Oil inventories and their five-year average
In the week ending on June 28, US crude oil inventories were 5% higher than their five-year average—the same as the previous week. Oil prices and the inventories spread usually move inversely. If the inventories spread contracts, oil prices could see another rise. The inventories spread is the difference between oil inventories and their five-year average.
Oil prices and energy stocks
Since the EIA (U.S. Energy Information Administration) released its inventory data last Wednesday, US crude oil August futures have risen 0.6%. The contraction in the inventories spread and OPEC plus extending the output cut until March 2020 might have supported oil prices amid concerns about another contraction in the demand growth forecast on Friday.
On July 3–8, oil-weighted stocks California Resources (CRC), Diamondback Energy (FANG), and Oasis Petroleum (OAS) rose 0.7%, 1.7%, and 2.6%, respectively. They were among the outperformers. California Resources, Diamondback Energy, and Oasis Petroleum operate with a production mix of 74.4%, 84.7%, and 72% in commodities linked to oil prices. The change in the inventories spread will likely be important for these energy stocks.
Changes in inventory levels
On Wednesday, the EIA is scheduled to announce last week’s US crude oil inventory data. A fall of equal to or more than ~9.1 MMbbls (million barrels) could help the inventories spread contract. A Reuters poll suggests a fall of 3.56 MMbbls. If the EIA reports a figure that’s in line with the poll, the inventories spread will remain unchanged. The shutdown at Philadelphia Energy Solutions after the fire on June 21 might increase US crude oil inventories. Philadelphia Energy Solutions has a refining capacity of 335,000 barrels per day. The shutdown could continue until the end of the summer.
As of Sunday, the US crude oil futures contracts between August and September are priced in ascending order. After September, US crude oil active futures are priced in descending order for the next year. Last month, geopolitical tension in the Middle East increased the demand for front-month futures contracts. The change in the price pattern is a positive sign for ETFs that follow US crude oil futures including the ProShares Ultra Bloomberg Crude Oil ETF (UCO) and the United States 12 Month Oil ETF (USL).
USL holds US crude oil futures’ deliverable for each of the next 12 months. UCO tracks daily changes in the Bloomberg WTI Crude Oil Subindex. A negative roll yield, which occurs when expiring futures’ contract prices are lower than the following month’s futures contract prices, would likely impact these ETFs’ returns. UCO’s actual and expected returns could also differ due to daily price changes. However, given the investment style and the forward curve, investors in USL might be at an advantage.
Bullish sentiments rising
On Sunday, the US crude oil August 2019 futures closed ~$2 above the August 2020 futures. On July 1, the futures spread was at a premium of $2.74. On July 1–8, US crude oil August futures fell 2.4%.
Historically, periods of stronger crude oil prices have coincided with the backwardation structure. The crude oil forward curve switched to a backwardation structure on June 13. Since then, crude oil active futures have risen ~10.3%.
Backwardation and oil prices
When there’s an immediate demand for crude oil, active crude oil futures trade at higher prices than the futures contracts for the months ahead. As a result, the crude oil futures forward curve slopes downward. The situation in the crude oil futures market is referred to as “backwardation.”
The market sentiment for oil supply and demand is reflected in the futures spread. Usually, the future spread and prices move in the same direction. During the last four trading sessions, the spread’s premium contracted with more than a two percentage fall in prices. Concerns about another contraction in the demand might have dragged prices and the spread despite the production cut extension by OPEC plus.
US crude oil’s futures forward curve is important for US oil producers’ hedging decisions. Given the backwardation, oil producers might find selling current production at a future date less profitable. These dynamics can also impact midstream oil transportation and storage companies.
On Sunday, Brent crude oil active futures settled ~$6.45 higher than the WTI crude oil active futures. On July 1, the spread was at $5.97—the lowest level since August 21.
In the past five trading sessions, Brent crude oil September futures have fallen 1.5%—50 basis points less than the fall in WTI or US crude oil July futures. During this period, the United States Brent Oil ETF (BNO) has fallen 2%—90 basis points less than the fall in the United States Oil ETF (USO). BNO tracks Brent crude oil futures, while USO tracks US crude oil futures. The OPEC plus cut extension might have supported the Brent-WTI spread.
Factors that could impact US oil exports
Generally, there has been a positive relationship between US crude oil exports and the Brent-WTI spread since December 2015. Exports seem to follow the Brent-WTI spread with a lag. When the US lifted the ban on US crude oil exports in December 2015, US crude oil production started rising. From December 2015 to the week ending on June 28, US crude oil production rose ~33% to 12.2 MMbpd (million barrels per day)—near its record level.
In the same week, US crude oil exports fell by ~0.78 MMbpd to ~2.99 MMbpd. On a YoY (year-over-year) basis, US crude oil exports rose by ~0.654 MMbpd. Lately, the contraction in the spread dragged US crude oil exports. The trend in exports might continue in the coming weeks. This week, OPEC’s Monthly Oil Market report and the IEA’s Oil Market Report will likely be important for the Brent-WTI spread. If the US crude oil inventories spread rises for the last week, it might help Brent outperform WTI crude oil.
Brent-WTI spread and downstream stocks
Any expansion in the Brent-WTI spread could benefit US refineries and cause their input costs to fall. US refiners’ output prices are benchmarked to stronger Brent prices. A narrowing spread has the opposite impact.
On July 1, the Brent-WTI spread fell to its almost one-year low. US downstream stocks account for ~31% of the VanEck Vectors Oil Refiners ETF (CRAK). The lower Brent-WTI spread might drag CRAK. However, stronger gasoline prices because of the shutdown of Philadelphia Energy Solutions is a positive development for CRAK.
Brent-WTI spread and US upstream companies
The narrowing gap between Brent and WTI crude oil prices could increase the transportation cost burden for US crude oil exporters. The higher spread could help mitigate transportation costs and increase profits.
A rise in the Brent-WTI spread could mean lower domestic prices for US crude oil producers like Chesapeake Energy (CHK) and Concho Resources (CXO) compared to ConocoPhillips (COP). ConocoPhillips’s net income sensitivity with every $1 change in Brent/Alaskan North Slope crude oil prices per barrel is $150 million. The company’s same relationship with WTI crude oil is ~$30 million–$40 million. Pioneer Natural Resources (PXD) will likely be impacted by the lower Brent-WTI spread. The company’s oil output follows Brent crude oil prices.
Brent-WTI spread in 2019
On June 11, the EIA (U.S. Energy Information Administration) reported its Short-Term Energy Outlook report. Based on the report, the EIA expects US oil production to grow by 1.4 MMbpd and 0.9 MMbpd on a YoY basis in 2019 and 2020, respectively. The rise in US oil production could expand the Brent-WTI spread due to the possibility of lower OPEC output until March 2020.