recent unofficial meeting in Algeria in late September, the cartel told markets that their customers would guide their production policy despite pressure from U.S. President Donald Trump for OPEC to pump up their output and control prices. A continuation of robust economic growth in the United States and around the world helped to boost the price of oil. Additionally, tax and regulatory reforms in the U.S. has increased company earnings, individual discretionary spending, and the demand for energy.
The ongoing proxy war in the Middle East between Iran and Saudi Arabia continue to support the price of crude oil as half the world’s reserves are located in the region. The decertification of the Iran nuclear nonproliferation agreement by the U.S. added another layer of tension to the area. In November, new sanctions on Iran could add to volatility in the energy sector. Ethanol prices dragged down the rest of the energy sector because of lower grain prices caused by the ongoing trade dispute between the U.S. and China.
In the natural gas market, the injection season began in Q2 and will end during Q4 sometime in November. Inventories in natural gas remain below last year’s level and the five-year average. When it comes to ethanol, higher gasoline and lower corn prices provided pulled the biofuel in opposite directions over the past three months, but grain prices dominated price action in the ethanol futures market. Trade issues did little to stop the rally in crude oil, but in the coming months, an escalation of trade tensions and the potential of the trade war could cause recessionary pressures to mount which would weigh on the price of energy products. On the other hand, the rising potential for turbulence in the Middle East will continue to support the price of crude oil. Energy commodities power our lives, and economic growth means more consumption of the products that we often take for granted. The price of crude oil is going into the final quarter of 2018 at close to the highest price since 2014 while natural gas is sitting at the top end of its trading range at the $3 per MMBtu level. Ethanol is trading at historical lows in the futures market.
Crude Oil Review
The price of crude oil remained strong despite a firm dollar, trade issues, and pressure on other commodities prices. At the beginning of Q3, the price of the energy commodity continued to climb, reaching a high of $75.27 per barrel on the active month NYMEX futures contract during the week of July 2. Meanwhile, the price of nearby Brent crude oil futures reached a peak of $83.39 per barrel at the end of the third quarter as November futures rolled to December on the final day of Q3.
NYMEX light sweet crude oil was down 30.47% in 2015 after falling by 43.31% in 2014. In 2016, oil gained 45.03% on the year. In 2017, NYMEX crude oil gained 12.47%. A gain of 7.48% in Q1 of 2018 kept the bullish party going. In Q2, NYMEX light futures posted a 14.18% gain and in Q3 it fell only 1.21%. The energy commodity that trades on NYMEX was 21.23% higher for the first nine months of 2018. The nearby November futures contract settled at $73.25 per barrel on September 28 near the highest price of the year.
NYMEX continuous contract crude oil futures traded to its most recent high at $75.27 per barrel in early July. The range for the first nine months of 2018 was from $58.07 on the lows to $75.27 per barrel on the highs.
The weekly chart illustrates the rising price of NYMEX crude oil in 2018. Early in 2018, crude oil rose above the May 2015 high at $62.58 which was technical resistance for the NYMEX futures. That level has become critical technical support in WTI crude oil. Price momentum crossed to the upside on the weekly chart in September and the nearby November futures contract rose to a new contract high. Crude oil was trading close to the high of the year, and the highest level since 2014 at the end of the third quarter with technical metrics on the weekly chart pointing higher.
Crude oil production in the United States rose quickly as the price moved above the $50 per barrel level. Technological improvements such as horizontal drilling and fracking have given producers the ability to turn production on and off quickly to respond to price changes in the market. The EIA forecasted that U.S. output should rise to the 11.4 million barrel per day level in 2019. Rig counts (as reported weekly by Baker Hughes) had been falling precipitously with crude oil in 2015-2016, but the move higher caused the number of rigs in operation to rebound dramatically. Rig counts stabilized over the past three months and stood at 863 as of September 28, 2018, only 5 higher than at the end of Q2, but 113 above last year’s level at the end of Q3.
