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The Biggest Question For Oil Markets As Brent Breaks $40

Amad Shaikh

Brent futures have broken above $40 for the first time since early March. Volatility continues to trend downwards, with the biweekly rolling average moving towards mean levels. Physical oil has also recovered, with the Dated BFOE physical benchmark nearing parity with ICE Brent futures, from a discount of $10 in April. The Dubai inter-month structure has also reverted to backwardation for the front months, after a period of super-contango. This means Arab Gulf OSPs will likely see a spike reflecting improving market structure, which would translate to a ~ $2-$4 per barrel increase.

Brent
Oil

A month or so ago, traders were concerned about low prices and producers were forced to watch as wells became unprofitable and were forced offline. The key question now is what a reasonable price ceiling should be, with OPEC+ holding most of the leverage and oil markets set to move into undersupply at the beginning of the third quarter. Should OPEC+ continue to hold back supply, or should it take a breather to recover cash flows? The disputed range of $40-50 is a ten dollar differential that can make all the difference for many shale or high-cost producers. U.S. production, which has been in freefall since March, seems to be flattening out. As I argued in a recent article for Oilprice.com, loosening the leash on production too quickly would be a costly mistake. Instead, it is time to force permanent shale closures or obtain concessions from U.S. state regulators. While Texas and other states have declined to participate in any oil controls, the right political leverage could yet bring them to the table.

Global
Brent

We find ourselves in a very similar situation to the one that launched the oil price war months ago, with Russia and Saudi Arabia unsure about extending the most recent historic cut of ~10mbp. Saudi Arabia is currently proposing a three month extension to September, while Russia appears to be offering a one month extension to July. The OPEC+ meeting scheduled for tomorrow could very will shake up oil markets once again. As before, Russia, with good reason, is afraid of seeing the prices go up above $50+, which could certainly happen if the extension is granted. This would be a shot in the arm for struggling shale producers, and a shot in the chest for OPEC+.

Rigs

While crude is enjoying a bullish run, it is putting even more pressure on already poor refining margins, with diesel cracks slumping to decade-low levels in the Atlantic Basin. The chart below is a very basic approximation of global refining margins using a 2:1:1 proxy crack with the most liquid ICE traded products (2 x Brent – ICE gasoil – ICE RBOB). While actual margins vary with location and refinery configuration, this chart indicates the lowest refining incentives in years. Even with some recovery from March lows, the current proxy margin is half of the 3-year average. But there is hope. If crude prices continue to rise, pressure on margins will rise, leading to lower refining intake. Furthermore, many refining maintenance programs have been delayed to summer. The combination may help tighten refined product balances and improve refining margins. On the flip side, this also means less crude demand, but that may not be such a bad thing to stem rapidly rising prices.

Proxy

By Amad Shaikh

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