It Was A Strange Week For Crude Oil

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Includes: BNO, DBO, DTO, DWT, NRGD, NRGO, NRGU, NRGZ, OIL, OILD, OILK, OILU, OILX, OLEM, OLO, SCO, SZO, UCO, USAI, USL, USO, USOD, USOI, USOU, UWT, WTID, WTIU, YGRN
by: QuandaryFX
Summary

The crude markets strongly switched into backwardation this week - on a day in which the price of crude actually fell.

The fundamental balance remains tight and is likely to tighten in the future, but price movements were Trump-driven this week.

As long as OPEC cuts continue, we are probably going to see prices of crude rise - the odds favor an upside trade in crude.

This previous week in crude markets was very unusual in that we saw backwardation enter the forward curve as well as a broad-based selloff in price. Specifically, at present the market is $0.14 per barrel in backwardation in the front month contract which is the largest level of backwardation seen since the inventory drawdown of mid-2018.

What is particularly unusual about the switch into backwardation is the fact that it came very suddenly (mostly in the course of a single day on Monday) and also occurred on a day in which the price of crude fell strongly. Backwardation normally signals fundamental tightness, but it appears that the timing of this key inflection point in the market data was masked by overarching macro level themes (namely Trump's trade war tweets).

It is my belief that this switch into backwardation shows strong underlying strength in the crude markets and investors looking to buy near the lows should consider entering soon. I believe that we are likely to see prices rally through the remainder of the year and that the best prices of the year are soon to get away from those sitting on the side in this trade.

Crude Fundamentals

The primary reason why I believe that crude oil is likely to rally through the remainder of the year rests upon the fundamental story which the market has told. Even though last week the EIA reported a build in inventories of 3 million barrels (which is contrary to the overarching seasonal draws seen throughout summer), the builds came on the heels of two months straight of incredibly strong draws as seen in the year-to-date balance.

At present, inventories are telling a very similar story to that of 2018 and 2017 - two years in which crude inventories witnessed a historic meltdown in inventories through this point in the year and each of those years saw crude rally through the next few months with the market pushing into backwardation.

If you're unfamiliar with the term, backwardation is the state in which the front month futures contracts are above the back month futures contracts and it indicates that supply is currently unable to keep up with demand in the prompt market in most situations (provided there is no seasonality in the curve). What is interesting about the present market is that the market is strongly imbalanced with supply lagging demand, but demand itself actually isn't that strong in the crude markets. The primary reason why supply is unable to meet demand is that imports are very weak right now due to ongoing OPEC cuts - this is causing the balance to see massive draws as crude is being pulled from inventories to satisfy ongoing demand. Let's walk through the four components of supply and demand to get a feel for where the balance (and therefore prices) are likely to be headed in the future.

Demand

Let's start with demand. On the demand front, most of this year has seen crude utilization substantially weak versus the five-year average with a strong rise seen in last week's reported figure.

The problem with refining utilization this year largely stems from the fact that there was a massive oversupply in gasoline stocks at the beginning of the year, which means that cracks have been weak, and it has been more economic to import gasoline than actually process it and ship it from a domestic refinery.

If this element was taken in isolation, we would potentially jump to the conclusion that crude oil is bearish since demand is weak. However, this cursory analysis omits the fact that the supply and demand balance is what really matters for a holistic assessment of market health as well as the fact that exports represent another large and growing chunk of demand.

While crude exports have been weaker over the last month due to effects of Hurricane Barry, they have consistently come in over the five-year average in basically every single week of the last two years (however, keep in mind that exports were legalized in early 2016 so the range isn't fully representative).

It seems that logistics constraints have cleared and the only limiting factor remains the differential between domestic prices of crude and international prices of crude. As long as the Brent-WTI spread remains elevated, crude oil exports are likely to continue to grow and flow for several years to come.

Supply

The supply side of the balance is where the story starts to get very interesting. Starting with production, we can see that there's been a pretty consistent growth output seen over the past several years due to the ongoing shale revolution with places like the Permian seeing unusually strong drilling.

However, if you notice, this year has seen a slowing in drilling activity in what market participants are attributing to capital discipline being enforced by the E&Ps as well as an impact from the lower prices at the tail-end of 2018. Whatever the ultimate cause of the overall decrease in drilling, it remains a strong possibility that this decrease in drilling will reflect through to lower production at some point in the future. In the weekly data (which isn't perfect), the slowdown has not emerged, but at some point in the future if activity remains subdued, we will see lower supply into the market which will be bullish for crude.

The imports piece of the balance remains the most pivotal this year with OPEC's ongoing cuts being the saving grace of crude for 2019. As you can see in the following chart, OPEC's cuts have taken a toll with most weeks this year witnessing historically low volumes moved into the United States.

A simple glance at the source of these barrels dramatically makes the case that OPEC is the primary driver of weaker supply into the United States this year.

To put it into another perspective, the amount of barrels imported into the United States this year is the lowest in several decades as seen in the following year-to-date cumulative figures.

These weaker imports are going to continue through at least March of 2020 as OPEC has clearly communicated at its most recent meeting. In fact, Saudi Arabia has gone so far as to indicate that it would do anything necessary to balance the market. In other words, Saudi Arabia wants higher prices, and it will spare no expense to make this happen.

As long as OPEC stands by its cuts, the price of crude is likely to keep rising due to constrained supply into the United States. The impact of OPEC cuts can be clearly seen in the five-year range of inventories in that almost every week this year has lagged the trend of the five-year average, which is strongly indicative of undersupply.

As long as inventories continue to lag the five-year average, the price of crude will continue to rise, and as long as OPEC continues its cuts, inventories will in all likelihood lag the average. Based on the ongoing reduced supply, it really is a great time to be long the crude markets.

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.