Our market remains in a state of confusion. We discuss below the possible reasons for the unprecedented divergence between crude oil and refined products, a chasm that widened significantly yesterday. The Heat/WTI differential reached a fresh record high of $95/bbl, as WTI fell by well over $3/bbl (Brent's decline was even steeper), while Heating Oil gained the equivalent of $1.65/bbl. The same trend can be observed in the RBOB crack, which settled above $61/bbl, also a record high. It is somewhat perplexing that the 3-2-1 crack, in absolute terms, is almost as expensive as a barrel of crude oil, while Heating Oil ($179/bbl equivalent) is worth more than twice as much as WTI ($82/bbl).

Falling inventories and palpable trepidation about prolonged supply disruptions from the Persian Gulf and the Red Sea provide clear support for refined products; evidently, several consuming regions of the world are structurally short. Although Saudi Aramco has been forced to shut its 400,000 bpd Jizan refinery due to Houthi attacks, and the Iran-aligned terrorist group also claimed to have fired a ballistic missile at a Saudi tanker, traffic through the Bab el-Mandeb Strait reached a four-day high as China entered talks with the Houthis to allow its ships to transit the Strait.

More importantly, Oman's proposal for joint control of the Strait of Hormuz with Iran, which would include voluntary fees paid by cargoes sailing through the Strait, was viewed—prematurely, as it turns out—as a small but salient step towards the complete reopening of this chokepoint. The proposal appeared to enjoy the backing of the Gulf states; however, in a rare point of agreement between Iran and the US, it was simultaneously dismissed by both warring parties. At the same time, tensions once again escalated overnight between the adversaries. Attempted ballistic missile strikes on US military forces in the region were accompanied by a joint US-Saudi attack on "Iran-aligned terrorists" in Iraq, bringing the brief pause in hostilities to an abrupt end.

There is no conclusion to be drawn other than that, above $100/bbl, the US seems keen to negotiate, whereas around $80/bbl, tensions are poised to flare up again. Oil flows from the region are far from paralysed; nonetheless, they remain well below peacetime levels and, frankly, judging by the unravelling of the June 17 ceasefire extension, no meaningful improvement appears to be forthcoming. As such, continued inventory withdrawals over the coming weeks, and possibly months, would not catch the oil fraternity off guard.

Lost Love

It is now a widely accepted cliché that uncertainty and unpredictability have been driving investors’ actions—and, consequently, the prices of different asset classes—ever since the outbreak of the war of choice the US instigated against Iran. Relationships between different markets and contracts have been upended, and because of the precarious nature of the hostilities and the capricious policymaking surrounding the conflict, headlines, posts, and soundbites have turned out to be the dominant market drivers, even when they originate from actors whose credibility has been severely diminished.

One of the casualties of this seemingly perpetual war is the usually rock-solid relationship between crude oil and refined products. Taking a step back to, say, the beginning of 2010, the correlation between WTI and Heating Oil and between WTI and RBOB has been close to 100% (91% and 94%, respectively, over the past 16 years, to be precise). The connection between the US crude oil benchmark and the 3-2-1 crack spread, while not as strong as between the individual contracts, still stands at 48%. The message is that, to a healthy extent, they move hand in hand—and why shouldn't they? Demand for crude oil originates from refiners that produce refined products. When refinery feedstock is intensively sought, it is for a reason: there is an insatiable appetite for gasoline, distillates, and other petroleum products.

This argument—or rather, this axiom of oil economics—has been turned on its head over the past five months. The correlation between CME crude oil and product futures contracts has fallen to 76% for Heating Oil and 64% for RBOB, while the relationship between WTI and refining margins, as represented by the 3-2-1 crack spread, has turned negative, reaching -27%. Let us pause to digest this development: demand for refined products is now moving in the opposite direction to crude oil.

The most difficult part is done; the anomaly (or new norm?) has been identified. All that remains is to establish why this unusual divergence has occurred and what clues it may hold about the future. In one respect, what we are witnessing is a paradox: when predominantly headlines, substantiated or otherwise, drive prices and sentiment, the market is broken. Yet it is always right. Put differently, the crude oil futures market is not accurately reflecting the underlying fundamental backdrop. As deftly noted in yesterday's report, outright oil price movements are frequently "a portfolio necessity rather than the expression of any oil-specific view."

Of course, there are also more prosaic reasons for the disconnect between crude oil and refining margins. The US-Iran war and the Russia-Ukraine conflict have resulted in an atypical imbalance between crude oil and refined products, with crude oil being relatively abundant compared to products. Despite the closure of the Strait of Hormuz, alternative routes have been effectively utilised to circumvent this vital chokepoint and ship crude oil to international markets. Product exports from the region, on the other hand, have fallen by close to 90%. In Russia, Ukrainian attacks on oil infrastructure have caused considerable product shortages while concurrently leading to swelling crude oil inventories. The problem is not so much crude oil availability but refining capacity.

Geographical differences are also conspicuous. The latest IEA Global Indicator of Refining Margins puts the Mediterranean light sweet cracking margin at $16/bbl for May, compared with $19/bbl in Northwest Europe, $20/bbl in Singapore, and $31/bbl on the US Gulf Coast. In Asia, a pivotal market for Middle Eastern crude, demand destruction and stock drawdowns have helped put a lid on rising margins, although they remain considerably higher than in February. In Europe, margins have also increased; however, the impact of plummeting Russian product exports to the region has been partially offset by tighter crude oil availability. The undisputed winner of the geoeconomic upheavals in the Middle East and Eastern Europe has been the country furthest from the war zones. US refiners, particularly those on the Gulf Coast, have been the principal beneficiaries of the supply disruptions and have become the world's swing exporters, as illustrated by high refinery runs, swelling exports, and depleting oil inventories.

The relative cheapness of crude oil, especially in the US, will plausibly begin to disappear if and when the Strait of Hormuz reopens (provided the Bab el-Mandeb Strait does not close), refining capacity—particularly in Russia—comes back online, and sizeable demand destruction, precipitated by soaring refined product prices, emerges. The view from this chair is that, if anything, it is the latter that has the greatest chance of narrowing the yawning gap between crude oil prices and refining margins. Nevertheless, such a convergence does not appear imminent.

Overnight Pricing