Oil: What 2021 Price Action Taught Us

Futures Curves and Spreads

We went from a system that was worried it wouldn't have enough places to store excess barrels to one that was becoming increasingly vulnerable to lack of investment

Previously Part 1: A Trip Down Memory Lane

2021 Market Review - Futures Curves and Spreads

The OPEC+ interventions on the market in recent years have helped the oil industry to see the beginning of the return of confidence and investments. Russian Deputy Prime Minister Alexander Novak told Russian TV channel Rossiya 24 in an interview in December.

“We positively assess the joint actions since 2016. They allowed us to return investments and restore confidence in the industry. This is a strategically longer period for planning our activities.”

This is a confident statement - a victory lap of sorts. Nonetheless, it's a plausible statement given the recovery we have seen in oil prices.

Crude Oil - Flat Price and Curve Structure

In 2020, we saw the complete devaluation of the energy complex (brown line vs red line below). The entire curve plunged well below $50, questioning the fate of future production growth. Prices remained below this level into early 2021 (cyan line below, 1/04/2021 futures curve). By mid-2021, the demand side of the equation began to take over as excess global inventories began to recede (navy line below, 5/03/2021 futures curve). We went from a system that was worried it wouldn't have enough places to store excess barrels to one that was becoming increasingly vulnerable to lack of investment and short-term supply disruptions (rather than demand destruction). By the close of business last Friday (gold line below) prices across the curve were above $60, well-above that level even in shorter-dated futures.

By August of 2021 the 12-month calendar 2022 futures strip was above the $70/bbl level (green line below). It remained above $70 long enough that participants began to wonder where the hedgers were. Wasn't this a magical gift of a number producers could only dream of in 2020? What became clear was that unlike past industry cycles, production wasn't responding meaningfully to higher prices. From a fundamental perspective this suggested that further oil price increases may be on the way. Even the calendar 2023 strip briefly flirted with the $70 level before being rejected (gold line below).

Outright prices began to buckle a bit, however, under the weight of SPR releases and continued monthly increases in OPEC+ production. Keep in mind that these supply increases (as defined in the US SPR release schedule) end in April, 2022. Additionally, the OPEC supply increases are currently on track to end in September of 2022 (barring any changes made to their existing schedule in future meetings). Between the two, over 146 million barrels are expected to be added to the market in 2022 (400k/day OPEC = 96 million barrels from Jan-Sep 2022 and 50 million from the US SPR).

Crude Oil - Time Spreads

The front-loaded nature of the supply additions noted above puts in focus the level of backwardation witnessed this year in oil markets. As 2021 progressed, the market focused more on short-term upside risks than down-side risks and backwardation began to take hold. The chart on the left below depicts one-month WTI calendar spreads realized in 2021. the chart on the right shows the level of one-month backwardation in 2022 futures.

So far this year, the market has been unable to realize the optimistic levels that futures spreads have reached at expiration. This pattern has caused many players to move their bullish time spread bets further out on the curve in order to avoid expiration weakness but still capture upside momentum.

It was, after all, the expiration of the 12-month Dec-21/Dec-22 calendar spread in WTI that was able to maintain record historical backwardation into expiration (of the Dec-21 leg) albeit well off its highs (lime green line below). Interesting given the nature of supply additions noted earlier.

Is this just a result of thin year-end markets or something deeper lying beneath the surface? The narrative that has developed in the latter half of 2021 is one of capital investment deficiencies that will harm supply growth going forward. Seems odd that the market would be willing to part with inventory today while at the same time questioning their potential to replace those barrels in the future via production. What reconciles this? Higher prices and a contango structure? This is a tough sell when it's widely known that producers of commodities are more prone to hedge their price risk than consumers. Producers usually hedge 1-2 years out while the marginal consumer usually is a price taker in the spot market. Putting pressure on spot market prices using inventory (SPR, etc.) not only doesn't entice production, but it also doesn't lower consumption. What is the old adage - High prices cure high prices and vice versa?

Refined Products

Speaking of the consumer, gasoline and distillate futures prices have experienced the same trend as crude oil as seen in the two charts below (US gasoline on the left and ULSD on the right).

In relation to crude oil though (as seen via crack spread futures below), refined product futures are not showing as robust of a move. Both the gasoline and distillate cracks have stalled a bit since their initial move higher earlier in the year. Should we start to see these come under pressure in 2022, this might be an indication of consumer fatigue at these levels.

Inventory

Total US inventories (crude oil + gasoline + distillate) are now the lowest they have been since 2014 (2021 = purple line below). This total includes SPR inventories which we know will continue to draw for the next several months according to the release schedule.

It's relevant to look at combined inventory levels since, at the end of the day - it's all crude oil, just in different forms. As it stands now, we will begin 2022 with historically low inventories. A welcome thought if you expect the new Omicron variant to induce demand destruction and therefore we will need the storage space. A scarier thought absent that. Enough said.