Oil Market in Disarray - Transcript

Welcome to RBC’s Markets in Motion podcast recorded July 6^th, 2022. I’m Michael Tran, Managing Director and Global Energy Strategist at RBC Capital Markets, filling in for Lori Calvasina. Before getting started, I’ll remind our audience to please listen to through to the end of this podcast for important disclaimers.

Over the next 10 mins I’ll cover three key oil market themes to watch. First is the disconnect between the physical and financial oil markets. Second is the recessionary risks to the market and what the oil term structure is telling us and finally the third theme focuses on demand destruction, the health of the consumer and the strong dollar impact for global end users.

First, we’ve been mega bulls on oil for the past 18 months. And recession or not, we believe that the oil complex, just simply, remains in a structural, multi-year tightening cycle…that will send prices as far and as high as the economy can bear.

SO…where…does this leave us…now? Clearly, the market is stuck in the push-pull between the current deteriorating macro backdrop and the looming threat of a recession…which is…pitted against the strongest fundamental oil market set up…in decades, or maybe even ever.

To kick off - What we’re seeing currently, is an incredibly strong physical oil market. If you follow our work, you’ll know that we focus a lot on the global marginal barrel in the market. We call them the Atlantic Basin barrels, these are your North Sea and West African barrels. And many of them are pricing either at or near the highest levels we’ve seen on record. The physical strength has clearly been validated with the Saudi Official Selling Prices (or OSPs) recently set at near record physical premiums for their customers for August delivery. Throw in there the potential added tightness of a suspension of oil flows through the CPC system leads us to believe that the physical market will remain tight over the near term.

This tight physical market is being contrasted with the financial paper market which is seeing benchmark oil prices plunge by more than 20% over the past four weeks. So in short, what we’re seeing is supply tightness, coupled with seemingly unwaveringly strong physical demand for crude currently, which is a diametrically opposed picture that is being painted in the plunging paper market.

What does this boil down to? We believe that the physical market is pricing in scarcity while the financial market is pricing in a recession.

Look…Physical weakness…HAS…to…come before a recession. Which means that…until we see signs of physical weakness, we’ll remain bullish.

Second – What’s fascinating is that despite the retracement in spot oil prices, term structure remains relatively intact. This means that the term portion of the curve is also retracing significantly lower. And probably too aggressively. For example, the 2024 Calendar Brent strip, which is historically less volatile than the front end spot prices, is down over 13% from the peak last month. We’re talking about a relatively illiquid portion of the forward curve.

So unless the recession is deep and protracted, we think that the dated calendar strips are largely undervalued.

I will say…that, while we’re constructive on the crude market, near term recessionary risks must be respected.

We published new scenarios last week, and in a recessionary scenario in which demand is impacted at a similar rate as previous downturns, we could see a scenario in which spot prices retreat into the mid $70/bbl range in the back half of this year. Now, we only place a 15% probability to such an outcome, but we have all been doing this long enough to know that oil price moves can be swift, violent and unforgiving, in both directions.

What I’ll say about our discussions with commodity clients is that the bullish conviction is high and remains intact, but sentiment is soft. When asked when they’ll step in, buy the dip and defend price…the answer is “once the non-specialist macro funds finish liquidating their length”. And we saw a lot of this macro length pile into the oil trade over recent months with the goal of being an inflation hedge…and now given that the fear has turned from inflation to recession, those macro funds are done renting the trade and are now spinning out the risk.

And lastly, the third point: demand destruction. Look, we’ve spent the first half of the year, writing non-stop on demand destruction, so I’ll encourage you to check out any of our recent publications,

1. Record gasoline prices. Look, We all, as a market…we as a society complain about high gasoline prices. The media loves to talk about demand destruction…and why not? I mean, gasoline, diesel prices are at record levels in the US and many other places on the planet.
   1. But here’s what they don’t tell you…historically speaking, we rarely see large and material amounts of true demand destruction. So how often does demand destruction actually happen? We looked at the past 30 years of US gasoline demand data leading into the pandemic. We found 39 individual months in which US retail gasoline prices increased by 30% or more, YoY.
   2. Now…….Of those instances, we have seen gasoline demand retrace by 2% or more on only 12 of those occasions. And five of those instances took place during the 2008 Great Financial Crisis. Why am I highlighting this? Because meaningful demand destruction events have historically been rare, even in significant rising price environments, absent a recession.
2. Now, everyone uses 2008 as a historical comp for demand destruction. Everyone, and I mean everyone uses 2008 as the comp for demand destruction...because…that was the last time we saw record pricing and also the last time we saw gasoline demand destruction…but we need to stop doing that. It’s a poor comparable. And here’s why:
   3. So we looked at 60 years of US household savings rates. What we found was that the 12 months leading into the all-time peak for oil prices in 2008…coincided with the lowest point in US household savings rates over the past 6 decades…and savings rates averaged 3.5% in the 18 months leading up to the peak in oil prices. This was less than half of the historical average of household savings rates of 8.3%. So, in short, the last time gasoline prices hit record levels was during a period when the US consumer was the most financially vulnerable to energy price shocks over the past 60 years.
3. Perhaps most important point I’ll make is fuel as share of wallet, or gasoline expenditure as a percentage of total Personal Consumption Expenditure. We model this number to be 3.5%. This compares to the 3.6%, which is the 30 year historical average for gasoline expenditure as a percentage of PCE. Let’s think about this for a minute. We have record pump prices….but current consumer expenditure for gasoline as a percentage of total spend…remains below historical averages.
   1. This means that there is discretionary spending that could be pared back before core items like gasoline are truly impacted.
   2. Another way to look at demand destruction is that in 2008, gasoline expenditure as a share of PCE was 4.5%, our regression based modeling implies that…in order to reach those levels, average retail US gasoline prices need to rise to $6.60/gal, or another 35% higher from current levels.

These are simply some of the reasons why gasoline prices have been unrelentingly strong, but we’re not seeing material amounts of demand destruction, at least yet.

The one point we need to watch on a global level, is the strength of the US dollar. The strong dollar means that oil priced in local currencies is still punching in either at or near all-time record highs for many regions across the globe…which is clearly a burden for most global consumers outside of the US. As long as the dollar continues to stay strong, this will remain a headwind for buyers of crude denominated in US dollars.

In closing, I’ll remind listeners that the next week is an important one from a data release perspective. Of course we’ll be watching the EIA product supplied data to give us insight on how robust…or not the fourth of July weekend was…and also, we should be getting Chinese import and runs data any day now. And both of those are important releases that could alter the sentiment through the balance of summer.

That’s all for this edition of Markets in Motion. I’m Michael Tran, guest hosting for Lori Calvasina. Thanks for listening.