Crack in Oil Supplies
Macro News: Saudi Arabia's oil cut decision and impact on global oil markets
July 2023 saw fresh oil production cuts from Saudi Arabia, the largest member of OPEC+ in terms of production. This is to continue into August 2023, as announced on 3 July, 2023. Saudi Arabia may come out with an update about production schedule for September later this week, and there is strong sentiment for cuts to extend into September 2023. We analyse the impact the announced cuts have had, and give our thoughts on what may be in stock for the remainder of the week in speculation of the announcement.
The reason for the production cuts are evidently to boost revenue for oil-exporting countries. Oil prices have been low for several months, due to high global supply and slow demand recovery. Cuts should support prices.
6 June, 2023
Early June was the date for the July cut to be announced. This was a cut of 1m barrels per day. The economic theory underlying production cuts is that there is excess demand relative to supply, and hence prices must rise all else equal.
The key market reactions:
Market response was muted in the physical market
Physical Market - real market for transfer and delivery of physical barrels of crude oil and refined petroleum products.
We should expect there to be an impact on the short-term physical market relative to the long-term physical market. We can consider this as a spread (difference between two prices) and see how the spread changed. A contract to trade this is the Dated Brent Calendar Spread.
Dated Brent Calendar Spread - the difference between two Brent crude oil contracts with different delivery months.
While still part of the physical market, Dated Brent contracts are specified for delivery of Brent Crude Oil (from the North Sea) in particular months. We expect the price of nearer months to be higher than distant months, hence the market to be further backwardated.
Backwardation - when near-month contracts trading higher than later-month contracts. The future curve is downward sloping, as prices converge at maturity.
Following the production cut, the July-August spread was 7 cents more backwardated from the previous week, below previous levels seen in April cuts.
Mild tightening of financial markets
Financial Market - market serving to provide financial instruments and derivatives linked to oil prices, but not the physical good itself.
Brent futures tightening father into backwardation from 86 cents to $1.20 from the previous week.
Neither market delivered significant price rises, and this is due to external economic factors contributing to market sentiment. While production cuts raise prices, decreasing demand pressure reduce them:
Slow demand recovery from China
Major G10 economies and oil-importing countries suffering from recessionary fears, or slow growth
Strong oil supply from the US in the face of Russian sanctions
All contributed to lower prices, and the relatively muted reaction in June.
3 July, 2023
Announcement of production cuts to continue into August 2023.
Markets responded similarly and were further backwardated. This cut came at a slight shock to markets:
Brent Crude Futures rose 43 cents (0.62%) in a couple hours. Brent Crude rose 0.8% on the day.
Similar reaction to WTI oil, which rose 1.1% on the day.
In July, particular towards the end Brent oil prices reached highs of $85.39. This was in part due to the sustained cuts from OPEC+, but also recovery of growth in China and Western economies, as well as some alleviation of recessionary fears. The FED stated that their in-house economists had determined the US was not facing recessionary fears anymore. These both contributed to stronger price support for oil and a move to a less-backwardated market.
1 August, 2023
1st August, 2023 saw a surprise shock to all global markets. Fitch rating agency downgraded their verdict on the US Economy from the top level of AAA to AA+. This came with significant sell-off in equity markets and rise in yields, with the 10-year Treasury bond up 2bps.
It is therefore not surprising the oil market was hit. Brent saw its largest one-day decline in over a month, down 2%, and WTI fell 2.3%. Even in spite of low inventories, signalling high demand, and theoretically higher prices, a macro sentiment of lower confidence was the stronger catalyst.
Looking Ahead and Estimations
There is a strong sentiment for an extension of cuts into September 2023 making it 3 consecutive months of the 1m barrel/day cut.
We provide our thoughts on what lies ahead for the oil/commodities market due to this:
Immediate rise in Dated Brent calendar spreads for October-November and November-December
Driven by rise in physical market Dated Brent due to oil cuts
Volatile environment for sentiment given healthier economic growth in the US and EU, however poor due to rating downgrade. Slowdown in demand stronger incentive in near-term. Less backwardated oil Futures contracts.
Crack spreads fall
Crack Spread - difference in price between a barrel of crude oil and the petroleum products refined from it. Industry-specific profit margin for refineries.
The US Energy Information Administration demonstrated on 2 August, 2023 that between 9 June, 2023 and 14 July, 2024 regional inventories for distillate fuel oil (diesel) actually increased by 18%. More refinery activity has increased inventories. Much of this refined product is shipped to the East Coast from Midwest or to the Gulf. However, there is scheduled maintenance until September 2023 on the Illinois River, connecting Lake Michigan to the Mississippi.
As oil cuts have raised benchmark prices, crack spreads have fallen, as they are measured by subtracting benchmark prices from refined distillates. The inability to ship as much refined product and build-up of inventory has meant crack spreads have begun to fall. We expect the refinery margins to continue to fall into September, and until the maintenance leads to a full-reopening. We believe crack spreads will fall.
The oil cuts have been in an attempt to lift prices, and as seen in July, succeeded to an extent. Poor sentiment to do with the US Economy, dampened demand outlook, and we believe this will persist for the near-future. However, sustained production cuts along with continued economic growth in the EU and USA will support prices throughout September and thereafter.