We Have A Crude Problem

The oil market has a crude problem in the short term. It's essential we dive into this problem by revisiting 2018, again (unfortunately). For those who remember that period vividly, US sanctions were supposed to go into full effect in November 2018. But former president Trump pulled a 180 and decided to give waivers to Iranian oil buyers. And during the run-up to November 2018, Chinese teapot refineries scrambled to find an adequate amount of crude. We saw that during the run-up in oil prices in September and October of 2018.

What followed the sanction relief was a combination of long positions being heavily liquidated on the futures market and the physical market materially softening. Chinese refineries had overbought in the anticipation that Iran barrels would be sanctioned, and this resulted in a temporary glut, which saw Brent timespreads go into contango.

Now fast forwarding to today, we have a similar problem for the oil market, but this time, it's nowhere near as bad as 2018. In our OMF report last week titled, "Oil Is At An Important Crossroads." We postulated the following logic chain as to why crude is weak:

I think my very simple explanation of this is related to China and the incoming Russian oil embargo. I had a lot of time to think this over and this was the only way I could explain why oil prices are not reflecting 1) the incoming end of the SPR release and 2) the OPEC+ cut.

China is the largest oil importer in the world. When China sneezes, the oil market catches a cold, and winter is coming. China's COVID case counts are going to spike, and with it, these present headline risks. We've already mentioned before that Chinese refineries won't be making a return this year due to poor refining margins. So we've already lost a huge catalyst, and with China possibly locking down more, traders don't want anything to do with being long oil for the moment.

Now you couple that with the fact that the EU embargo on Russian crude will be kicking into effect in just a week, and Russia is currently pumping out as much crude as possible, and you can start to see why oil is so weak for the moment.

While I can never be certain that this logic chain is what's causing oil to be weak, we can tackle this problem from another angle. Oil isn't selling off because supplies are surprising to the upside. US shale, while it did grow in November, is nowhere near the surprise territory, and OPEC+ is cutting oil production. This means that demand uncertainty is the only variable that could cause price weakness. And the easiest way to gauge demand health is by looking at refining margins.