Over the last few weeks, we have seen sustained upside in the price of crude oil with the NYMEX futures contract rallying by over 10% in the last month. As I have previously argued, I believe that what we are seeing is the green shoots of a rally which could reach 50% or more over the next year. I believe that we are witnessing a significant fundamental shift in crude oil and that we have several more months of positive upside ahead. Further, I believe that this is unnoticed and unobserved by traders and that now is the time to buy.
As always, I like to start off an analysis of the crude markets by examining the five-year range of inventories. This gives us a good and objective standpoint from which we can assess the battle between supply and demand and see which side is winning.
As you can see in the chart above, 2019 has been marked by a progressive tightening against benchmarks like the five-year average and the levels of 2018. This trend hasn’t been 100% consistent in that some weeks see inventories gain against these benchmarks, but over the course of the year, this distance has shaved substantially. Put simply: something is afoot in the crude markets which has led to inventories currently sitting at the third smallest year-to-date change in several decades.
Let’s kick off our discussion by examining the different sources of demand. The last few months have been marked by near-constant coverage of the fact that demand is weak and likely to remain so. As can be seen in the following chart, the bears do have a pretty good point: demand has been dismal this year.
With most weeks seeing utilization below the five-year average, 2019 has been a pretty bad year for crude demand. However, there’s a little more to the story.
First off, we have seen substantial disasters in the refining industry this year. For example, we had PES explode and shut down on the east coast which took around a fifth of the capacity in that region offline and led to a collapse in utilization.
Additionally, we had floods in the middle of the country which resulted in a few refineries shutting down due to high waters this summer.
And all of this coupled with the fact that globally, refineries are currently undergoing not-insignificant changes to prepare for the IMO 2020 regulations which take effect in January. So while it is true that demand has been poor this year, there are a few key unavoidable situations (like refineries literally exploding) that are influencing the number which the bears are honing in on.
Additionally, as I mentioned in last week’s analysis, ongoing turnarounds and offline capacity has resulted in a situation in which the key refining cracks across North America have all risen to some of the highest levels in months.
A rise in the crack generally precedes an increase in demand as refineries increase runs to capture heightened margins. Given that we are seeing the strongest cracks in several months, we are likely to see demand increase.
The other form of demand is exports and this was a very interesting week for crude export markets.
As you can see in the chart above, exports took a large hit by falling nearly a million barrels per day. The reason why exports are falling now really has to do with the surge in the freight markets in October. The short story is that the United States sanctioned COSCO in October which caused freight rates to surge. The basic economic calculation for exports depends heavily on transportation costs and with high freight rates, exports drop because fewer players will be able to make the move economically. It takes time for crude traders to assemble a cargo for export so what we’re seeing is just an effect of a situation which was largely resolved in October. In other words, we may see low exports for the next few weeks, but structurally, the larger trend is in place: crude exports are going to continue growing and the current Brent-WTI spread is giving clear economic indication that exports are economic.
The other side of the balance is supply and here’s where things get really interesting. First off, let’s talk production. Production certainly is growing as the bears cite.
But as the bears often don’t cite, the rate of production growth has fallen off a cliff.
And this is where I believe there is very serious risk to the crude balance because this ongoing drop in production is showing no signs of stopping. The reason why this drop has occurred is that in 2019, E&Ps have been pressured by banks and other lenders to focus on earning positive cash flows through capital discipline. This demand for capital discipline coupled with a slowing of investment from banks has resulted in a wave of bankruptcies in prolific regions like the Permian as operator after operator collapses.
This trend will almost certainly continue until the price of crude rises and if it continues for much longer, there’s a chance we could actually see production begin to slow. Specifically, if we see the current trend in declining growth continue, we will enter into production growth within a year.
This is an important point to grasp because demand tends to grow in a given year due to population growth and outright economic growth. Supply must grow at the same pace as demand or else you will have crude shortages. The current pace of slowing growth suggests that we will have outright declines in production on a year-over-year basis one year from now. This trend may slow and ultimately reverse before then, but the adjustment process, we will certainly see crude inventories be compressed and prices will likely rise.
The other facet of supply is imports and imports have most certainly been one of the most bullish factors for crude oil in 2019.
