Cautiously Bullish Oil

The physical market remains relatively strong

For the most part, indicators of the physical market for crude oil remain relatively bullish - as they have been for much of this year.

On the term structure front, both WTI and Brent remain firmly in backwardation across the entirety of the futures curve. This signifies the market is tight and there is a premium for immediate storage/consumption, despite the additional costs associated with said delivery.

The same can be said of diesel futures. Through a combination of reduced Russian diesel exports, reduced production of Saudi heavy/sour crudes (which are generally easier to refine into diesel as opposed to gasoline) and a number of other factors, the diesel market remains incredibly tight and is certainly something energy bulls will want to see in addition to crude oil backwardation.

Meanwhile, WTI calendar spreads (represented below via the one-month less two-month prompt futures spread and one-month less 12-month spread) continues to confirm the positive price action for oil.

The gasoline market on the other hand looks much weaker than that of diesel or crude oil as a whole. The EIA's (historically noisy) estimates of gasoline demand suggest demand has been waning, but whether this is a result of an oversupply or falling demand remains to be seen. Regardless, the market for gasoline is clearly far less favourable at present.

We can assess this by examining both the RBOB gasoline futures term structure above, as well as looking at refined product crack spreads. As we can see below, gasoline crack spreads have moved materially lower over recent weeks, while diesel and jet fuel cracks have held firm.

Clearly, the market for refined crude oil products is becoming increasingly bifurcated, a dynamic which suggests to me the tight market for crude oil is more so being driven by the supply side rather than the demand side.

Such dynamics are beginning show up within refinery demand, whose throughput and utilisation rates have largely trended back toward their seasonal averages. Refiners are in a bit of a tricky spot at present, having to decide whether to continue to refine at above seasonal rates to capture the higher diesel and jet fuel margins on offer and thus continue to oversupply the market with gasoline, or to reduce runs, thus reducing the amount of crude they consume. This is why crack spreads provide such valuable insight into the state of the oil market. After all, refiners are ultimately on of the primary buyers of crude oil.

Thus, all else equal, unless we see gasoline demand pick up and thus gasoline cracks firm, it will be very difficult to see oil move much beyond the $95-$100 area in the near future, particularly when European and Singapore gasoline cracks are also moving lower.

Though, as we have seen, outside of gasoline the physical market remains strong and bullish overall for oil. Other key differentials are confirming this dynamic, with the Dubai-Brent spread (a proxy for Asia/China oil demand) continuing to trend lower overall and near parity.

While the various Africa-Brent crude oil differentials also remain strong. This is an important relationship to track, as West African crudes tend to be the first to sell off.

Inventories shifting to neutral

While the physical market overall looks to still be rather tight, we are not seeing this translate into inventory draws to the same degree that we saw from August through September. Indeed, if we look at weekly changes in total crude and petroleum product inventories relative to their seasonal averages, the picture has now turned unfavourable, as we are seeing far more builds than draws.

In terms of commercial inventory levels overall, total crude and petroleum stocks are more or less in line with seasonal averages. Crude oil stocks on the other hand remain below seasonal averages, as do diesel stocks. The recent build in gasoline stocks is again reflective of the bifurcation between the crude market and the various refined products we are seeing at present. For me to once again become uber bullish (though I remain cautiously bullish), persistent inventory drawdowns across the board would need to become the norm.

The market should remain in deficit through Q4

In terms of the outlook for supply and demand, consensus forecasts continue to suggest we are likely to see the Q3 deficit continue through Q4, though to a lesser extent, prior to the market returning to surplus at some stage during Q1 of 2024. Although such forecasts are full of assumptions and thus fraught with error, it is worth noting what the EIA, IEA, OPEC and others are expecting in terms of production and consumption. For now, consensus is expecting a 0.5-1 mb/d deficit to close out the year, which if true, will show up in persistent inventory drawdowns as well as the key indicators of the physical market, which to me are far more reliable indicators of the outlook for oil.

Speculative positioning should cap upside gains

When it comes to positioning, this is unfortunately where things take a bearish turn.

All good bull markets in energy are driven by low levels of speculative positioning (i.e. hedge funds and CTAs) who are then forced to cover shorts and drive prices higher on the back of favourable fundamentals. This is exactly what has occurred since speculators were caught heavily underweight crude oil around mid-year, thus providing the fuel for much of the subsequent rally from $70 to $95 crude.

Now, despite a significant level of unwinding of speculative longs in RBOB gasoline and ultras low sulfur diesel (ULSD) futures, hedge funds and CTAs remain heavily long WTI futures, a dynamic which will prove a material headwind for oil. This is not to say speculative positioning cannot become even more extended, but the fundamentals need to be significantly bullish for them to do so.

The technical picture

From a technical perspective, however, it is difficult to argue that recent price action remains favourable for bulls. We continue to see a trend of higher highs and higher lows, with the $90-$92 level now acting as key resistance. Should we fail once again to break through this level, then I suspect this is the market telling us how high the ceiling is for oil prices for the time being. But, as it stands, price action remains constructive and a break above $92 for WTI should usher in $100 crude in short order.

The same can be said of the energy equities, with the XLE ETF (XLE) continuing its relative strength and very much looking like it wants to break out above the $93 level which has acted as key resistance for over 12 months now. Again, a decisive break to the upside would be telling in relation to the future movements in the energy space.

On the other hand, it is also worth noting we are now entering the worst seasonal period for oil prices in the final few months of the year. The Northern Hemisphere's summer driving season is behind us, although it must be said seasonal swings in demand have had very little impact on price movements this year, as supply shortages have been the primary market driver.

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.