One of the reasons for the ascent of crude oil’s price over recent months has been a steady improvement in the global economy. A combination of optimism and economic growth have increased demand for the energy commodity has caused more consumption of oil-based products. Another reason for strength in the price of crude oil has been the growing tension between Saudi Arabia and Iran. While both are members of OPEC, they are nations at war in the region and arch-enemies. In Q2, the Trump Administration refused to recertify the Iran nuclear nonproliferation agreement and imposed new and stricter sanctions on the theocracy in Teheran adding to tensions in the Middle East. With half the world’s oil reserves in the region, the move increased the risk premium for the energy commodity. In November, those sanctions will take effect and begin to bite the Iranian economy. Iran has told the world that they will not stand by idly while the U.S. imposes its sanctions on the theocracy.
The Strait of Hormuz is a narrow seaway that separates the Persian Gulf from the Gulf of Oman. While 2.7 million barrels of Iranian oil exports flow through the Strait each day, a total of 19 million barrels heading for consumption points around the globe flow through the seaway which represents 20% of the world’s daily demand. President Rouhani of Iran has said that if sanctions prevent Iranian exports, the theocracy will make sure that shipments from other oil producing nations in the Middle East would not flow smoothly to their destinations. The Strait of Hormuz could become a hub of international concern over the coming weeks and months. Any increase in hostile actions in the Middle East that impact production, refining, or logistical routes like the Strait of Hormuz could cause availability problems around the world. If the Strait becomes a focal point, we could see a military buildup in the area which would raise the political temperature in the region.
Meanwhile, the Saudis suspended their plans for an IPO of Aramco, the state oil company, during Q3. While the Crown Prince of Saudi Arabia had hoped for a valuation of what would be the world’s leading oil company in the neighborhood of $1 to $2 trillion, it became clear that the international market did not value the company anywhere near that level. The Saudis decided that the valuation was too low and abandoned their IPO strategy until the market is willing to pay a higher price.
The three dominant oil producers in the world are the Saudis, Russians, and the United States. It is in the best interest of all three nations for the oil price to remain strong. At over $70 on WTI crude and $80 on Brent, the Russians receive a stable revenue flow, U.S. production flourishes, and the Saudis are printing money. In the aftermath of the recent gathering in Algeria, the Saudis and Russia wish to continue to keep upside pressure on the energy commodity despite President Trumps wishes and threats.
The Middle East is a region that always has the potential for issues. Any increase in tension in the Middle East is likely to impact the price of crude oil quickly. The conflict between the Saudis and Iranians is now on five fronts. The front lines of war, if it breaks out, could be in Yemen, Qatar, Lebanon, Iran, or Saudi Arabia. Moreover, Libya and Iraq could also become battlegrounds between the kingdom and theocracy if the conflict continues to escalate. The potential for hostilities in the Middle East has kept a bid under the price of crude oil as there is a growing potential for price spikes if production, refining, or logistical routes in the area become targets in coming weeks and months. The two sides each have powerful backing as the U.S. stands with KSA and Russia is behind Iran. The fourth quarter has the potential to become a highly volatile period in the crude oil market.
Brent crude oil fell 34.97% in 2015, and in 2016 it rallied by 49.87%. In 2017 outperformed WTI and moved 19.69% higher on the year. In Q1, Brent posted a 3.69% gain for the three-month period. In Q2, it moved 14.26% higher, in Q3 while WTI moved 1.21% lower, Brent posted a 4.35% gain for the three-month period. As of September 28, Brent crude has moved 23.64% higher over the first nine months of 2018. December Brent futures closed on September 28 at $82.68 per barrel. Brent traded in a range from $61.76 to $83.39 over the first nine months of 2018 and closed the third quarter ear the highs of the year.
Brent's premium to WTI increased to the $9.45 per barrel basis the December contracts up $2.68 per barrel over the three-month period. The Brent premium traded to the highest level since May 2015 at $11.55 per barrel on May 31.
The dollar is the reserve currency of the world and is the benchmark pricing mechanism for crude oil. There is a long-term inverse correlation between the value of the U.S. dollar and commodities prices, and crude oil is no exception. One of the most bullish signs for the demand of the energy commodity over Q2 and Q3 was the price strength in the face of a rising dollar. The dollar index moved 0.41% higher in Q3, and it was 3.17% higher over the first nine months of the year compared to its December 2017 closing level. Other commodities prices in the precious and base metals sector fell in response to the stronger dollar, but crude oil prices ignored the greenback and continued to display strength.
