Oil focuses on geopolitics as inventory draw looms

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From every mountain side…let freedom ring

Samuel F. Smith

A much larger than expected decline in crude oil as reported by the API last night coupled with the growing unrest in Egypt has pushed the spot WTI price back above the $100/bbl level for first time since September 2012. WTI has been leading the oil complex higher throughout the recent rally that is now in play since the market formed a bottom on June 24.  The August Brent/WTI spread blew through another support area and is now trading with a $3 handle while all of the crack spread combinations in the US remain in decline mode.

Oil has broken away from the externals as the global equity markets are pretty much in a free fall overnight after the resignation of several Portuguese officials. Equities have been a negative price driver for the oil complex along with the rising US dollar. However so far this week the oil market has been mostly driven by what the market views as a growing geopolitical risk as massive protests continue in Egypt. Although Egypt is not an oil producer (actually a net oil importer) the concern is the unrest in Egypt spreading to the oil producing region of the Middle East and thus the potential for a supply interruption.

 

So far there are no signs of this view taking place and as such the risk premium that has built into the price of oil is strictly based on anticipation or the possibility of a supply disruption. As I have discussed all week the risk premium is not likely to recede this week with the long holiday weekend in the US beginning tomorrow and sideling many major trading participants.

I do find it interesting that for the first time in a long time the geopolitical risk premium seems to be building in the WTI contract at a more accelerated rate than in the Brent market. With the Brent/WTI spread continuing on its normalization path (as I have been predicting for months) the market is also changing its focus and seemingly placing more global attention on the WTI contract over the Brent contract.

The Aug Brent/WTI spread did not take too long to breach the $4/bbl support level and has now moved into a new lower trading range of $2.50/bbl on the support side and $4/bbl on the resistance side. The spread is trading at a level not seen since the very end of 2010. There is no doubt that the spread will hit parity this year as I have suggested it would months ago. More and more capacity is coming on stream during the course of 2013 that will increase the outflow of crude oil from the Cushing area. It is only a matter of time before crude oil inventory levels in the Cushing area recede significantly and all but eliminate a return to the massive inventory overhang levels seen over the last several years that completely turned the benchmarking world upside down.

Further adding to the bearish viewpoint of the spread is the growing backwardation of the WTI forward curve which is suggesting that inventories are likely to decline in Cushing going forward as there is no economic advantage to building crude oil inventories. I have been and remain bearish the Brent/WTI spread as parity is clearly in sight and if the infrastructure changes continue along with North Sea production operating mostly normally WTI will actually begin to trade at a premium over Brent as it did before the massive crude oil surplus issues hit the US Midwest.

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