Oil market special: Scraping the bottom of the barrel

Market Analysis / 4 Min Read
Stephen Innes / 23 Apr 2020

Oil prices have recovered from a 21-year low, after several days of frantic front-end position de-risking.

The short-covering bounce came after President Donald Trump ordered the US Navy to destroy any Iranian gunboats that harass American ships at sea, heightening geopolitical risk across Middle East oil producers in a rippling effect. 

Also supporting the June contact, the USO ETF re-weighted their average expiration date, reducing pressure on the June delivery date. And the market could remain gingerly supported as traders wait hopefully for the legalities to be ironed out for a proration deal from the Railroad Commission of Texas to compensate shut-ins from the currently proposed 20% cut in Texas oil production.

Still, ominous clouds continue to loom overhead as the H1 supply saturation risk presents the ultimate barrier for oil price recovery.

Any bottoming out in prices is solely dependant on either an immediate OPEC+++ coordinated action to limit the downside slide and or an unlikely swift demand recovery in May as either could trigger a reassessment of relative value on the forward curve. 

WTI concerns are widely attributed to localized physical settlement and restricted storage issues at Cushing. But the problems at Cushing have set a new theme for the markets as traders are just as distressed about front contract settlement risk as they are about the relative value of oil. This is creating an incredibly messy proposition for oil price discovery and pegging a relative value for oil prices via cross-asset correlations.

It feels impossible to be even slightly bullish in June, knowing the paper market overhang, and those market makers will front run and price to perfection in their favor at roll time. However, I'm quite optimistic along the curve.

For bullish paper traders, it's tough to fight the deliverable mechanism in the WTI contract at the moment, and it's exposing some significant cracks in the NYMEX market that could see more traders shift to Brent or even moving local and trading Shanghai Yuan-denominated oil futures contract. 

Is Brent going to zero?

Brent going to zero is still an unlikely outcome of the glut in supply in 2Q, but it can't be ruled out given that market participants are always keen to test; give traders a target and they’ll continue to throw darts at it. 

Brent was down hard yesterday before recovering on possible intervention chatter following another day in which the magnitude of the expected 2Q oversupply weighed heavily on sentiment, despite the planned OPEC+ cuts. 

Storage issues 

I'm a bit leery of making comments regarding peak storage as oversupply assumption variances are far too broad given the current projections lie anywhere between 15 mb/d to 30 mb/d, which could make the difference between May and June peak storage. 

Q2 the lost quarter for oil markets

The end of the price war and the G-20 producer economies' willingness to reason is a significant positive that the group would once again begin to attempt to coordinate action to limit the downside for oil, even although the initial cuts agreed were woefully ineffective. 

It appears that OPEC is now thinking along similar lines and media sources have reported that planned OPEC+ cuts might begin immediately instead of on May 1 as originally scheduled. But it’s also likely there could be additional shut-ins in the US and short-term voluntary production cuts across OPEC +, which should prove to be price supportive.

While this falls into the 'too little, too late' category, it's reassuring that the current crisis is being taken seriously. 

From a fundamental perspective, 2Q is a lost quarter for oil – it’s not realistic to expect that additional OPEC+ action, even with support from other major producers, can rebalance supply and demand within the next few months: it's all about stemming the tide as we move into H2.

Will June become a dead contract?

When it comes to June WTI, it feels like the markets are flogging a dead horse, which suggests June could become a dead contract as more open interest – paper and real – logically shifts July and beyond. 

On the currency market, it’s the 12-month price average that counts, not the front contract. And, further out, both currency and energy equity markets do not expect oil to be in the $20 price range for long, hence the relative resilience shown by the Canadian dollar and oil majors. 

Energy stocks outperformed yesterday as the sector decouples from the underlying front month as the oil stocks are supported by high dividends and expectations of a positive price correction in Q3. 

The infomation is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.

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