Previously, every rally attempt has coincided with speculators short covering. We’ve seen time and time again where the physical market fails to catch up with the financial price move only to see prices fall back down. And the last rally came at the expense of refining margins, which proved once again to be unsustainable.
3-2-1 Crack Spread
barchart.com
Note: Please divide the figure above by 3 to arrive at the 3-2-1 crack spread.
1-2 Brent Timespread
barchart.com
To me, this is the first step to sustainably higher oil prices. Refining margins have to rally in tandem with flat prices, and backwardation needs to steepen. Without either of these things, any rally in crude will be short-lived as the sentiment remains firmly bearish.
For readers looking for signs of higher oil prices, these two indicators are one of the most straightforward to track, and historically, if timespreads and refining margins rallied in tandem, higher flat prices shortly follow.
Fast forwarding to today, both of the indicators we pointed out have materially improved.
3-2-1 Crack
barchart.com
1-2 Brent Timespread
barchart.com
Despite the fundamental improvement we are seeing in the physical oil market, flat prices only moved up from $73 to $76. To me, current physical market indicators point to much higher prices ($79-$81).
In addition to the bullish development we are seeing on the physical front, readers who closely follow the oil market will also note that the physical market has always been a good leading indicator for incoming storage changes.
In our OMF yesterday, we noted that U.S. commercial crude storage will build in February due to disappointing refining margins. We said that product draws would have to outpace the crude build. But judging by the market reaction, the market sees the incoming balance changes as positive, which is a bullish signal.
Step change, but moving in the right direction…
The healing process, that’s currently taking place in the oil market, is playing out, but it will take time. With global refinery maintenance season coming soon, it will be important for the actual inventory changes to validate what the market is currently saying. If so, it will have bullish implications for global balances going into Q2.
In essence, what readers should expect are the following:
Crack spreads to remain elevated throughout the maintenance season.
Steeper backwardation in both Brent and WTI.
Inventories to validate the bullish market reaction we are seeing.
Aside from the fundamental development, OPEC+ will be meeting in early March to determine whether or not they will extend the voluntary production cuts for another quarter. Our base case is that another extension will take place, but with the caveat that if demand improves, then OPEC+ could start to unwind the cuts by the middle of the year (topic for another write-up).
If OPEC+ follows this route, the oil price upside will be capped as the market digests the excess spare capacity coming in. So, even if demand surprises to the upside, we don’t see the risk of an oil price spike this year. In addition, 2024 is an election year, so from a geopolitical standpoint, OPEC+ is better off unwinding the cuts (if warranted) than risking a potential price spike.
As a result, if fundamentals trend the way we think they will, then we see a comfortable oil price range between $80 to $90.
