Oil Market Surprise: Return Of The Bulls

After oil prices dropped about $10 a barrel since this spring, they now appear to be on an upward trajectory, despite continued fears that the trade war will cause a recession or that the imbroglio between Iran and President Trump (“I’ll see your limpet mine and raise you two tweets”) will reduce supplies.  From $51 three weeks ago, WTI has recovered to about $56. Of course, given that this is the last week of August, just before Labor Day, it is easy to dismiss the move as based on thin trading by second-tier traders.

Examination of a number of the financial indicators suggests the move is soundly based, at least as much as any oil price move can be. First and foremost, the market has moved into backwardation, which is typically a sign that traders believe the market is tight.  As the figure below shows, the market has returned to contango after being at or near backwardation for the past year.

(The figure shows the difference between the first and fourth month’s future contract.  A positive number means the near contract is higher and the market is backwardated, while a negative number means the near price is lower, also called contango.  Backwardation indicates a tight market, contango the reverse.)

Another indicator that doesn’t seem to have received enough attention is the differential between Brent and West Texas Intermediate (WTI) crude.  Before the shale revolution, WTI was typically a couple of dollars higher than Brent, but since then the reverse is true.  The bigger the glut of WTI, the higher the differential, which encourages the export of U.S. crude (and discourages crude imports).  As the figure below shows, the discount for WTI has declined sharply, from $10 just three months ago to $5 now.

The impact on imports can be seen in the latest data, which shows that, compared to a year ago, crude oil imports are down over 1 mb/d.  This, combined with higher exports from the U.S. as pipeline capacity in the Permian improves, has meant a significant decline in U.S. crude inventories, which have been elevated for some time.  The figure below, showing total private crude stocks and those at Cushing, and both have been moving sharply lower in recent weeks.

Needless to say, the causality works both ways:  lower inventories reduce the differential, and the lower differential discourages imports, lowering inventories. Although it might seem that a differential of $5/barrel between Brent and WTI might discourage exports, with higher takeaway capacity in the Permian (and lower transport costs to the Gulf Coast), crude exports are likely to remain profitable for the new future—unless the differential slips much further.

While the U.S. crude market might seem to be the canary in the coal mine, warning us of trends in the wider market, it is also like the streetlamp under which the drunk looks for his keys, because the light is better there.  Data on most global inventories is either delayed or non-existent, meaning that traders often focus on the weekly U.S. oil data more closely than might seem warranted.

But in reality, the U.S. is a reflection of the total market: if the global market was in glut, U.S. exports would be lower and imports higher. A sharp decline in U.S. inventories is, to a significant degree, an indicator that the overall market has tightened recently and while a global recession could lead to a new inventory build, for now at least the bullish trend in the market appears well-supported by such data as is available.