"Oil slowly cracking (no pun intended)"
On Wednesday, Brent Oil was down 3.5% post oil inventory data released, showing a build of 2.9 mln barrels in gasoline and build of 1.2 mln barrels in distillate. Why does this matter? And why is oil cracking now (no pun intended) as President Trump's sanctions on Iran have actually started?
Base metal commodities and their relative equities have been crushed over the past two months as US/China trade war headlines began to hit our screens. But someone forgot to pass the memo to steel and iron ore apparently as they have been making new highs this year. Now someone needs to pass this memo onto their relative equities that seem to ignore their positive trends! If the world really is worried about a global recession or an elevated China response to Trump's demands, why then has oil held up so well?
We are in the peak summer driving season where gasoline demand is what dictates oil price action over the summer months given its seasonal importance for the US market. Demand has been decent and margins have been strong all summer and refiners have been boosting their utilization of oil to produce as much gasoline (and byproduct distillate) as possible to monetize on the lucrative margins. But what is more interesting are the dynamics developing in the distillate market. Distillate is not really needed till later this year when winter heating season starts. Earlier this year it was the distillate market that has been cause for concern given its low level of inventories vs. the 10 year average. But this supposed tightness is now being addressed over the past few weeks as supply has picked up. Demand has been relatively flat to slightly softer.
The equity market always worries about demand collapse before it actually happens. Look at emerging markets and the turmoil there. It will be no surprise that we start to see lower demand numbers filter through in just a matter of time. According to July production numbers, Saudi Arabia's production in July so far has been 10.65 million bpd, up from 10.60 million bpd in June, Russian oil production jumped by 123,000 b/d in July to 11.20 million b/d. This is the highest level since January 2017. These two producers had been increasing production even prior to the Vienna meeting at the end of June. The meeting was just to save face to rest of the world, but let's face it, OPEC is being run by SauRu, the new face of OPEC. The other members are just in it for the ride.
So why is the distillate market so important? Mid-distillates accounted for 35 million barrels per day of global oil consumption in 2017, about one-third of the total, according to BP (BP) ("Statistical Review of World Energy", 2018). Freight transportation, including cargo moved by road, rail, pipelines, shipping and aviation, is the biggest end user of fuels derived from the middle part of the crude barrel. In short, distillate consumption is closely linked to the overall manufacturing and well being of the global economy. Given what we are witnessing in the other asset classes, does the outlook for distillate demand really bode well going into 2H18?
China, India and the EU are some of the largest buyers of Iranian crude. Most of them have refused to give into Trump's threats. Has Iran now slashed the price of its light crude relative to Saudi Arabia, to a 14 year low, to entice buyers of its crude? Seems like an oil price war is in motion. Yesterday, Trump decided to place additional sanctions on Russia based on their alleged use of chemical weapons in the UK. The Russian ruble got crushed. Russian oil producers are comfortable producing oil as long as it trades > $50/bbl. But with the ruble now lower, their production becomes even more advantageous as their local costs denominated in rubles falls. More oil to come?
Brent oil six months physical market spreads are now firmly in contango (near term price lower than the futures price signalling more supply in the near term). The curve never lies. Fundamentals are weakening. It takes a bit of time to move the needle for oil. But when the tide turns, it can be fast and painful. Given the malaise seen in other "cyclical/growth" stocks, it seems like the oil stocks stand out like a soar thumb. Momentum has been weakening slowly since July, but noticeable only if one takes time out from reading the jittery headlines of war and sanctions.