Geopolitics tends to have a more profound impact on oil prices in a falling market, simply because the temptation to react to potentially bullish developments and to take action is greater at the bottom than at the top. After four consecutive days of retreat, it is therefore understandable that Russia’s weekend air incursion into Estonia, following its earlier violation of Polish airspace last week, together with the ongoing and rather successful Ukrainian assaults on Russian oil installations, captured investors’ attention yesterday.

In addition, the US President, whose admiration for the Hungarian autocratic leader knew no bounds on the campaign trail, hinted at putting pressure on “his friend” to halt Russian oil purchases. This surely must have left PM Orbán red-faced, as he has relentlessly accused the EU of imposing undue and unfair demands to buy energy from alternative sources, thereby jeopardising Hungary’s energy security, while simultaneously praising the US President for doing everything possible to end the war. The abrupt reversal in the US stance on Ukraine, namely that the President now believes all Ukrainian territory could be won back, further added to the change in climate on the geopolitical front.

The $1/bbl rally in crude oil prices and the even higher jump in Heating Oil were further supported by the dispute over arrears between Kurdistan and Iraq, which, for now, continues to block the resumption of Kurdish oil exports via Turkey. As impressive as yesterday’s rebound might have appeared, it is worth noting that the oil complex still firmly remains within the trading range defined by this month’s highs and lows and the last quarter of the year is still expected to be typified by supply excess.

All Roads Lead to Distillates

As frequently mentioned in this report, the defining characteristic of the past few months has been the counter-seasonal strength of middle distillates. Summer in the northern hemisphere is commonly referred to as the driving season, and by definition, it implies healthy gasoline demand, particularly in the US, the major consumption centre for this motor fuel. Yet, between Memorial Day and Labor Day, the front-month CME Heating Oil contract averaged almost 19 cents per gallon above RBOB. While heating oil trading at a premium to gasoline during the summer months is not unusual, since refiners are typically well prepared to meet actual or perceived gasoline demand, the extent of the premium is historically high, surpassed only by the 44 cents/gallon differential seen in the year of Russia’s invasion of Ukraine.

The contemporary dominance of distillates in the oil basket is evident not only in healthy crack spreads and attractive refining margins but also in money managers’ positioning. Indeed, whatever shifts have been observed in Net Speculative Length (NSL) recently reported by the CFTC and ICE they have directly or indirectly stemmed from the relative strength of distillates.

Looking at the broader picture, it is noteworthy that inflows of capital into the oil market have been rising. The latest data, covering the week ending September 16, show that just over $30 billion has been committed by financial investors to the five major oil futures and options contracts, calculated by multiplying each contract’s NSL by its end-of-period price. This marks an $8 billion increase in four weeks and nearly triple the year’s low of $11 billion at the end of April.

Before examining the difference between crude oil and product NSLs, it is worth highlighting that distillate strength is strikingly visible in both WTI and Brent positioning. The US benchmark, for the first time since 2010 (the start of our record), posted net short positions for five consecutive weeks between mid-August and early September. During the same period, Brent NSL remained solid and even grew. Although money managers have since returned to a net long position in WTI, the gap between the two major crude benchmarks remains historically wide: WTI NSL at 6 million bbls versus 232 million bbls in Brent. Since Brent yields more distillate than its US counterpart, this disparity is unsurprising given the tightness in middle distillates. The weakening WTI/Brent arbitrage and the Dubai marker’s relative strength against lighter grades likewise reflect the supportive distillate backdrop.

Investor appetite for Brent remains healthy, while clear signs of fatigue are visible among WTI investors. Products, however, have been in even greater demand than Brent. The combined share of the three major product contracts, CME Heating Oil, CME RBOB, and ICE Gasoil, reached 52% two weeks ago. Although it retreated to 47% last week, it remains seasonally high as winter approaches.

A curious development in recent months has been the behaviour of RBOB investors, who tried to remain as sanguine as possible and more than doubled their NSL since August. Yet during these six weeks, prices have fallen.

Over the same period, CME Heating Oil prices and NSL remained steady, showing neither decline nor advance. ICE Gasoil, by contrast, proved more resilient. In the latest reporting week, NSL reached 118 million bbls, the highest since the spring of 2022, when fears of an unmanageable shortage sent the proverbial distillate fear index through the roof. Once again, Russia is driving this increase, as the prospect of tighter sanctions now hangs over the market like the sword of Damocles.

If or when distillate support is withdrawn, the most significant layer of price support will disappear. Would this mean an unconditional fall in oil prices? Probably not, it will depend on developments in other asset classes. Should the AI-fuelled euphoria in equities fade, demand concerns will resurface, and capital will flow into safe havens such as currencies or gold, exacerbating the downturn in oil. Continued optimism in equities, however, may provide a floor under prices, but in any case, a correction in Heat crack spreads and a jump in the WTI/Brent arbitrage value will be widely anticipated.

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