- A marginal selloff in the oil market
- A bid in processing spreads and tightness in the forward curve
- WTI-Brent is bullish
- Geopolitics scream higher
- Things to watch in the oil market over the coming weeks
Many commodities prices have been moving lower as the dollar index rallied to a new high in April and trade negotiations with China hit a roadblock. Last Friday, the Trump Administration rolled out new 25% tariffs on the Chinese and the Asian nation is likely to retaliate. The escalation of the trade dispute weighed on the price of copper which declined below $2.80 per pound taking other nonferrous metals prices lower. Precious metals had also been under pressure over recent weeks.
Friday’s WASDE report took a backseat to the news on trade, but the bearish report from the USDA sent the prices of grains and cotton to new lows. Meanwhile, weakness in the Brazilian real is weighing on the prices of sugar, coffee, and orange juice futures in the soft commodities sector. Coffee and FCOJ fell to new multi-year lows over the recent sessions.
Crude oil also backed off from the recent peak at $66.60 on the nearby NYMEX futures contract in late April. However, the prospects for the path of least resistance for the oil price is a complex mixture of supply and demand fundamentals, and global economic and political considerations.
A marginal selloff in the oil market
As the daily chart of active month June NYMEX oil futures highlights, the price fell to a low at $60.04 on Monday, May 6 and was trading under the $62 level as of May 10. Technical metrics on the short-term chart are sitting in the upper region of oversold territory with the slow stochastic at just over 30 and relative strength a bit higher at 41. Open interest, the total number of open long and short positions in the futures market is steady at 2.151 million contracts after the decline and daily historical volatility at 22.35 is not out of the ordinary for the crude oil market. After an almost 45% gain in four months, a pullback in the price should not come as an earth-shattering surprise.
On the daily chart, the next level of support below $60 per barrel is at the March 8 low at $55.31. The price of crude oil could continue to correct and test that level. However, the overall state of the market currently suggests that any further price weakness that takes oil back to or through $60 per barrel is likely to be a buying opportunity. Meanwhile, all bets could be off if there is a risk-off period in markets caused by the current trade frictions between the US and China. However, a risk-off period triggered by events in the Middle East could have just the opposite impact on the price of the energy commodity.
When analyzing the oil market, I like to look at its market structure. As of the close of business last Friday, processing spreads, term structure, and a location and quality spread are all signaling that the downside for the price of crude oil could be limited.
A bid in processing spreads and tightness in the forward curve
One of my favorite indicators of supply and demand in the oil market is the processing or crack spreads that highlight the price differential between the raw crude oil and oil products. The refining margin for cracking a barrel of crude oil into gasoline and distillate products is a real-time measure of demand as consumers tend to buy oil products rather than raw crude oil.
As the daily chart of the June gasoline crack spread shows, the price has increased steadily since late January from $12.76 to $21.91 per barrel as of May 10. While seasonal factors have caused gasoline to outperform crude oil prices, the strength in gasoline is a sign of rising demand.
The daily chart of the heating oil crack spread shows that distillates have been making higher lows and higher highs since early April rising from $21.43 to $24.58 per barrel. The rise in both crack spreads reflects robust demand for oil products which translates to support for the price of crude oil as the energy commodity is the primary ingredient in the cracking process.
As the chart shows, the forward curve remains tight and in backwardation with July 2019 crude oil futures trading at a $2.91 premium to crude oil for delivery in July 2020. The same spread in the Brent futures market settled on May 10 at $5.33 per barrel because of the impact of production cuts and the risk premium on Brent crude as it is the benchmark for pricing the oil that comes from the Middle East. Backwardation is a sign of tightness in the oil market, and the forward curve remained supportive of the price of both WTI and Brent futures at the end of last week.
WTI-Brent is bullish
The WTI-Brent spread is a location and a quality spread and is an integral part of oil’s market structure. WTI has less sulfur content than Brent making it easier to refine into gasoline, the most ubiquitous oil product. Brent is a better grade of oil for processing into distillate products. Before the Arab Spring in 2010, WTI typically commanded a small premium to Brent when it came to the same delivery periods. However, the spread also reflects the political risk of crude oil from the Middle East and increasing output from the US has shifted the spread to a premium for Brent.
The Arab Spring nine years ago caused a shift in the spread with Brent trading at a higher price than WTI for the same delivery dates. Moreover, as an indicator of political risk, the Brent premium tends to rise during bullish trends in the oil market and fall during bearish periods.
The daily chart of the price of WTI minus Brent for July 2019 delivery shows that the Brent premium moved from $6.13 on April 10 to $8.91 per barrel at the end of last week. The Brent premium for July is not far off its late November peak at $10.06 per barrel. The rise in the Brent premium reflects rising political risk in the Middle East.
Geopolitics scream higher
Last year, the US walked away from the Iran nuclear nonproliferation agreement. In November, sanctions on the theocracy in Teheran took effect, but the administration issued six-month exemptions that allowed some nations including China and India to continue to purchase Iranian crude oil. In April, US President Donald Trump ended all exemptions for the eight countries that buy Iranian oil. The US also declared that all members of Iran’s Revolutionary Guard are terrorists because of the nation’s support for terrorist organizations in the Middle East. Iran retaliated and said that all US troops stationed in the Middle East are terrorists.
The rhetoric between Washington and Teheran has intensified over recent weeks, and the US dispatched the USS Abraham Lincoln warship to the area. The Strait of Hormuz could become a flashpoint as the narrow seaway is the chokepoint for 20% of the world’s seaborne crude oil that flows from the Middle East to consumers around the globe. As the rhetoric continues to rise along with the potential for hostilities and military action in the area any violence that threatens production, refining, or logistical routes in the Middle East could cause the price of crude oil to spike higher on supply concerns. The Middle East is home to more than 50% of the world’s crude oil reserves.
Things to watch in the oil market over the coming weeks
The price of crude oil has corrected from the April peak, and the prices of many other commodities are under pressure. Meanwhile, the market structure and geopolitical state of the Middle East are highly supportive of the price of the energy commodity, Technical support for nearby NYMEX crude oil futures is at the recent low which is just above $60 per barrel. Below there, $55.31 stands as the next level on the downside. Resistance is at $66.60 per barrel on the June future contract.
The most significant factor when it comes to the path of least resistance of the price of crude oil these days is the rising temperature in the Middle East and the deteriorating relations between Washington and Teheran. On June 25, the oil ministers of OPEC will gather in Vienna, Austria for their biannual meeting. The following day, the cartel will meet with Russia. The Russians have become a powerful voice within the cartel even though they are not a member. It is likely that OPEC will agree to reduce or eliminate the production cuts with support from Saudi Arabia and perhaps even Russia given the current price level of Brent crude oil which is still above the $70 per barrel level as of the end of last week. While the market may interpret any reduction in output cuts as bearish, the situation in the Middle East should keep the bid under the price of crude oil. Therefore, I am a scale-down buyer of crude oil on any price weakness in the current environment and will only trade the energy commodity and related equities from the long side of the market.