Although this note predominantly intends to round up events and developments surrounding the oil market, in today’s interconnected environment sometimes macroeconomic headlines take over. And yesterday they certainly played an outsized role. The pivotal Personal Consumption Expenditure, the Fed’s favoured measure of inflation, did not disappoint. This salient metric indicated easing price pressure as it retreated from 2.6% in December to 2.4% in January. The core reading also fell in line with the forecast as it showed an increase of 2.8%. The forward guidance has been obscure if anything, yet the process of disinflation is reassuringly under way therefore smart money is currently on a June rate cut, the CME FedWatch Tool implies. Further encouragement came from this side of the Atlantic in the form of easing consumer price pressure in Germany, Spain, and France. The prospects of the ECB lowering borrowing costs in the foreseeable future are also brightening and once the price of money starts falling economic and oil demand growth should receive a timely boost. The point is, as we argue below, that with yesterday’s auspicious inflation reports the immediate risk in oil probably remains skewed to the upside.

Financial investors have always played a salient part in the formation of oil prices, their role, however, has considerably appreciated ever since the introduction of the electronic exchanges nearly 20 years ago. The financialization of markets (black boxes, algorithmic and high frequency trading) brought with it an explosion in trading volumes and given that this growth was the multiple of the rise in physical demand the elevated importance of money managers is simply evident. Average daily volume traded in Brent on the IPE/ICE rose tenfold between 2004 and 2023. During these 20 years global physical demand grew from 82.5 mbpd to 101.8 mbpd, an increase of 23% (IEA data).

Liquidity has received an enormous boost, and the widely accepted fact is that these financial players are responsible for the direction outright prices take and the trade, the traditional oil market participants intimately involved in physical trading, shape the structure of the futures contracts. It is almost an axiom that the two go hand in hand; well, most of the time. The same amount and quality of information is available for both groups of participants and in the case of a bullish development the reaction will be the same – a jump in flat price strengthens the structure and vice versa.

The 2016-to-date period has seen the ups-and-downs of oil trading as the boom in shale production, a health crisis, wars, and geopolitical tensions provided a volatile backdrop. Yet, what we find is that the relationship between front-month Brent and the M1/M2 spread has been solid – 77%, to be precise. The same goes for Gasoil and Heating Oil although this connection is much looser on WTI (57%) and, possibly due to the twice-a-year spec change, it is below 50% in RBOB.

What is noticeable is that affectionate love has been lost between outright prices and spreads. The comparatively sturdy link has become somewhat capricious since the beginning of 2023 (although the correlation has improved on WTI). It seems that financial players are taking a different view on the forces that shape our market than traders. It is possibly the result of the ambiguous outcome of the fight against inflation on the one hand and the perceived negative oil balance (i.e. supply deficit) predicted for 2024 coupled with geopolitics on the other. The structures of Brent, Gasoil and Heating Oil are more robust than outright prices and weather the volatility observed in flat price trading quite impressively.

Physical markets paint a more buoyant picture than outright futures prices suggest. And it is not only the backwardated nature of the futures contracts that implies genuine tightness. Brent CFDs, which foretell the value of the benchmark weeks ahead, are also strong and the strengthening of WTI against Brent hints at healthy demand for US crude oil. The premiums front Heat and Gasoil commands against their longer-dated peers have shrunk worryingly of late and so have their crack spread values, nonetheless they both are still very respectable compared to the pre-invasion seasonal patterns.

The dilemma, therefore, is whether what seems a supportive oil balance reflected in the structure will ultimately force money managers and other financial investors to commit themselves to the upside for the long run. Backwardation, in principle, serves as an incentive to hold length as extra profit is to be made by rolling. The physical outlook might not change in the foreseeable future. OPEC+ will remain determined to keep the market as tight as possible. Ukrainian attacks on Russian refiners seem effective as embodied in the inevitable ban of Russian gasoline exports. Sanctions also work. After the introduction of the latest round of hundreds of punitive measures India, one of the major post-invasion buyers of Russian crude oil, might run into difficulties to continue sourcing oil from Russia as the country’s major tanker company has also been sanctioned. The initial reaction to an ostensible truce between Israel and Hamas could send prices south but it is vital to keep in mind that the Middle East atrocities did not cause actual supply disruption therefore its impact could be brief.

Which leaves us with the subject of interest rates. It is, undeniably, the primary impediment on a decent oil price rally as ever-changing expectations of a rate cut obfuscate the macroeconomic outlook. Yet, the move will happen and when it is announced the last piece of the jigsaw puzzle will fall into place. In the current precarious trading environment, the above logic could be faulted and might turn out to be misplaced. Nevertheless, the current snapshot implies that with prolonged backwardation the minnows of the futures market might just trump over Goliath laying the foundation of the march towards $90/bbl.
 

Overnight Pricing

tamas.varga@pvm.co.uk

© 2024 PVM Oil Associates Ltd