THE ONYX VIEW | MAY 2018

Published 02 may 2018

The financial market is well invested as we all know, however there is a move from the rhetoric of geopolitical concerns to low inventories and lack of future investment in oil production. 

 

 
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The Benchmark crudes WTI and Brent are under considerable pressure in the prompt delivery months
 

WTI:

  • In Cushing, the increased production of shale crude is coming from the permian basin which in turn is weighing on the WTI Midland contract. This contract is at -$8/bbl to WTI Futures, 3 year lows, whilst WTI Futures are at a $6.00/bbl discount to Brent Futures.
     
  • Pipeline infrastructure is maxed out and therefore limiting the movement of crude that can be sent to areas of higher prices such as the Gulf Coast in US or abroad.
     
  • As WTI Futures is a physically delivered contract (FOB Cushing), the backwardation in the front WTI Futures spread incentivises owners of physical storage in Cushing to sell the time spread, selling their crude at the spot price and buying it back at a lower price next month.  
     
  • Fund rolls- Financial money must sell the front timespreads to roll their position to the next month to keep in the outright price whilst also avoiding physical delivery.
     

BRENT:

  • An overbought May in the North Sea has led to North Sea grades being far too over priced relative to the broader N.W.E and Med crude market, where the substitutable grades are trading at negative discounts to the Dated Brent Benchmark.
     
  • Forward looking Dated Brent derivatives are pricing in a substantial correction in Crude differentials in the North sea for June and July cargos.
     
  • Light sweet overhang and a severe price discount in the US is incentivising exports where possible to Europe, where prompt cargos are being brought over to further compete with June and July loading programs.
     
  • West African crude is also weakening considerably, and with a flurry of Chinese buying in May dying out, the outlet is also pointing to Europe and therefore further pressure on prompt pricing crudes.
 
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Refinery Margins are positive, but what makes profit yields light products


When considering Refinery Margins in their current state then if, as a refinery, you are geared to run lighter crudes then you can justify very high run rates and reap strong profits. It is therefore no surprise that refiners globally are maximising input of light crude in their CDUs, whilst Independent refiners in the U.S. such as HollyFrontier and Delek US holdings are enjoying 20-30% bump in their share price given their main feedstock is in such abundant supply. At the other end of crude quality, heavy crudes are yielding significantly worse profitability, particularly in Europe. Despite a considerable weakening in Urals differentials to multi-year lows, the margin for running Urals crude and selling the yielded products in North West Europe is marginally profitable when considering costs.

The combination of the refinery margin complex and crude differentials suggests a bearish picture for the overall market. After very strong May demand from the East for Forties and return of refiners from maintenance, the North Sea market strengthened. Despite this, and despite strong light end refinery margins, the lighter end of the N.Sea complex has still struggled to clear whilst competing light sweets in Europe, WAF and U.S. are trading as substantial discounts to the North Sea light crudes, suggesting the overhang is persistent and structural rather than a blip. Marrying this with ever weakening sour crude diffs in a low refiner profit environment, it must be concluded that there is simply too much oil around in the prompt.

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Going forward we believe the market will enter into a period of transition, where we will see the following:

  • Refineries selling Gasoline, LPG and Naphtha cracks on bullish price action.
     
  • Refineries to continue maxing out light end crude and therefore yielding lighter end products.
     

We therefore believe it is logical that extremes of the light end barrel that have a discount to crude such as Naphtha and LPG will be flooded into the market with not enough demand to soak the relative extra production up. This will in turn pressure the light end complex and unless there is serious spike in Gasoline on the back of a supply outage (hurricane or refinery outage) then the oversupply in light sweets will transpire to create a bearish market in the physical oil market in general.

 
 

OUR CONCLUSION
may 2018

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Given the CURRENT landscape of the Oil market, we go into the remainder of Q2 18 bearish.

The Crude Oil market is under considerable pressure, with US production at all-time highs; refineries struggling to justify running heavier Crudes which are already at low levels to their benchmark; and, the appetite for lighter Crudes is not sufficiently clearing the market. However, given market positioning, we expect the majority of May to price relatively strong due to the market leverage and investment that we saw in May cargos. However, as June approaches, and this markets positioning becomes less prominent, we see the downside to both Crude contracts and Futures, which we expect are artificially high as a result of the above.

Although the financial market appears to be invested in the long-side, the open interest makes long positioning a vulnerable trade in this period of transition, even with the probability of May pricing strongly. Similarly, the geopolitical chatter has quietened, with the only relevant consideration the
re-imposition of Iran sanctions. However, even with this the US is more than making up for any production that may be taken away from the global crude market.

The Product market has generally been underperforming relative to expectations going into summer season. This, coupled with the supply from running light crude oils, we expect will transpire as the extremes of the barrel being under pressure.  Specifically, without some disruption to gasoline, Naphtha and other blend stocks will be in abundance with light sweet Crude running at high rates.
 

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If we are to see a market recovery, we expect it would have to be led by:

  1. Product cracks strengthening
    Specifically, we would expect this to be end-user led, rather than refinery led.
     
  2. Margins to improve for heavy crudes
    Specifically, we would expect this to be led by strong VGO/feedstock and Fuel-Oil appetite to entice refineries to switch from light-sweet crudes to heavier crudes. It is unlikely it will be led by heavy Crude diffs weakening further, as they have already lowered substantially, and the impact appears to be minimal.
     
  3. Outage
    In the instance of an outage, we would expect a strong Crude response, given the reduction in availability of refine-able Crude. As a knock-on effect, if the outage is globally sustained, we would expect this to filter through to products.