Oil prices slump as fundamentals reassert themselves

By most measures the oil market is the weakest it has been since late June before Saudi Arabia and its OPEC⁺ partners reduced by crude production by more than 1 million barrels per day. Front-month prices and calendar spreads have retreated sharply since the end of September, reversing much of the spectacular increase over the previous three months:

• The front-month Brent futures contract closed below $80 per barrel on Nov. 8, down by more than $17 (18 per cent) from the end of September and only up $7 (10 per cent) from the end of June.
• Brent's six-month spread ended in a backwardation of $1.30 per barrel down from $9.33 at the end of September though still above the 8 cents just before the end of June.
• Inflation-adjusted prices have retreated to an average of $84 per barrel (52nd percentile for all months since 2000) in November from $93 (60th percentile) in September.
• The six-month spread has averaged $2.30 (73rd percentile) so far in November from $5.72 (96th percentile) in September.

The retreat in prices and nearby spreads for US crude futures (NYMEX WTI) has been even more severe than for Brent.

DARKENING OUTLOOK

Some commentators have attributed the collapse to rising interest rates and a worsening outlook for the global economy cutting the outlook for crude consumption.

Benchmark yields on 10-year US Treasury notes climbed to a 16-year high in October as traders anticipated the US central bank would be forced to hold overnight interest rates higher for longer to contain persistent inflation.

Manufacturers in the United States, Europe and China all reported worse business conditions in October undoing some of the gradual improvement between June and September.

On the production side, US crude and condensates output surpassed the pre-pandemic record in August, defying expectations it would begin to turn lower in response to the fall in prices since mid-2022.

But the limited changes in production and consumption evident over the last two months cannot explain the speed and scale of the drop in prices and spreads.

The massive run up in nearby futures prices followed by an equally sudden collapse has the characteristics of a short-covering rally and a squeeze on deliverable supplies that has since unwound.

CUSHING SQUEEZE?

Between the end of June and the end of September, total US petroleum inventories including the strategic reserve increased by almost 15 million barrels.

But commercial stocks of crude oil fell by 38 million barrels, and more than 21 million barrels were depleted at Cushing in Oklahoma, which serves as the delivery point for the NYMEX WTI contract.

Chartbook: Oil inventories and prices

Cushing accounted for 55 per cent of the nationwide depletion even though it held less than 10 per cent of all crude inventories at the end of June.

There were only small depletions in the rest of the Midwest (5 million barrels) and along the Gulf of Mexico (8 million barrels) and insignificant changes elsewhere.

Cushing inventories depleted in 12 of the 13 weeks between the end of June and the end of September with a much more consistent depletion than in the rest of the country.

The draining of deliverable stocks sent the WTI futures contract into a near-record backwardation by the end of September.

The record shows a close correlation between the drawdown in deliverable stocks and the increase in the nearby backwardation.

SHORT COVERING

In response to the rise in prices, hedge funds and other money managers were forced to cut bearish short positions in NYMEX WTI to 20 million barrels at the end of September down from 136 million at the end of June.

In turn, the enforced reduction of bearish short positions anticipated, accelerated and amplified the run up in prices, creating a self-sustaining rise in both spot prices and spreads.

By the end of September, bearish short positions were outnumbered by bullish longs by a ratio of 16:1 up from 2:1 at the of June.

Since then, prices and spreads have collapsed, even though US crude inventories at Cushing and elsewhere have barely changed so far.

Fund managers' short positions have again increased to 75 million barrels and bullish longs outnumber bearish shorts by a ratio of just 3:1.

FUNDAMENTALS

For much of October and early November, the end of short covering and unwinding of the squeeze was masked by the sudden upsurge of violence in the Middle East and the risk it would escalate and hit crude oil production.

But as risk of escalation has seemingly fallen, the unwinding has become much more apparent and amplified the downward pressure on nearby futures prices.

In effect, the market was never as tight as prices and spreads implied in the course of late August and throughout September.

Now the unwinding of the squeeze and reduction of conflict premium has returned the market to a more neutral state.

In real terms, prices for both Brent and WTI are almost exactly in line with the average since the start of the century.

Six-month spreads for both WTI (63rd percentile) and Brent (54th percentile) are still a bit higher than the long-term average.

But the residual strength in the spreads reflects the fact crude inventories are moderately below average for the time of year.

US commercial crude inventories are about 9 million barrels (-2 per cent or -0.22 standard deviations) below the prior ten-year seasonal average.

Overall, the market has reverted to a neutral state, neither bullish nor bearish, compared with the strongly bullish conditions that seemed to prevail in September.

Production restraint by Saudi Arabia and its OPEC⁺ partners is being offset by continued growth in non-OPEC output and a downgraded outlook for global growth.