Energy Prospectus

Physical oil and futures align to tell story of a tighter market

LONDON (Reuters) - The physical crude oil market and the structure of the oil futures curve have rarely been more aligned over the past few years than in recent weeks, and they tell a counterintuitive story of a tight oil market next year.

While OPEC and the International Energy Agency point to a swelling oil glut next year due to booming non-OPEC supplies including in the United States, the physical market offers a different story. < As I have often posted here, the word "glut" is grossly overused. There is no glut of oil in storage. In fact, barrels in storage are way below they should be on a days-of-supply basis. - Dan.

Traders are prepared to pay near-record premiums for sweeter barrels as new marine fuel regulations from 2020 encourage refiners to switch to crude grades that produce smaller quantities of high-sulphur fuel oil.

However, premiums for heavier grades, which produce more fuel oil, also continue to rally due to a deficit created by U.S. sanctions on Iran and Venezuela.

In addition, the structure of the oil futures market shows that premiums of front months to later dates – known as backwardation – have narrowed in recent weeks, also suggesting the market’s expectations of a glut are diminishing somewhat.

To be sure, benchmark oil futures do not necessarily follow the physical market and could still decline next year if global oil demand falls because of the U.S.-China trade dispute or if U.S. oil output surprises again on the upside.

Soaring physical crude prices are also negatively impacting refining margins, often prompting refiners to cut processing.

New marine fuel rules have created a rally in certain crude oil grades. From January 2020, the United Nations’ International Maritime Organization (IMO) will ban ships from using fuels with a sulphur content above 0.5%, compared with 3.5% now, unless they have sulphur-cleaning kits called scrubbers.

Nigeria’s biggest crude stream, Qua Iboe, is valued at a premium of $3.30 a barrel, the highest since 2013, Refinitiv Eikon data shows. Azeri Light, or BTC, has a premium of $5.10 to the benchmark, its highest since 2013.

Both crudes are valued especially highly by simple refineries as they are ideal for producing IMO-compliant bunker fuel oil, said Eugene Lindell, an analyst at JBC Energy in Vienna.

“The focus now is on not producing high-sulphur fuel oil at all costs. If you are a simple refinery, it comes down to choosing the right crude,” he said.

“The end result is a lot of people are going to be seeking these grades and that boosts the price. They will remain strong and may increase further.” < VERY GOOD NEWS for WTI and LLS crude markets. Dan.

While the rally in those two light, sweet grades stands out, sour crudes such as Russian Urals have been supported by other factors. Urals in northwest Europe is trading at a premium of $1 a barrel to dated Brent, a record high.

“The strength in sour crudes, despite IMO 2020, is due to the loss of sour crude supplies from Venezuela and Iran and high demand for heavy molecules to feed the conversion units of more complex refineries,” analysts at Energy Aspects wrote.

U.S. sanctions on Iran and Venezuela have forced the two OPEC members to cut oil exports sharply, tightening the market for sour crude.

Voluntary OPEC cuts due to a supply pact that producers are expected to renew in December have also curbed output. Expectations of a growth slowdown in U.S. shale could also tighten the market further.

North Sea crude grades, which underpin the Brent futures contract, are also rallying. Ekofisk, one of the five grades that can set the value of dated Brent, jumped to its highest since 2013 on Tuesday.

Wall Street Journal: Bearish Oil-Drilling Indicator Is Full of Holes
Energy traders’ assumptions may be way off

By Spencer Jakab
Updated Nov. 21, 2019 5:40 pm ET
Things are looking down for oil prices, but a key plank of the market’s bearish argument may be rotten.

U.S. benchmark crude prices have lost $9 a barrel, or nearly 14%, since peaking in April. That is despite the attack on a vital Saudi facility and a sharp decline in the number of active drilling rigs in the U.S. shale patch. The number of oil-specific drilling rigs tracked by Baker Hughes just hit the lowest level since March 2017, while the number of U.S. wells drilled in October was 25% lower than a year earlier, according to the U.S. Energy Information Administration.

Given the very rapid decline rates of unconventional oil wells that now make up the majority of U.S. output and all of the country’s net output growth, production should be on the verge of rolling over. Yet the EIA and many other forecasters see a continued, substantial increase in output. The EIA predicts U.S. crude production will rise by about 1.3 million barrels a day this year and by another 1 million barrels in 2020.

One big reason for these forecasts is that there are plenty of wells that have been drilled and remain available to produce crude fairly quickly. This signals to analysts that U.S. producers could respond rapidly to an unexpected surge in oil prices. These drilled but uncompleted wells, or DUCs as they are known in the industry, have dropped recently but remained elevated at over 7,000 in October. That is about 15% more than their level in April 2016, when the number of completed wells hit a cyclical low and proceeded to nearly double in the next 12 months as prices recovered.

But the market is drawing false assurance from DUCs, says Marshall Adkins, head of energy investment banking at Raymond James.

“So many people look at that and see that huge backlog that’s going to flood us—the scale is just much lower,” Mr. Adkins said.

He says that changes in drilling methods that have made the industry more efficient also mean that many DUCs shouldn’t be counted. A more accurate barometer would be months of supply, on which basis the number of DUCs is slightly lower than average. And, while the precipitous decline in drilling rigs also can’t be compared directly with past cycles—oil producers now use equipment and crews more effectively—Mr. Adkins points out that there is no way to square today’s level of activity with expected supply growth. Furthermore, the incredible efficiency gains of recent years that have lowered the break-even crude price for shale producers have slowed and perhaps even stopped.

If he is correct, then the market is drawing false solace from DUCs and, unless something happens to dent demand, the oil market is far tighter than many observers assume. The combination of these trends is bullish for crude prices and especially positive for reeling oil-field-service providers such as Halliburton and Baker Hughes. An index of U.S. oil-field-service companies and one of exploration-and-production companies are down by 55% and 52%, respectively, since last October. Even more economically sensitive sand-mining companies, which are tied directly to shale-fracking activity, such as U.S. Silica Holdings and Hi-Crush Inc. are off by 76% and 95%, respectively.

Oil prices and energy companies could be set for a bounce.