Macro: Sandcastle economics
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Crude oil supported by tight market conditions
Ole Hansen
Head of Commodity Strategy
Summary: Crude oil has reestablished some upside momentum after the early August correction ran out of steam before damaging the technical setup, something that is important for technical focused traders who in recent month added length in both WTI and Brent futures. In the near-term extended OPEC production cuts will help support tight market balances but the combination of rising production spare capacity and worries about the economic outlook, may in our opinion still prevent prices from having a sustained move above $90.
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Crude oil has reestablished some upside momentum after the early August correction ran out of steam before damaging the technical setup, something that is important for technical focused traders who in recent month added length in both WTI and Brent futures amid the outlook for a tight supply following Saudi Arabia’s decision to cut production by 1 million barrels a day from July and onwards. With Brent prices having stalled in the mid-80’s however, the prospect for those Saudi barrels returning to the market anytime soon looks slim and the impact is increasingly being felt across the world as commercial stock levels of crude and fuel products continue to drop.
In the near-term the mentioned production cuts, not only from Saudi Arabia, but also from Russia and others will help support tight market balances in the coming months, but it does not alter our view that rising spare capacity from OPEC producers, as a result of supply constraint, together with rising exports from countries like Iran and Venezuela who are not restrained by quotas, as well as ongoing demand concerns may prevent prices from having a sustained move above $90.
Overall, the current market tightness remains on clear display through the elevated backwardation shown across the time spreads, an example being WTI which has seen its front month spread rise from a 10 cents discount (contango) in late June to a current 50 cents premium while the corresponding spread in Brent commands a 60 cents premium. The positive price action during the past few months has also been supported by elevated fuel product prices, not least diesel which last week traded near $140 per barrel in New York and $128 per barrel in Europe, before trading a tad softer this week.
If jet fuel is in high demand, why don’t refineries increase supply?
Petroleum refineries convert crude oil and other liquids into many petroleum products, and they adjust their operations to meet the market demand for the most profitable products, such as gasoline and diesel. With limitations for how much jet fuel can be produced from a barrel of crude, a period of high demand and low stocks like the current post-COVID recovery in airline travel may drive up the price of jet fuel without necessarily triggering higher production. On average, U.S. refineries produce from a 42-gallon barrel (159 liter) of crude oil around 10% jet fuel, 30% distillates like diesel and heating oil and 46% gasoline.
The total cost of jet fuel is normally found by adding the regional jet fuel swap on top of the regional distillate contract, in Europe the ICE Gasoil future and in New York, the ULSD (Ultra-Light Sulphur Diesel) (HO) futures contract. In Europe, the Jet CIF NEW v Gasoil futures swap trades around $70 per metric tons, the highest seasonal level in almost ten years.
Today, the market will be watching the weekly stock report from the EIA for further clues about the current market conditions. Last night the API (American Petroleum Institute) reported a hefty 11.5 million barrel drop in US crude stocks, being only partly offset by increases in gasoline and distillate stocks. The market will be watching crude stock levels at Cushing, the delivery hub for WTI futures, which according to API’s data could be heading towards the lowest level since January, some 20% below the seasonal average.
In addition, the market will be watching the impact of Hurricane Idalia as it gathers speed in the Gulf of Mexico, as well as developments in Gabon, a 200k barrel a day producer following reports of a military coup, four days after the central African nation held disputed presidential elections in which President Ali Bongo sought to extend his family’s 56-year hold on power.
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