A couple of days a week, the Desktop is given over to market indicators, and Wednesdays belong to oil. Midweek, we highlight the key fundamental and technical indicators underlying crude oil and its essential refined products. The Wednesday oil roundup coincides with the U.S. Energy Department’s weekly release of national petroleum inventory data.
Given the interest shown in the Wednesday Desktop, we figure it’s time for a more thorough oil market backgrounder. (We took a preliminary look at the space back in January’s “A Primer On Oil Indicators.”) So without further ado, we present the first installment of our petroleum guide:
In anticipation of the Energy Department’s data release, sell-side and independent analysts make forecasts on the ebb and flow in crude oil, distillate fuels and gasoline stockpiles. We recap these predictions and contrast them with the estimates made by the oil industry-supported American Petroleum Institute. All the prognostications are then held up against the definitive supply numbers published by the Energy Department.
The Street’s forecasts and the API estimates often drive trading ahead of the government’s data release. Surprises, such as unanticipated changes in crude oil and product stocks, can move prices in the Wednesday session following the data release as well. Be mindful, however, that exogenous events can overshadow these reports. The current volatile situation in the Middle East and North Africa, for instance, is much more important to the overall oil market than U.S. inventory numbers. When things cool down overseas, however, we can expect the API and DOE reports to regain their larger impact on the space.
Domestic Crude Oil Inventories
Supply and demand – Expectations for refinery utilization are also contrasted along with a comparison of refinery output and consumption trends.
Trading Week Recap
Refining margins – Weekly price trends in the crude oil, heating oil and gasoline markets are recapitulated to provide a context for the vacillations in refiners’ gross profit margins. We contrast returns for refinery runs geared toward lighter distillates, such as gasoline, and those weighting heavier fuels, such as heating oil and diesel, to better illustrate the motivation behind refiners’ utilization and production decisions.
Like anything else, refining margins fluctuate based on supply and demand. In this case, supply is refining capacity (utilization), while demand is the consumption of petroleum products. Long term, margins tend to be fairly well-behaved, but in the short term, there can be dramatic swings. Hurricane Katrina caused an enormous spike in margins as refineries along the Gulf Coast were shuttered. More recently, the Tōhoku earthquake in Japan shut down over 30 percent of the country’s capacity, also boosting margins.
Gross Refining Margins – WTI Crude Oil
Ethanol crush – The yield for refining corn into ethanol, a key gasoline-blending component and alternative fuel, is highlighted each week. Higher yields nominally encourage production, while lower returns tend to dampen output. We also track the price spread between finished ethanol and gasoline.
Ethanol Crush Margin
WTI/Brent spread – West Texas Intermediate (WTI), the benchmark grade in the U.S. market, is a light, sweet input that’s better suited for gasoline production than the more viscous and sulfur-laden crudes traded on the world market. WTI’s nearest competitor—a light but sour crude—is North Sea Brent.
WTI historically trades at a premium to Brent, reflecting its lower throughput costs, but supply imbalances can sometimes tip the spread to a discount. Currently, because of high stocks of WTI piling up in the Midwest region of the U.S. and a relative dearth of new Brent and similar crudes, the domestic benchmark has moved to a deep discount. In fact, last month the spread reached as high as $16, an all-time record.
One consequence of the high spread is that refiners that have access to relatively cheap WTI in the Midwest are making huge profits.
WTI contango – We track the week-to-week changes in the oil market’s contango to help traders and investors better understand current supply dynamics.
Contango refers to a positive spread in futures prices seen as one moves forward on the delivery calendar. Today, for example, crude oil for April delivery trades at $98 a barrel, while a contract calling for July delivery is worth $100 a barrel. The pricing difference—the $2 contango—reflects the costs of carrying the crude oil inventory (storage, insurance and financing) to the contracts’ respective delivery dates.
The existence of a contango denotes a surfeit of supply. On the other hand, when above-ground supplies are tight, the crude oil market tends to invert, or move into backwardation, i.e., future prices are discounted relative to nearby ones.
A substantial contango encourages further storage and “cash-and-carry” operations, where commercials buy physical inventories and sell futures to lock in higher delivery prices.
Contango reduces the returns earned by long-only oil products such as front-month-only exchange-traded notes and funds. The underlying index methodology subjects these products to negative roll yields. Backwardation, in contrast, would augment the returns of such products.
Average daily volume/open interest – Keeping an eye on trading volume and the number of contracts outstanding in the WTI market helps put the weekly price trends into perspective. A significant price change—up or down—coupled with expanding volume denotes strength; low volume makes the move suspect.
Volume simply indicates the number of contracts changing hands over a given period. Open interest reflects the number of contracts outstanding. As such, open interest represents potential volume.
Open interest increases when new traders open positions opposite one another, i.e., a new long contracts with a new short. Open interest falls when existing longs and shorts both close out their positions. In all other situations (e.g., an existing long liquidates against a new long entering the market), open interest remains unchanged.
A rise in open interest, especially when accompanied by increasing volume, reflects strength in the concomitant price trend.
ETF Daily News Notes Some Oil Related ETFs: United States Oil ETF (NYSE:USO), iPath S&P GSCI Crude Oil (NYSE:OIL), PowerShares DB Oil (NYSE:DBO), ProShares Ultra DJ-UBS Crude (NYSE:UCO), PowerShares DB Energy (NYSE:DBE), United States 12 Month Oil (NYSE:USL), PowerShares DB Crude Oil Dble (NYSE:DTO), ProShares UltraShort DJ-UBS (NYSE:SCO), United States Short Oil (NYSE:DNO), PowerShares DB Crude Oil Long (NYSE:OLO), United States Brent Oil (NYSE:BNO), PowerShares DB Crude Oil Short (NYSE:SZO), United States Heating Oil (NYSE:UHN), Oil Services HOLDRs (NYSE:OIH).
In our next feature, we’ll wrap up our petroleum primer with a discussion of the technical indicators tracked on our weekly price chart.
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