Market structure in the crude oil market are pieces of a jigsaw puzzle that can provide clues about the path of least resistance for the price of the energy commodity. The Brent-WTI spread is a location, quality, and political risk spread, Crack spreads reflect the price differential between petroleum and oil products. Term structure is the shape of the forward curve. Trends in the pieces that comprise the market’s overall structure can lead to a robust picture of supply and demand.
Technical factors when it comes to price action, tell us about herd behavior. When I began trading in commodities markets in the early 1980s, a senior trader said to me that raw material prices move higher when there are more buyers than sellers, and lower with selling overwhelms buying. A price chart and the statistical analytics contain all of the technical information on one page. A combination of technical and fundamental data often presents a comprehensive view of a market. After wild volatility in the crude oil market over the past months, the volatility is likely to continue.
The United States Brent Crude Oil product (NYSEARCA:BNO) moves higher and lower with the Brent futures that trade on the Intercontinental Exchange.
A significant comeback in the energy commodity but inventories remain high
After a ride in an elevator shaft to the downside in March and April, the price of NYMEX WTI crude oil futures has staged an impressive recovery.
Source: CQG
The daily chart of the active month July futures contract highlights the rebound in the energy commodity. May futures fell to a low on April 20 in negative territory. The June contract fell to a bottom of $6.50 per barrel on April 21. The low in July futures was a few days later on April 27 at $17.27. The most recent high came last week on June 3 at $38.18, over 120% higher than the low a little over one month before.
Inventories have been trending higher in crude oil since late 2019. Last week, the Energy Information Administration reported that crude oil stockpiles were 12% over the five-year average for the week ending on May 29. The rise in stocks is not a bullish sign as it signifies demand weakness in the crude oil market. At the same time, gasoline stocks were 10% above the average level over the past five years, and distillate stocks were 28% above the level.
Oil has been trending higher, but inventories remain at very high levels.
Brent-WTI moves lower - Bullish or bearish?
The Brent-WTI spread is a location, quality, and political risk differential that I highlighted on Seeking Alpha last week. Over the past decade, the Brent premium over WTI typically paralleled the overall price direction of both petroleum benchmarks.
Source: CQG
The chart shows that the Brent premium over WTI on August futures has steadily declined from $4.41 on April 30 to $2.44 on June 3. Over the same period, NYMEX WTI futures moved from below $20 to over $36 per barrel. Brent futures rose from under $25 on April 30 to over $39 per barrel as of June 3. The typical relationship between the Brent premium and the price of crude oil has not worked over the past month. Time will tell if the decline in the Brent premium is ultimately a bearish signal, or if it signifies a change in the fundamentals for Brent and WTI crude oil production after the substantial price corrections. Therefore, the jury is still out on if the decline in the Brent premium is a bullish or bearish factor for the energy commodity.
Crack spreads - Not running away on the upside - A caution about demand but the output is falling
Crack spreads reflect the margin that refiners earn for processing a barrel of crude oil into gasoline and distillate products. Since many consumers purchase oil products rather than raw crude oil, the crack spreads also serve as a real-time indicator for the demand for crude oil, which is the primary ingredient in the refining process.
Source: CQG
The chart of the gasoline crack spread shows that it rose from negative $2.96 per barrel in late March, where refiners suffer losses, to $10.09 as of June 3. Last year at this time, the gasoline processing spread stood at over $20 per barrel.
Source: CQG
The heating oil crack spread is a proxy for all distillate products. At just over $7.80 per barrel on June 3, the July heating oil refining spread was at its lowest level since 2010. Last year at this time, the distillate refining margin was at over $23 per barrel.
The weakness in crack spreads is a bearish factor for the price of crude oil.
Term Structure - Supportive of the rally
The term structure in the oil market can be a barometer of the trend of supply and demand fundamentals. Backwardation occurs during periods of supply concerns and rising demand, and contango when the market is in equilibrium or a glut condition. Prices of crude oil for nearby delivery are lower than for deferred delivery when the market is in contango.
Crude oil moved from backwardation at the beginning of 2020 to contango, which rose to a high in April.
Source: CQG
The chart shows that the spread between crude oil for delivery in July 2020 and July 2021 moved from a backwardation of $5.65 per barrel in early January to a contango of $13.46 on April 27. The move reflected the glut in the oil market during the global pandemic, and as OPEC decided to abandon production quotas in early March.
Meanwhile, the contango has declined steadily since late April in a sign that production is falling around the world, and demand is increasing compared to the level in April. The move in the term structure has been supportive and bullish for the price of crude oil futures.
Technicals are all over the map - BNO is the Brent ETF product as Brent could be most sensitive to geopolitical events
The daily chart of July NYMEX crude oil futures shows that the recovery that began at the low on April 27. July futures made its latest new high of $38.18 on June 3.
Source: CQG
As the daily chart highlights, price momentum and relative strength indicators are at or close to overbought conditions. The total number of open long and short positions at 2.128 million contracts is at the lowest level since mid-March as many market participants moved to the sidelines in the oil market. Daily historical volatility at 54.7% on June 3 is substantially below the high from early May at over 180%.
Meanwhile, the price has worked its way into the gap between $37.64 and $41.88 per barrel. The technical picture is telling us that the price of crude oil could run out of some of its upside steam that caused the price to more than double over the past month. The top end of the gap could be a target over the coming days and weeks.
Meanwhile, the future path of least resistance for the energy commodity depends on the demand side of the fundamental equation. With production falling rapidly in the US and around the globe in response to low prices, a return of demand could cause the recovery to continue. At the same time, further outbreaks of the virus that cause a tightening of social distancing guidelines could send the price of oil lower again. As of the end of May, the EIA reported that daily output dropped to 11.2 mbpd compared to 13.1 mbpd in mid-March.
One factor that could blindside the oil market would be any problems in the Middle East. Iran remains a clear and present danger in the part of the world that is home to half the world’s crude oil reserves. Any hostilities that impact production, refining, or logistical routes in the region would likely cause immediate supply concerns. Since the Brent benchmark is the pricing mechanism for petroleum from the Middle East, the most significant moves could occur in the Brent futures market. The most direct route for a risk position in Brent crude oil is via the futures and futures options that trade on the Intercontinental Exchange. The United States Brent Crude Oil product (BNO) provides an alternative for those who do not venture into the futures arena. The fund summary for BNO states:
Source: Yahoo Finance
BNO has net assets of $268.58 million, trades an average of over 2.88 million shares each day, and charges a 0.90% expense ratio. August Brent futures rose from $22.50 on April 22 to a high of $40.53 on June 3 or 80.1%.
Source: Barchart
Since late April, BNO rose from $5.91 to a high of $10.41 per share or 76.1%. The ETF tracks the price action in the futures market, but BNO underperformed the August Brent contract from April through May.
Market structure in the crude oil market presents a mixed bag after the rally that took the price of both WTI and Brent significantly higher than levels seen in April. Production will continue to decline as oil producers adjust to profound changes in the fundamental equation. Demand continues to be the most significant factor that will drive the price over the coming weeks and months.
However, do not discount the potential for surprises, which could come from the Middle East.
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