Crude oil closed the third quarter of 2018 on the highs in Brent and close to the peak for the year in the WTI futures market. There are lots of supportive factors for the energy commodity as we move into the final quarter of the year, but trade issues and the potential of recessionary pressures are a reason to be cautious about the current prospects for the price of oil. Any risk-off period in markets triggered by the rising threat of a trade war could cause selling in the crude oil market. Additionally, the continued requests by President Trump for the Saudis and other U.S. allies in the Middle East to pump up their output has the potential to impact prices in the weeks ahead. Meanwhile, a solution to the saga of international trade that results in new agreements between the U.S. and China may trigger a period of increased optimism, and economic growth could lift the prices of all commodities including crude oil. At the same time, any issues that increase tension in the Middle East could set the stage for price spikes to the upside. Hostilities in the region could push nearby prices much higher. The last time we witnessed a surprise from the Middle East was in 1990 when Saddam Hussein marched into Kuwait. The price of nearby crude oil futures exploded higher on the potential for supply disruptions. The Strait of Hormuz could be a flashpoint and the hub of market concerns over the fourth quarter.
The price action in the crude oil market is bullish as we head into the final quarter of 2018, but there continue to be bullish and bearish factors in play which could make the coming weeks and months a volatile time in the energy commodity. All eyes will be on Iran and the Middle East over the coming weeks.
Oil Products Review
Oil products often reflect periods of seasonal demand, but they also provide significant clues about the price direction of crude oil which is the critical input when it comes to refining. RBOB gasoline tends to rally in the spring and summer, and heating oil or distillates tend to do best during late fall and winter. At the end of the third quarter of 2018, oil products followed their respective seasonal pattern.
Gasoline and heating oil futures moved in opposite directions in Q3 with a gain in heating oil futures and loss in gasoline. Refining margins weakened over the three-month period.
Gasoline was down by 13.66% in 2015 but rallied by 31.70% in 2016. Gasoline futures finished 2017 with a gain of 7.28% for the year. In the first quarter of 2018, gasoline moved 12.52% higher. In Q2, gasoline posted a 6.46% gain and in Q3 gasoline fell by 3.04%. Gasoline futures have moved 16.14% higher over the nine-month period compared with the price at the end of 2017.
As the weekly chart highlights, gasoline has traded in a range of $1.6519 per gallon to $2.2855 on the active month contract on the NYMEX over the past nine months. The price pattern on the weekly chart since early 2016 has been positive as gasoline has made higher lows and higher highs. Gasoline prices have been a supportive factor for the price of crude oil and a sign of a strong economy. Nearby futures closed on September 28, 2017, at $2.08570 per gallon wholesale. The bullish trend in gasoline remains intact, but the futures market now reflects price action and fundamentals during the off-season for demand for the fuel.
Heating oil was down by 38.71% in 2015 but rallied 53.88% higher in 2016. In 2017, the oil product gained 19.58%. In Q1, heating oil futures on NYMEX moved 2.28% lower as the winter season came to an end. In Q2, the rally in crude oil took the price of heating oil futures 9.34% higher. In Q3, heating oil futures gained 6.28% as the market moves towards the peak season for demand. Heating oil futures are a proxy for diesel and jet fuel as the oil products are all distillates and have similar characteristics. Heating oil futures have some seasonal features, but less than gasoline as jet, diesel, and other distillates are year-round fuels.
The weekly heating oil chart shows a constructive and bullish trend since early 2016. Heating oil took off to the upside starting in late June 2017 and had not looked back, but a seasonal dip took the oil product to lows in mid-February 2018, and after a correction from late-May through mid-July, the price turned higher at the end of the third quarter. Nearby heating oil futures closed on September 28 at $2.3485 per gallon wholesale. Heating oil traded in a range from $1.8084 to $2.3618 per gallon over the first nine months of 2018. Oil products continue to reflect the economic strength and robust demand for energy as both closed a lot closer to their highs than their lows for 2018 at the end of Q3. When it comes to refining spreads, seasonal factors drove processing margins as the driving season came to an end in early September and the heating season will begin in November and December.
