The oil market is similar to a jigsaw puzzle. The picture will not become complete until all the pieces fall into place. Last week a tsunami of development lifted the cloud of uncertainty and tangibly ameliorated investors’ sentiment. The factors that played salient roles in increasing risk appetite again were economic, geopolitical and oil supply issues. The current precarious environment makes a prolonged rally in risk assets debatable and financial diarrhea might re-surface soon. Last week, nonetheless, the mood brightened meaningfully.

To begin with the global and regional economic developments China and the fight against inflation in the developed part of the world were in the crosshair of market players. Chinese economic struggles are well publicized and economic potentates are cognizant that without fiscal and/or monetary support the economy will struggle to gain traction. This help arrived in the form cutting the amount of money banks are required to keep as reserves. It reportedly amounts to more than $140 billion to have been made available for lending and the announcement did the trick: the Shanghai Composite Index, after falling 17% between July 2023 and this month, hastily jumped more than 5% in the space of three days.

Moving to the west, the eurozone economy is in a state of uncertainty but the light ahead is plausibly the end of the tunnel and not a Eurostar express train approaching with a speed of 200 miles/hour. The ECB decided to leave its benchmark rate untouched with the bank’s president saying that it was ‘premature to discuss cuts’ but at the same time noting that rapid wage growth was slowing. More upbeat news arrived from the other side of the Atlantic where the US economy proved resolute in 4Q 2023 and the December core PCE, one of the most important gauges of measuring inflation showed an annual increase of 2.9% exceeding expectations. The probability of rate cuts in May is now more than 50%, according to the CME FedWatch tool as the Fed is winning its cumbersome fight against rising consumer prices. The S&P 500 index rallied 1% with the MSCI global share index returning 1.3% to investors last week.

Buoyant equities help oil, but the black stuff was sanguine on its own right. An increase in prices is always the function of rising demand, falling supply (actual or perceived) or the combination of the two. Last week concerns about production and supply were deemed the dominant factors. Freezing temperatures had adverse impacts on both oil production and refinery runs in the US. Output, chiefly due to disruptions in North Dakota, fell 1 mbpd and getting it back to normal will take weeks. Expect a slow recovery back above 13 mbpd. Refinery utilization rates fell 7.1% mainly impacting distillates (-1.4 million bbls) and the ‘other products’ category (-16.6 million bbls). Weekly US proxy demand retreated but optimistic GDP and inflation data foretells healthy consumption going forward.

Geopolitics has also played its part. We long argued that that unless there is palpable involuntary reduction in Middle East oil supply the price impact of the Israel-Gaza war will be muted. Although this view is maintained the increasing involvement of Iran, Israel’s reluctance to even contemplate ceasefire, the consequent Houthi atrocities (for the first time in the current conflict a fuel tanker was hit on Friday), and the US/UK reciprocal measures all contribute to the rise in geopolitical temperature. The weekend’s drone attack on a US base in Jordan killing 3 and wounding more than 30 US personnel raises the prospect of stricter enforcement of US oil sanctions on Iran. Additional supply risk came from Ukraine. After Novatek was forced to suspend operation at its Ust-Luga complex more than a week ago due to a huge fire triggered by a Ukrainian drone attack, Rosneft’s Tuapse refinery at the Black Sea halted oil processing and output following a fire caused by possibly the activity of the very same forces.

Spreads as Reliable Precursor

Oil failed to strengthen meaningfully lately although the tension surrounding the biggest oil producing region in the world provided fertile ground for an upside break out of the recent trading range. Financial players, whilst keeping one eye on the Middle East were possibly pre-occupied by economic developments, let it be potential interest rate cuts, the strong dollar, or Chinese economic woes. The trade, however, strongly implied that the oil market is getting tighter due to several factors: longer voyage, higher insurance, or weather-related disruptions. This tightness was embodied in assorted spreads, crack values as well structures and last week flat price finally joined the party.

WTI flipped into backwardation less than two weeks ago because of the inauspicious effect freezing temperatures had on US output and possibly due to healthy export volumes. Brent has been in backwardation since December last year and its CFD derivatives also suggest a strong physical market as Dated Brent commands a very respectable premium over the forward contracts (albeit falling). Crack spreads are also on the rise. The CME 3-2-1 crack has risen over $4/bbl in the last 2 ½ weeks and so did the Gasoil/Brent spread with front Gasoil backwardation widening from $6.50/ton on January 5 to $24.25/ton this morning.

A significant weakening in outright prices should be preceded by falling spread values. The chances of that in the immediate future are limited. The upcoming Chinese New Year will underpin transportation and jet fuel demand. Refinery maintenance in Europe and the US should support crack spreads. The increasing number of tankers that are being diverted from the Suez Canal and sail around the Cape of Good Hope will also make crude oil as well as refined products more expensive. Whilst we maintain our view that the upside is limited, chiefly due to economic consideration and abundant availability of oil, particularly from non-OPEC+ countries, spread values suggest the in the short-term the equilibrium price ought to tend higher and only explicit weakness in spreads will raise red flags that the buoyant sentiment is turning.
 

Overnight Pricing

john.evans@pvm.co.uk

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