Oil markets proving a study in supply and demand

Waiting for Ben Again

It was a quiet Monday for oil as the market traded in a tight range. Oil (NYMEX:CLQ13) sold off early on Chinese data but rebounded late in the day on U.S. data... It was obvious though that the bulls and bears lacked conviction, so the market seemed to just give in to the recent trend. It probably helped that OPEC as reported by Dow started to drop hints of a December production cut, yet that might be too early to worry about. So it is obvious that the market needs some reassurance and who better to provide that then Federal Reserve Chairman Ben Bernanke himself.

Without any real fresh news to drive oil it appears that most markets are awaiting Ben Bernanke’s testimony Wednesday at 10:00 a.m. before the Senate Banking Committee and Thursday at 10:30 a.m. The Humphrey Hawkins is considered key to try to determine just where Ben’s head is at when it comes to tapering after the market freaked out when Ben dared suggest that the Fed could taper down Fed purchases. Then we rallied when he tried to assure us that he does not mean that the Fed still would not be highly accommodative. He and other Fed Governors also said that if need be they would taper up or taper down based upon economic data. Now with the stock market pushing new highs and oil pushing $106 it will be up to Ben to keep the party going.  Bank of England's Executive Director for Markets Paul Fisher seemed to slam Ben Bernanke this morning saying that “U.S. market reaction to potential Fed tapering shows the need for clear communication” Oh sure, put more pressure on Ben Bernanke. Thanks a lot Paul.

RBOB futures pulled back a bit after Friday’s panic buying run-up. We saw whole sale prices pull back dramatically yet the market still feels very nervous. While supplies are abundant in some parts of the country, in other parts we are running on fumes. Bloomberg reported Valero says a fluid catalytic cracker and alkylation unit are returning to planned rates at Wilmington refinery in California. Valero has no timetable for restarting a fluid catalytic cracker at its Port Arthur, Texas, refinery, Bill Day, spokesman for Valero in San Antonio, says in interview.

Now breaking this morning Bloomberg reports Phillips 66 Bayway Refinery Performing Unplanned Work.  The company declined to identify units involved in work, duration of maintenance.

Robert Campbell of Reuters writes that “The United States has plenty of gasoline and a surfeit of crude oil. But in the case of both commodities supplies are much tighter when it comes to the specific grades that are acceptable for delivery against the main futures contracts.

The case of West Texas Intermediate crude is better understood. Some analysts have been attributing the market's move to a sudden realization that a combination of factors long known to many players was in fact happening. If this is the case, those appealing to this sort of logic have to admit it is difficult to explain why last week was the trigger instead of any other time.  More likely last week was simply a short-covering frenzy. The smart money had already known that Cushing was now in a structural supply deficit due to new pipelines.  It also knew that linefills were going to take up a lot of oil this summer and, indeed, at the end of this year and the start of next when another 8 million barrels will go into new pipes.

The simple fact is the futures price reflects a vastly tighter outlook for a very narrow category of oil: The specific type of crude that can be delivered against WTI futures at Cushing, Oklahoma.

This is where the concept of basis risk comes in. Hedgers may see a well-supplied market for oil but are stuck with a tool that reflects something very different: A tight market for WTI. This explains the dramatic backwardation in the WTI curve while crude stocks in most of the United States are at relatively high levels. The futures curve is tracking more closely the availability of a specific grade of crude at a specific place.

Of course, this is exactly what a futures contract is supposed to do. The value of a given barrel of oil cannot be separated from either the value of the products it yields upon distillation or its location.

Pipeline dynamics, specifically take-or-pay contracts, that obligate shippers to use new pipelines that drive WTI-type crude away from Cushing are the key factor here because it is not so much that there is a shortage of WTI-type oil but rather there is an expected shortage of WTI-type oil at Cushing.

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