In my last update I had predicted that the oil market would be on a solid footing going forward given Asian / Chinese buying would return (after maxing out purchases of Iranian barrels), Europe and the rest of the developed world would continue progressing on vaccinations, and supply discipline from both OPEC+ and US Shale producers would continue.
Most of those predictions have turned out to be correct, but as is always the case with oil and macro analysis, there are some new risks / factors to consider:
1/ Vaccination rates have continued to climb, but now we have to deal with a new mutation of the virus (commonly referred to as the Delta Variant) which is extremely contagious (R0 of 6-8) and impacting not only the under-vaccinated developing countries, but also developed economies like the UK and the US
2/ OPEC+ reached an agreement to maintain supply discipline and gradually raise production for the rest of the year and into 2022, but only after several tense negotiating sessions which uncovered disagreements between UAE and Saudi Arabia. This understandably unnerved the markets given memories of the Saudi/Russia price war debacle are still fresh in investors’ minds
These two risks had started weighing on sentiment in early June, when XOP was rejected off of the 100 level. After failing to break this level several times, oil equities began to fall in earnest starting early July. The price action in oil equities was a leading indicator of what was to come for oil, which continued to trade at 70+.
Starting July 14, oil finally started to dive and took a 15% draw down from the mid-70s to the mid-60s. The fall in oil equities was even more dramatic with XOP and Gear Energy falling ~25% and 40% from their June highs respectively.
The violent unwind in the energy sector was likely a function of positioning which had become too bullish. According to RBC there were 8.6 long contracts for every short contract in WTI futures market, so a swift retracement was going to be inevitable as the market re-calibrated the future trajectory of oil demand recovery and the probability of fresh mobility restrictions / lockdowns. Since then, oil prices have recovered back above 70, while oil equities have continued to languish.
In my opinion, the recovery in oil is a symptom of the current physical market conditions which remain extremely tight as oil demand continues to recover and inventories continue to draw.
In the US, crude oil inventories are now below the 2019 levels due to strong pick up in mobility and demand for gasoline combined with a lack of recovery in US Shale production.
In fact crack spreads globally suggest that the strong demand story is not just a US phenomenon but rather the rest of the world is also out and about.
Brent 1-12 time spread is another indication of strong physical demand globally.
Oil equities seem disconnected from current oil prices / physical market conditions because they are likely discounting the potential future risks posed by the Delta variant and a potential OPEC+ price war. Are these worries justified? Parts II and III of this update will assess these risks going forward.
The Pale Blue Dot 