The story here is that ongoing OPEC cuts have pulled a large supply of barrels from U.S. shores. The cuts were initiated in January of this year and extended through March of 2020 in the middle of this year. And presently, OPEC is considering deeper cuts to carry forward the supply tightness.
Digging into the data, there’s a very interesting story behind these cuts and how they are impacting the crude markets. First off, the fact that OPEC is driving the drop in imports can be seen when you examine imports by source.
And secondly, imports on a year-to-date basis are currently at the lowest level seen in decades.
And if you actually look at where the imports are arriving, you can see Canadian barrels attempting to fill the gap by flooding PADD 2 whereas PADD 3 (where most refining capacity lies) is starved.
Put simply: imports are very bullish for the overall crude balance because lower imports have effectively removed around 500 million barrels of supply from North America this year as compared to the five-year average. As long as this trend continues (at minimum through March of 2020), the balance will be subject to supply risk and persistent supply tightness.
Putting it all together
Fundamental data in and of itself doesn’t generate profits. What generates profits is actually seeing how price responds to fundamentals and positioning ourselves to capture these price responses.
At present, the model which I’m paying most attention to is the year-over-year change in crude stocks.
Over the last six months, we have seen strongly bearish sentiment from the financial media due to a perceived weakness in demand coupled with expectations for growing supply. However, if you look at the chart above, the actual data is telling a different story. While stocks have grown on a year-over-year basis, growth is melting down. Specifically, we have seen inventory growth shed 10% over the last five months. That’s right – while many have been very bearish crude oil, the actual fundamentals are moving towards tightness and bullishness.
The reason why this matters and how we can profit as oil traders is this: changes in inventories are directly correlated to changes in price.
Numerically speaking, if you can call the trend in inventories over a year, you have around a 74% chance of calling the trajectory of the price of crude oil over the same time period based on 25 years of data. At present, the current trajectory of declining growth in stocks will see inventories decline by around 20% over the next year. As I mentioned in last week’s piece, over the last 25 years, inventory movements of this size have resulted in average gains of 51% in the price of crude oil.
This is a fairly straightforward and logical economic relationship: when you’re drawing down inventories, the price of crude oil is going to be rising because the commodity is scarcer. It is my belief that we will see:
- Refining runs rise to capture the strongest margins in several months
- Exports recover from the freight headache and continue to grow
- Production continue to decline due to bankruptcies in the Permian
- Imports remain low through at least March of 2020
Every one of the key fundamental factors is currently either bullish or rapidly becoming bullish. I believe that the market is waking up to this fact as seen by strong buying in crude oil after the market failed to hit new lows in early October.
Technically speaking, that’s the chart of a market in which an exhaustion selloff (late September) failed to breach new lows and the strong buying pressure which followed indicates the selloff was capitulation. In other words, from a technical standpoint, it would be fair to say that crude oil has probably bottomed and we will see a breakout into a new uptrend in the coming weeks.
It’s important to monitor the financial markets to understand what large traders are doing. It is my belief that this unfolding fundamental situation is unnoticed by the financial community, and that in the coming weeks, we will see traders pile into the crude trade once again, driving prices higher. To beat the crowd, now is the time to buy.
The reason why I say that this trade is unnoticed is due to the commitment of traders data provided by the CFTC – specifically, the ratio between long and short open interest of money managers.
As you can see in the chart above, traders are very bearish crude oil at this time….too bearish as I see it. If you look very carefully, you will see that historically speaking, when traders are this bearish crude oil, the bottom is almost certainly in. I’ve examined this data across several years and the trend you see in the chart above is largely consistent across time: when the last bull trader exits the market, the bottom is soon to follow. To numerically frame this up, here are the last three times the market became this bearish crude oil:
- Late 2018 – Similar ratio followed by an immediate rally in crude oil of 47%
- Mid 2017 – Similar ratio followed by an immediate rally in crude oil of 70%
- Mid 2016 – Similar ratio followed by a continued upwards rally in crude of 30%
This is the capitulation trade. The large trading firms are out of crude oil markets, and when they become bullish again, the market is likely going to surge due to the billions of dollars sitting on the sidelines. To buy now is to buy when blood is in the streets, and that is precisely the time to be greedy. It is time to buy crude oil.
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.