Yesterday was somewhat unusual. Risk assets in general trended lower, but, curiously, traditional safe havens during periods of turbulence, such as gold and bitcoin, also lost value. The pressure on equities, which reversed this morning, stemmed from the growing belief that inflation will remain sticky and that the US central bank, much to the chagrin of the country's president, will be forced to raise interest rates. The shining beacon was the dollar, which recorded its third consecutive daily gain, while its index reached its highest level in a year.

According to conventional wisdom, when expectations of higher interest rates support the dollar, oil prices have only one direction to go. That was clearly the case yesterday. Oil prices, it seems, continue to fall relentlessly; nevertheless, the weakness originates from optimism over supply, and not anxiety about demand. Bluntly put, there is a growing conviction that, with the reopening of the Strait of Hormuz, supply will exceed demand in both the near and medium term. Ostensible evidence of this is the US claim that some 20 million barrels of oil transited the Strait of Hormuz within just 24 hours. Whether this figure is accurate or not is largely irrelevant; what matters is that market participants perceive rising supply and increasing exports from the Persian Gulf, hence the persistent downward pressure on prices, also aided by the latest EIA stats showing sizeable swelling of both distillate and gasoline stocks as exports are declining. All the while, US crude oil stocks are hitting their lowest for 42 years, and Cushing inventories are at or below operational capacity.

Futures and Physical Markets are Both Under Immense Pressure

We can debate all day whether the current weakness in oil prices is justified, but it would be impossible to argue against the palpable and profound change in market sentiment. Several indicators point to the souring mood among financial players, a trend that began well before the announcement of the extension of the ceasefire between Iran and the US, while nuclear negotiations were underway. The reversal is discernible in both the futures and physical markets.

The erosion in value is blatantly conspicuous. Front-month (M1) Brent has lost $40 since mid-May and $22 since the truce was announced and the reopening of the Strait of Hormuz was promised. The US crude oil benchmark has declined by almost the same amount. The M1/M2 Brent backwardation disappeared, and M1 Brent is now cheaper than M2. The M1/M7 Brent spread has fallen from over $21 in May to $1.36 by yesterday’s settlement, while the equivalent WTI spread has plunged from above $23 to $2.62. It is worth noting that over the last two months, as expectations of a ceasefire and the resumption of oil flows through the Strait of Hormuz have increased, Brent has proved more vulnerable than WTI. As a result, the premium it commanded over its transatlantic peer last month has shrunk from $7 to well under $4.

Of course, with crude oil prices drifting considerably lower, refined products joined the herd. Yet the extent of their decline has been considerably less severe than that of crude oil futures contracts. WTI has shed more than 35% of its value since mid-May, compared with declines of 24% in Heating Oil and 22% in RBOB. Better still, while backwardation has contracted meaningfully in Heating Oil, it has held up reasonably well in Gasoil and has been admirably resilient in RBOB, perhaps owing to the US driving season and rising US exports. The relative strength of products is mirrored in resilient crack spreads. The CME 3-2-1 crack spread has refused to weaken since mid-May and has actually gained more than $10/bbl over the past three weeks.

Sluggish financial demand and growing financial supply are neatly reflected in the Commitment of Traders data, particularly for crude oil, the latest release of which covers the week ending 16 June, after the ceasefire was announced. (No doubt the observed trend will accelerate when the next report is published tomorrow.) Combined WTI and Brent net speculative length (NSL) fell to 215 million bbls, the lowest level since the beginning of the year. The European crude oil marker has been losing lustre much faster than WTI. Its NSL has declined from 335 million bbls to 114 million bbls over the last four weeks, compared with a fall of a mere 10 million bbls in WTI. This corroborates the strengthening of the arbitrage referred to above. NSL retreated slightly in Heating Oil but increased in both RBOB and Gasoil. Led by the exodus from crude oil contracts, total assets under management in the five major oil futures and options contracts (NSL multiplied by price) have plunged from $67 billion to $31 billion. The crude oil share of the speculative pie has declined from 72% to 53% since mid-May.

The gloomy outlook currently held by financial players is confirmed by developments on the physical side. The price of Dated Brent, as reflected in the CFD market, has also declined sharply. On 19 May, for example, the nearest-week CFD traded at a premium of $6.60/bbl to forward contracts. That premium has since flipped into a steep discount. Dated Brent is now assessed below forward contracts for the next six weeks; therefore, seeing the front spread turn into contango is not that shocking.

After the Strait of Hormuz closed to both incoming and outgoing traffic, the scramble for alternative crude oil grades intensified. Replacement barrels were sourced from Kazakhstan, Russia, West Africa, the US, Latin America and Canada. Closer to Europe, the Russian export blend Urals rose well above $100/bbl in both the Mediterranean and Northwest Europe at the beginning of April, with Mediterranean barrels trading as much as $7 above their NWE equivalents. That differential has now narrowed to just 30 cents, while outright prices have fallen well below $60/bbl. The geopolitical implication of these changes is that the windfall generated by the outbreak of the Iranian conflict, which helped finance Russia’s war in Ukraine, has disappeared. Given Ukraine’s advances on the battlefield, one might conclude that Russia’s nefarious excursion into Ukraine could soon come to an inauspicious end, at least from President Putin’s perspective. Seismic changes all around.

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