An Education In The Calculus of the Crude Oil Market

Fundamental analysis in the crude oil market is a process of putting together various pieces of a jigsaw puzzle in an attempt to establish a picture for the path of least resistance for the price of the energy commodity.

I have been watching the crude oil market since the late 1970s and had the unique experience of working with and sitting next to one of the world’s leading oil traders from 1991 through 1997. Andrew J. Hall had a unique ability to read the tea leaves in the oil market which made him hundreds of millions over his career. I ran the metals business for Phibro in the 1990s, and while Andy Hall was my boss, his expertise was in energy. Sitting next to the man who dominated the oil market for decades was an education that was priceless.

Andy Hall’s investment philosophy was to assemble the pieces of the oil market’s puzzle. He compared the oil market oil to a multivariable calculus equation with a solution that led to riches for those who could put the pieces together. Those variables, or pieces of the puzzle, are the market’s structure.

In the world of oil, structure consists of at least five variables. Terms structure, processing spreads, locations and quality spreads, macroeconomic trends, and technical factors provide insight into a picture for the crude oil market.

The price of the energy commodity fell from $76.90 on October 3 to a low at $42.36 on December 24 in what was a period of price carnage in the oil market. What I learned from Andy Hall helped me to identify that the price action at the end of 2018 created a unique opportunity in the oil market. The bullish factors that began to emerge in late December continue to take the price of the world’s most ubiquitous commodity higher, and the market’s structure is telling us that the price of oil has not yet peaked even though it reached a new high for 2019 at the end of last week.

Term structure or the price differentials between oil for nearby and deferred delivery can provide clues about supply and demand. In the world of commodities, when deferred prices are higher than nearby prices a contango is a sign that a market is in equilibrium when it comes to supply and demand or in a state of oversupply. When deferred prices are lower than nearby prices, a backwardation can tell us that nearby demand is overwhelming supplies.

Source: CQG

As the chart of March 2020 minus March 2019 NYMEX crude oil futures shows, the market moved into a widening contango starting in October which supported the price correction in the energy commodity. However, the contango peaked in late December, and it narrowed gently in early 2019 which led to the recent recovery. As of last Friday, a contango of $2.59 is below the high at $3.14 from late 2018. The jury is still out when it comes to the term structure for the oil market, but if contango continues to trend lower, it will tell us that the oil market is tightening. Sometimes the term structure leads the price of oil, and at others, it follows. For now, it is not providing any conclusive evidence with the price of oil near the recent high at over $55 per barrel. 

Processing spreads can tell us a lot about demand in the crude oil market. Gasoline and distillate crack spreads reflect the economic margin of processing a barrel of crude oil into the products that consumers require.

Source: CQG

The weekly chart of the gasoline crack spread illustrates that the margin for processing oil into gasoline dropped dramatically from June through early 2019. Gasoline tends to peak in the spring and summer which is the peak season for demand and find lows in the winter. The gasoline crack spread fell to its lowest level since 2009 earlier this year at under $4 per barrel, but it recovered and was at over $10 at the end of last week. The price action in the gasoline crack has been highly supportive of the recent gains in the price of crude oil as the oil product outperformed the price of oil which is a sign of expanding demand.

Source: CQG

The heating oil crack spread is a proxy for other distillate products such as diesel and jet fuels. While the gasoline crack is seasonal, distillates are year-round products. The weekly chart shows that distillate refining spreads have been strong and trending higher which is a sign that demand for these oil products supports the price of crude oil. Since crude oil is the primary ingredient in all oil products when gasoline and distillates outperform the energy commodity it translates into rising demand for the energy commodity.

Location and quality spreads are another piece of the market structure puzzle. The spread between Brent and WTI crude oil futures is both a location and a quality spread. Brent crude oil is the pricing benchmark for two-thirds of the world’s petroleum. Oil production in Europe, Africa, and the Middle East tend to use Brent prices as a pricing mechanism. WTI represents crude oil output from North America.

WTI is a lighter and sweeter crude oil that is more easily processed into gasoline. Brent tends to have a higher sulfur content and is more favorable when it comes to processing into distillate fuels. For many years, WTI traded at a premium to Brent because gasoline is the most ubiquitous fuel, but since the Arab Spring in 2010, Brent has traded at a premium for two reasons. First, the Middle East is the most turbulent political region in the world. The Brent-WTI spread tends to reflect political risk in the region. Second, the growth of US shale output which has made the US the world’s leading oil producer has depressed the price of WTI. Recent OPEC production cuts only exacerbated the differential. The Brent premium over WTI tends to widen during bullish periods in the oil market, and narrow when the price is dropping. 

Source: CQG

As the weekly chart of WTI minus Brent shows, the differential fell to a low at $6.96 per barrel in late December.

Moreover, it trended lower from October as the price of the energy commodity was plunging. However, the recent move through the $10 level reflects the current bullish trend in oil. If the Brent premium continues to rise or remains near the current level, it is likely to take the price of both crude oil benchmarks higher.

When it comes to macroeconomic trends these days, optimism over a trade deal between the US and China is highly bullish for the price of crude oil. China is the world’s most populous nation with 1.4 billion people. An end to the trade dispute would likely ignite both the US and Chinese economies and lead to higher GDP growth. Economic expansion and demographic factors including rising population and wealth support more energy demand and a higher price for crude oil.

Finally, the crude oil market sent the market a highly bullish technical signal on December 24 that many market participants did not see until it was too late, and the price took off to the upside. Technical analysis is another integral part of the calculus of the energy commodity. 

Source: CQG

The price of crude oil hit bottom when NYMEX futures traded to a low at $42.36 per barrel on the nearby futures contract on December 24, 2018. Average daily volume in the crude oil futures market is typically north of one million contracts. On the day of the low, only 626,051 contracts changed hands. A low volume low is a sign that the market ran out of selling and that a reversal was on the horizon. Many market participants blamed the low volume on Christmas Eve and the holiday, but it turned out to be far more significant. The market did not have to wait long as the price began to recover on the very next trading session.

There are many other factors aside from market structure that determine the price path of crude oil. Seasonality, inventory data, political events, policy changes, as well as other inputs increase the clarity of the overall picture as they are all additional pieces of the puzzle. For now, the crude oil market looks set to continue to make higher lows and higher highs based on variables when it comes to the calculus of the oil market. Andy Hall taught me a lot about the ins and outs of the international crude oil market. However, the concepts apply to many other commodities that I had traded and analyzed since the late 1970s. Therefore, by the time I met Mr. Hall, I already had a substantial education in the world of raw materials trading and analysis. Andy Hall furthered my education in many ways, and I am pleased to bring that knowledge to the members of FATrader. Learning never ends, and I look forward to continuing to expand my knowledge base interacting with the members on the site.