A weekly look at what occurred in the oil markets of the U.S. and the world this past week and what's ahead.
If the price of diesel spikes because of IMO 2020, it increasingly looks like it is going to be coming from a very low base.
Bear market targets were reached this past week, with various key benchmarks dropping 20 percent from recent high levels reached mostly in April. The market did reverse on Friday, with the only apparent news some rumblings out of Saudi Arabia that the country would take even more steps to boost the falling market, particularly since the kingdom's initial public offering of a part of state oil company Aramco continues to be in its plans. But otherwise, the list of bearish factors pushing prices down is a lengthy one.
Macroeconomics: Ultimately, the price of oil can't rise if the world economy is headed toward recession. And maybe the economy isn't going to be there but the correlation this past week among oil markets, equity markets and foreign exchange rates was high. The strength of the U.S. dollar – to be expected during a flight to safety – is bearish for oil. It's not a one-to-one correlation, but a higher dollar will always exert downward pressure on oil, because oil is priced in dollars worldwide. Equity markets were down most of the day Wednesday; so was oil. They rebounded Thursday;' so did oil. If equity and bond markets are signaling recession, and oil demand growth into 2020 is already considered weak and 2019 demand is slowing, oil is going down with it.
U.S. crude inventories: From a peak of about 485.5 million barrels in early June, the world watched as those stocks drew down to 436.5 million barrels, according to the weekly reports of the U.S. Energy Information Administration. But this past week, though forecasts called for further declines, the trend reversed. Crude stocks increased about 2.4 million barrels when a decrease of more than 3 million barrels was expected. One of the reasons for that was a decline in U.S. crude exports of about 700,000 b/d, to 1.865 million b/d. That's the first time it's been less than 2 million barrels per day (b/d) since the end of January. Some traders looked at that fact and viewed it as a sign of declining demand around the world. The weekly numbers are considered somewhat preliminary, with the monthly numbers that come out with a two-month lag carrying more weight. They could reverse. But the market clearly reacted in a bearish way to the latest report.
What the market structure is saying: The Brent market – considered more of a global bellwether than the U.S. domestic crude benchmark, WTI – remains in a price structure known as backwardation. In backwardation, the most expensive price in the time series is the current price, and prices decline as you go out into the future. A market in perfect balance is the opposite, contango, with a steady increase in prices along the time series to reflect the cost of storage and the time value of money. A weak market will be in a steep contango. A backwardation is considered a sign of a tight market. Even as prices have been declining during the current bear market swoon, some market bulls would point to the backwardation and say: "See! The market's in backwardation! It must be tight!" Alas, that argument is disappearing. By the end of June, the spot price of Brent on CME was in a more than $3.50/barrel backwardation, with the front month that much more valuable than the price 12 months out. By the middle of this past week, it was headed toward $1. That is a very bearish sign.
China back in as an Iranian customer: One side effect of the U.S.-China trade war is that China is increasingly thumbing its nose at the U.S. sanctions that are designed to, as U.S. government officials have described it, zero out Iranian exports. The New York Times, in a detailed article last weekend, summed up China's activities under those sanctions: "China and other countries are receiving oil shipments from a larger number of Iranian tankers than was previously known, defying sanctions imposed by the United States to choke off Tehran's main source of income." The reality is that the U.S. sanctions have had an enormous impact on Iranian output. According to the latest monthly S&P Global Platts report, Iran produced 2.3 million b/d in July. A year ago, it was 3.72 million b/d. But what has always been one of the great unknowns is how much oil is Iran producing that wouldn't get accounted for by the normal methods of barrel counters, because they're getting put into tankers berthed off Iranian waters and are considered "floating storage." That lost Iranian oil hasn't been needed because of increased supplies from elsewhere. For example, the U.S. a year ago was producing just about 11 million b/d. It's now up to 12.2 million b/d. Other countries have added to their output as well. So if China is buying lots of Iranian oil when the market was assuming the Persian state was pulling back as a supplier, that's a problem for producers.
And the impact of it could be great. Bank of America Merrill Lynch, in the wake of The New York TimesT report, kicked off the week with a forecast that revived buying by China could put prices into "a tailspin." BOAML's chief oil analyst, Francisco Blanch, said such a development could send prices down an additional $20 to $30/b.
What the IEA said: The monthly report of the International Energy Agency came out Friday. In it, it called the oil market "fragile." The IEA ratcheted down its estimate of 2019 oil demand growth by 100,000 b/d. It said commercial stocks in the nations of the OECD–the major western economics–are significantly above the five-year average July. Estimated non-OPEC supply growth next year is far above the increase in world demand. In short, the report continued a long string of bearish forecasts but this one seemed particularly weak.
But diesel is resilient: With markets looking closely for any sign that diesel prices are starting to strengthen relative to the rest of the barrel because of IMO 2020, this small item should be noted. Since their recent market highs, while the four key benchmarks for U.S. crude and products are all down, diesel is down the least. Following the Wednesday settlement, since their recent spring-time highs, WTI is down about 23 percent, Brent about 24.6 percent, RBOB gasoline about 17.7 percent, but ultra low sulfur diesel (ULSD) is down 16.2 percent. As anybody in the trucking business can attest, that's certainly not because of booming diesel demand for freight. But before anybody jumps to the conclusion that it's the first sign of IMO 2020 demand kicking in, note that the physical market assessments by S&P Global Platts are both less than the ULSD price on CME, a normal state of affairs. The physical market at least is not yet showing signs of any IMO 2020 kick.
Besides IMO 2020, the big uncertainty is... the level of U.S. production. The Energy Information Administration in its most recent Short Term Energy Outlook trimmed back a tiny bit its optimistic forecast for U.S. output. The reductions didn't even reach the 100,000 b/d level. But as we've noted previously, debt obligations and tougher stances by lenders may squeeze output growth. If the price of oil continues to sink, it may stabilize at a price less than what one analyst has said is a magic level: $55/b. All of the forecasts for the rest of 2019 and into next year see OPEC needing to cut even more than it already has because of rising non-OPEC output, the U.S. in particular. If the U.S. fails to meet those forecasts, there may be a bottom to this market above the most bearish predictions.
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