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DIGITAL EDITION

January cover


THIS WEEK'S TOPIC:
CRUDE PRICES

We’re going to do the contango, so put on your dancing shoes
By MARK RACHAL
Cost Management Solutions    
Cost Management Solutions
We have begun a short series in Trader’s Corner on crude. As we stated in the other Trader’s Corners during this series, crude is like a fighter jet and propane is a missile fixed under its wing. For the most part, propane follows along with crude, but sometimes fires off in its own direction due to its own fundamentals.

It is important that propane retailers follow the factors that affect crude prices if they are to increase the odds of managing the risks associated with buying propane supply properly.

So far in this series, we have discussed the paradigm shift in crude markets that has taken place over the past few months. The Organization of the Petroleum Exporting Countries (OPEC) had been the self-appointed swing producer for crude. But now it looks as if they are going to take market share and become the world’s baseline producer, leaving higher-cost producers in the United States to be the swing production for global oil markets. That’s a great move for OPEC, but as we discussed in our first article in this series, it likely increases the chances of crude price spikes in the future.

In last week’s Trader’s Corner, we focused on U.S. crude production and showed how the rapid rise was the catalyst in forcing OPEC to shift its strategy. This week, we are going to look at U.S. crude inventory and what the oversupplied market has done to crude futures prices.

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Despite the fall in prices and all the talk of less drilling to this point, U.S. crude production is still climbing. Production was at 9.32 million barrels per day (bpd) last week. We have records dating back to 1983, and that is the highest production rate in all that time.

With production high, prices low and cuts in drilling activity, crude traders have decided to store crude and wait for the inevitable rebound in prices, when production begins to fall and prices firm up.

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On Friday, the crude futures price curve looked like the chart above. Note that the April price is lower than the price for May, and so on. This is called a contangoed crude price curve and encourages storing. Recently, the crude price curve has been contangoed into 2022. A contangoed price curve is indicative of an oversupplied market, making the current barrel of crude less valuable than one in the future when supplies may be tighter.

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The crude price curve shown above is from a year ago. The price for April crude was higher than May crude, and so on. This is a normal backwardated crude price curve. It does not encourage storage and is indicative of a balanced, or undersupplied, crude market. That makes the barrel of crude that is currently available more valuable than one that will be available in the future.

We can confidently assume that crude will return to the traditional backwardated curve at some point. Eventually, the crude market will work out its supply/demand imbalances, surplus inventory will be consumed, and the nearby barrel will be worth more than the one in the future.


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What is far more difficult is identifying when the balance will be restored. Some think prices will begin to recover in the second half of this year. The assumption is based on less U.S. production at that time.

But even when U.S. production begins to decline, supply and demand will not be immediately balanced. Plus, there is the matter of cleaning up all the crude that is being stored now. Further, those assumptions do not include more production from OPEC. For all we know at this point, the sanctions on Iran that have cut a million barrels per day of crude supply out of global markets could be lifted. You can bet Iran forces those barrels into the market as soon as it can - it needs the money.

Of course, it can go the other way too, with more disruptions to supply in the Middle East, perhaps caused by the Islamic State. But for now, we predict the fighter to which our propane missile is attached will be flying low for a while. That means price escalation in propane will likely be from changes in its own fundamentals, rather than a strong rally in crude this year - or even next.

There is plenty of reason to believe propane prices could go higher on their own - without the support of crude - later this year. But for now, our belief is that one must be cautious in assuming any type of major rally in crude prices this year. Commodities trader Goldman Sachs just predicted West Texas Intermediate (WTI) crude is likely to fall to $40 per barrel before recovering later this year. If it falls to $40, then a recovery in the second half of the year could simply be back to where prices are today.


WEEK IN REVIEW

Propane inventory had its largest draw of the year, but the focus of traders seemed to be on moderating weather. A very strong dollar and weak fundamentals kept crude prices in check. We went neutral on our outlook for propane prices last week and remain bearish for crude prices.

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LAST WEEK'S HIGHLIGHTS
Last Week's Highlights
Propane prices outpaced crude to the downside, showing weakness that would portend much of the activity for the week. Crude opened down, but trimmed losses by the close. Reports that a deal might be struck between Iran and the West on Iran’s nuclear program was bearish for crude.
Weakness in propane markets continued ahead of fresh inventory data. Mont Belvieu went up with crude but lagged, and Conway propane actually fell slightly on the day despite a 1.88 percent gain in crude. Crude was up as a result of Saudi Arabia raising its official selling price to Europe, Asia and the United States.
Propane markets reacted rather bearishly to a 4.2-million-barrel draw on U.S. propane inventory reported by the Energy Information Administration (EIA). The draw was 1.5 million barrels above expectations. Still, Mont Belvieu propane moved lower and Conway was unchanged. Crude shook off a 10.3-million-barrel build in U.S. crude inventory to move up 2 percent. West Texas Intermediate (WTI) crude was driven higher, as traders played the price spread between WTI and Brent by selling the Brent contract and buying the WTI.
Outlooks for moderating winter weather later this month and falling crude had propane prices posting significant drops. A strong dollar and weak fundamentals overcame speculative interest in crude to send it lower.
Propane prices continued to demonstrate weakness, as traders worried about forecasts for milder temperatures. Crude fell as the dollar index pushed to 11-year highs.
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