July 01, 2024 [Reuters]- Crude markets have exhibited an increasing disconnect this month between rising spot prices and calendar spreads on the one hand and swelling inventories on the other.

But futures markets are forward-looking and traders appear to be anticipating a much tighter supply situation that would underpin the higher prices and spreads over the next few months.

While the oil market was over-supplied in the second quarter, OPEC and many analysts are predicting a large deficit in the third, which would reduce inventories sharply.

However, traders have expected a rapid fall in inventories since late last year and the timeline has been pushed back repeatedly when consumption has failed to rebound as much as expected.

Forward-looking indicators for consumption in the third quarter are not promising, which may be creating conditions for another setback.

SWELLING STOCKS

Front-month Brent futures have climbed to almost $87 a barrel, the highest since late April, when traders were still anxious about possible open conflict between Israel and Iran.

Nearby futures prices have been rising much faster than those for later delivery, with Brent’s six-month calendar spread ratcheting up into a backwardation of more than $4 a barrel, up from $2 a month ago.

Such steep backwardation, in the 92nd percentile for all trading days since the start of the century, would usually accompany a shortfall in oil supplies and a sharp depletion of inventories.

Instead, crude inventories have been accumulating rather than depleting over the past two months, counter to the seasonal trend, indicating the market has been over-supplied rather than under-supplied.

In the United States, commercial crude inventories increased by 7 million barrels over the nine weeks ending on June 21, compared with average depletion of 10 million barrels over the same period in the previous 10 years.

As a result, inventories were 6 million barrels (+2% or +0.12 standard deviation) above the previous 10-year seasonal average on June 21, erasing a deficit of 11 million barrels (-2% or -0.22 standard deviation) on April 19.

Nearly all of this unusual rise has occurred at Gulf of Mexico refineries and tank farms, the part of the U.S. petroleum system most closely integrated with global markets.

Gulf Coast inventories were 25 million barrels (+10% or +0.79 standard deviation) above the ten-year average on June 21, up from a surplus of 8 million barrels (+3% or +0.23 standard deviation) nine weeks earlier.

Gulf Coast inventories were at the second-highest level on record for the time of year since 2020, when the first wave of the COVID-19 pandemic had caused consumption to plummet and plunged the industry into crisis.

But the disconnect between rising spot prices, severe backwardation and inventories is also apparent in the Midwest, where the delivery point for the NYMEX WTI contract is located at Cushing in Oklahoma.

Cushing inventories were 10 million barrels (-22% or -0.66 standard deviation) below the seasonal average on June 21, little changed from a deficit of 12 million barrels (-27% or -0.89 standard deviation) on December 15.

However, the three-month WTI calendar spread at Cushing is trading in backwardation of more than $2 a barrel, compared with a contango of 88 cents in the middle of December.

The relatively modest deficit in stocks around Cushing would normally be associated with much narrower backwardation.

SHORTAGE AHEAD?

Many forecasters have based expectations for a large depletion of inventories on a strong summer driving season resulting in greater gasoline consumption in the United States.

But U.S. gasoline inventories have been swelling rather than depleting over the past three months, indicating that refiners have been producing too much fuel and will be forced to trim their output plans slightly.

Gasoline stocks had climbed to 1 million barrels (+1%) over the 10-year average by June 21, erasing a deficit of 6 million barrels (-2%) on March 15.

Gross refining margins for making gasoline and diesel from WTI crude have fallen sharply since March and are now in line with the long-term average, indicating that fuel stocks are expected to remain comfortable.

In the crude market, spot prices and spreads have already priced in a very large inventory drawdown over the course of the next three months.

If it proves smaller than expected, conditions are being created for a sharp correction in spot prices and spreads in late August or September.