Crack Spreads Review
Crack spreads reflect seasonal factors at the end of Q3. In 2016, the gasoline processing spread was down only 0.06%, and in 2017 it lost 8.88% of its value. In Q1 of this year, with the peak season for gasoline consumption on the horizon, the gasoline processing spread posted a 33.87% gain. However, in Q2, the spread declined by 20.88%. In Q3, the gasoline crack fell by 9.33%. The gasoline crack moved 3.97% lower at the end of Q3 from the closing level at the end of 2017.
As the weekly chart shows, the nearby NYMEX gasoline processing spread corrected from highs at the end of May, moving from $24.88 per barrel to under the $15 level. Meanwhile, the heating oil crack moved 83.66% higher in 2016 and 38% to the upside in 2017. In Q1, the spread that represents the economics of processing a barrel of crude oil into heating oil and distillate fuels declined by 23.83% as the winter season came to an end. In Q2, the selling continued in the distillate processing spread as it fell by 9.33%. Q3 markets a reversal for the spread as it appreciated by 38.39% over the three-month period making it 4.43% lower since the end of 2017.
The weekly pictorial of the heating oil refining spread illustrates that it closed Q3 at $25.27 per barrel. The heating oil crack spread had been under pressure since 2013, but the price action in 2016 and 2017 broke the pattern of lower highs. The processing spread between crude oil and distillates made a higher high in January at $27.25 per barrel and then a lower high in late May at $26.57. To keep the bullish pattern since early 2016 in place, the processing spread will need to hold the early July low at $16.34 per barrel level on the weekly chart.
Crack spreads are real-time indicators for the profitability of those companies that turn raw crude into oil products. Volatility in gasoline and heating oil crack spreads directly impacts earnings of those companies involved in refining oil.
Natural Gas Review
The price of natural gas dropped 32.88% in 2014 and was down 19.11% in 2015. In March of 2016, the price of the volatile energy commodity fell to the lowest level since 1998 at $1.611 per MMBtu. However, in a reversal of fortune natural gas exploded higher and posted a 60.21% gain in 2016. In 2017, gravity took the price of the energy commodity back down as bearish sentiment and ample supplies weighed on the natural gas futures market throughout the year. In 2017, natural gas futures lost a total of 21.13% of their value compared to the end of 2016. In Q1, the slide continued as the volatile futures market fell another 7.45%. However, in Q2 the price rebounded by 6.99%, and in Q3 the energy commodity posted a 2.87% gain. Natural gas is 1.86% higher so far in 2018 as of the end of Q3. Natural gas traded in a range from $2.53 to $3.661 over the course of the first nine months of the year and closed on September 28, at $3.008 per MMBtu on the nearby November futures contract. Natural gas did not make a new low nor a new high in the third quarter as the entire price range for the year occurred in Q1. However, during the final week of Q3, the price traded to a high of $3.111 per MMBtu.
The highs in natural gas came at the end of January when a combination of short-covering and cold weather took the price to a lower high at $3.661 per MMBtu. However, the rally quickly ran out of steam, and the energy commodity fell back below the $3 level. However, record production did not cause the price to drop as an increase in demand for power generation, and growing shipments of LNG supported the demand side of the fundamental equation for the natural gas market.
Inventories rose to all-time highs in 2015 when they surpassed 4 trillion cubic feet before the withdrawal season. In November 2016, stockpiles rose to a higher high and a new record at 4.047 tcf. At the start of the 2017/2018 withdrawal season stockpiles of natural gas reached a lower high at 3.79 tcf. As of September 21, stocks of natural gas stood at 2.768 trillion cubic feet, 20% below last year's level at that time and 18.3% below the five-year average. The withdrawal season began early last November and ended later than usual this spring. The price found a low at $2.53 per MMBtu in mid-February and has been climbing over the past months. Critical technical resistance in natural gas is at the $3.661 per MMBtu level, the February 2018 highs and support is at $2.53 the February 2018 low on the continuous futures contract. With only six to seven weeks remaining in the 2018 injection season, the futures contract has again been flirting with the $3 per MMBtu. The upward momentum of the price of crude oil is a supportive factor, and inventories below last year’s level and the five-year average have pushed the price up to the $3 per MMBtu level. Inventories will go into the winter season of 2018/2019 at the lowest level in many years. In 2014, the price of natural gas reached a high of just below $6.50 per MMBtu. At this time of the year in 2013, the amount of natural gas in storage was 617 billion cubic feet above the current level which could provide lots of support if the coming winter season turns out to be colder than average, and heating demand causes a significant drawdown in inventories from storage facilities around the United States.
The price range in natural gas has been from lows of $1.02 to highs of $15.65 per MMBtu since 1990. The twelve-year price on the forward curve is below $3.50 which sounds like a bargain and free call option in a commodity where the downside is limited to zero, just $3.008 below the closing price at the end of Q3. Natural gas enters Q4 after a series of challenges of the $3 per MMBtu level. The trend in the energy commodity is higher, but anything is possible in the volatile world of the natural gas futures market.
In the US, ethanol is a biofuel -- a product of corn. Lower corn prices have weighed on the biofuel which posted a 10.18% decline for the three-month period making it the worst performing energy commodity over the third quarter of 2018 and weighed on the overall results for the energy sector.
The bottom line on energy
Supply and demand fundamentals drive the prices of oil and gas markets, but they are also a high stakes geopolitical chess game. When it comes to oil, we are entering the final quarter of 2018 at the highest price since 2014 and the next level of technical resistance on the upside stands at over $100 per barrel. Economic growth is supportive of the price of oil, and the market remains tight based on the forward curves in both Brent and WTI futures markets with backwardations in both benchmark crude markets. The Middle East is a turbulent and potentially explosive region of the world. However, trade issues and the potential for a trade war create the potential for a risk-off period where the prices of all assets could move appreciably lower over the coming weeks and months.
When it comes to natural gas, the forward curve is telling us that the price of the energy commodity is going nowhere fast over the coming decades. The fact that the highest price on the forward curve out to 2030 is lower than the highs we witnessed at the end of January 2018 is a significant signal for the market. Massive reserves in the U.S. are weighing on prices as quadrillions of cubic feet of the energy commodity are enough to satisfy demand requirements for decades, if not centuries. However, the demand side of the fundamental equation for natural gas has been increasing, and the rising price of oil is likely to boost requirements for the fuel that is both less expensive and cleaner.
Meanwhile, production costs continue to drop putting pressure on prices. Natural gas finished the final month of Q3 with another attempt to move above the $3 per MMBtu level. All previous attempts over recent months have failed. However, the lows have been higher as the historically volatile natural gas market is reflecting the slow rate of injections and inventories that are significantly below both last year’s level and the five-year average for the end of the third quarter of 2018.
Another energy commodity to keep an eye on is the coal market. The last Administration in Washington DC attempted to put the coal market to sleep, but President Trump is supportive of clean coal production in the U.S. Over his term, the Administration worked hard to bring coal back from the obscurity that the previous administration policies had in mind for the coal market. However, over the course of the third quarter, international coal prices moved higher.
As the chart of the price of January coal futures for delivery in Rotterdam, the Netherlands shows, closed Q2 2018 at $93.85 per ton and moved higher to $101.75 at the end of Q3, a rise of 8.4% over the three-month period. The price of Rotterdam coal futures outperformed both crude oil and natural gas over the three-month period and was a sign of economic growth around the world. The January futures contract in coal continued to make higher lows and higher highs throughout the quarter that ended on Friday, September 28.
The energy sector always offers some of the most exciting and profitable opportunities. It may be that politics rather than economics will determine the price direction for oil over the final months of 2018 as the situation in the Middle East continues to threaten stability in the region. International trade is likely to continue to dominate the news cycle over the coming weeks and months. I expect lots of volatility in coming weeks and months, and it is likely that the news cycle will be a significant factor when it comes to the path of least resistance for prices. The risk of a spike to the upside has increased with the prospects of the sanctions on Iran that will commence in November. There is lots of room on the upside in crude oil as the next level of significant technical resistance stands at the June 2014 peak at $107.73 per barrel over $30 above the September 28 closing level on the nearby NYMEX futures contract.
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