- Carnage in energy commodities in Q1
- Massive declines in WTI and Brent crude oil futures
- Product prices tank
- Natural gas falls to the lowest level of the century
- A new record low for ethanolThe energy sector tanked in Q1 2020. In 2014, the energy composite fell by 36.59% due to the swoon in crude oil, petroleum product, and natural gas prices. A composite of energy commodities fell by 25.14% in 2015, making it the worst-performing sector of the year.
The energy sector finished 2016 42.57% higher than it was on December 31, 2015. In 2017 the sector moved 3.35% higher, adding to gains. Energy commodities were down 15.89% in 2018. In 2019, the sector was 15.11% higher than at the end of 2018. In Q1 2020, energy was the worst-performing sector of the commodities market posting a 51.02% loss over the three months.
WTI and Brent crude oil posted significant losses in Q1 after the outbreak of Coronavirus weighed on demand. The failure of OPEC to respond to the price weakness led to a massive move to the downside in early March that took the price of crude oil to its lowest price since 2002. Oil product prices followed, with gasoline and heating oil moving lower in Q1. The prices of oil and products fell to multiyear lows in Q1 2016 and did the same in Q1 2020.
In the natural gas market, the peak season of demand starting in November 2019 did little to support the price of the volatile energy commodity. High inventory levels and warm weather during the winter months caused prices to make lower highs and lower lows in late 2019 and throughout Q1 2020. In early August 2019, natural gas fell to a low at $2.029 per MMBtu, which turned out to be a bottom for the energy commodity, until Q1. The price of nearby natural gas futures fell to the lowest level since 1995 when the price traded to a low of $1.519 in March 2020. Each attempt at a recovery failed over the first three months of this year as natural gas made lower highs and lower lows. Ethanol declined on the back of losses in oil and gas markets.
The energy sector of the commodities market will reflect the economic and geopolitical landscapes as we move into Q2, but the price of oil closed the quarter putting in a bearish reversal on the quarterly chart. The Middle East, which is home to more than half the world’s oil reserves, remains the most turbulent region on the earth. At the same time, Venezuela is a political and economic mess, which means the nation with the leading petroleum reserves in the world is not likely to see oil output increase any time soon. When it comes to China, the “phase one” trade deal provided some optimism at the start of Q1, but Coronavirus, which began in China and spread around the world, took any bullish winds out of the sails of the market. OPEC cut production at its December meeting, which helped stabilized the price of crude oil in the short-term. However, the failure of the oil cartel to respond to demand problems caused by Coronavirus in March caused a plunge in the price of the energy commodity that sent the price to a multiyear low and its lowest level since 2016. The US is the world’s leading producer of crude oil with a daily output climbing to a new record at 13.10 million barrels, according to the Energy Information Administration during Q1.
Energy commodities power the world. Bullish and bearish factors on the economic and political landscapes were pulling the price of petroleum in opposite directions through Q1. Tensions between Iran and the Us reached a boiling point at the start of the quarter on January 8, but Coronavirus and the lack of a response by OPEC with US output rising caused the price of oil to more than halve in value by March.
Natural gas was weak throughout the winter season as it continued to make lower lows. In March, the peak withdrawal season ended as natural gas inventories began to rise from a higher level than the previous year. Meanwhile, the price of ethanol at the end of the quarter reflects the price action in the other energy commodities.
Oil and gas equities had signaled that price carnage was in the cards for the two fossil fuels. The stocks had underperformed the energy commodities throughout 2019 and during Q1 until prices collapsed. OPEC met on March 5 and 6 to review the production policy. Saudi Arabia favored an additional 1.5 million barrel per day reduction in output, and the market expected at least another one-million-barrel production. After Russia balked, the meeting ended with no change in output on Friday, March 6, and the price dropped to a low of $41.05 per barrel before the weekend. The nearby NYMEX contract traded down to a low of $19.27 per barrel after a gap to the downside on Sunday night, March 8. Crude oil was not alone as Coronavirus created risk-off conditions in markets across all asset classes. The price plunged as Saudi Arabia and Russia decided to flood the world with the energy commodity.
Crude Oil Review
Crude oil traded within a range of $19.27 to a high at $65.65 in Q1 2020 on the nearby NYMEX futures contract. The high came on January 8 and the low on March 30, in the aftermath of the OPEC meeting and demand destruction because of Coronavirus.
NYMEX light sweet crude oil was down 30.47% in 2015 after falling by 43.31% in 2014. In 2016, oil gained 45.03% on the year. In 2017, NYMEX crude oil gained 12.47%. The energy commodity that trades on NYMEX was 24.84% lower in 2018. In 2019, the price of WTI crude oil was 34.46% higher than at the end of 2018. In Q1, crude oil fell 66.46% and settled at $20.48 per barrel on March 31.
We have seen lots of price action in the crude oil market since October 2018.
The weekly chart illustrates the fall in Q4 2018 and price recovery in Q1 and Q2 2019, but the price ran out of upside steam in late April and declined. The September 14 attack that knocked out 50% of Saudi petroleum production, which amounts to 6% of world supplies, sent the price the high of the fourth quarter of 2019 at $63.38 on September 16. After a decline to just under the $51 level, crude rose to a higher high at the beginning of Q1. On January 8, the price rose to what turned out to be the high in Q1 at $65.65 as tensions between the US and Iran reached a boiling point in Iraq. As calm returned to the Middle East, the price declined. The outbreak of Coronavirus weighed on the demand side of the equation for crude oil at a time of the year when the energy commodity tends to exhibit seasonal weakness. The market had expected OPEC to address falling demand with an additional production cut on March 6. Saudi Arabia initially advocated for another 1.5 million barrels of output reductions, but Russia balked. The meeting ended without any deal to reduce production, and the Saudis decided to flood the market with crude oil, sending the price to a low of $19.28 per barrel on March 30. The low was the lowest price since 2002.
The US is the leading producer of crude oil in the world as output reached a record high at 13.1 million barrels per day during Q1. At the December OPEC meeting, the cartel increased its production cut from 1.2 to 1.7 million barrels per day for the first half of 2020. The Saudis added another 400,000 barrels per day for good measure bringing the effective reduction to 2.1 million barrels per day. The move by OPEC stabilized the oil market. The production cut together with a “phase one” deal on trade between the US and China lifted the nearby NYMEX futures contract to the $60 per barrel level in December. In early January, hostilities in the Middle East pushed the price to a peak of $65.65. OPEC ‘s refusal to cut production in response to Coronavirus sent the price of the energy commodity to its lowest level in four years on March 8. The rig count in the US, according to Baker Hughes, rose over the past three months and stood at 624 as of the end of March 2020, 46 lower than at the end of Q4 2019. Production continued to rise to a new record high in the US in Q1.
Fewer regulations under the Trump administration and a more favorable corporate tax policy improved the economics for US producers. The American oil industry has become the leading producer in the world. The U.S. is now the world’s swing producer of the energy commodity. When the price declines, shale output will decrease, and the US can import cheaper oil from abroad. However, when the price rises, American shale production will flow, and the US will compete with other world producers to supply the energy commodity around the globe, and even to the Chinese now that there has been progress and a de-escalation of the trade war. The price action in March will cause US production to decline as the price has dropped to a level that is not economic for output.
The issues facing the Middle East remained a substantial concern early in Q1 as they reached a new peak in early January. Meanwhile, oil-related stocks in the US lagged the price of the energy commodity throughout 2019 and into 2020. The weakness in energy stocks was a sign of impending doom for the price of oil, which tanked in the aftermath of OPEC’s refusal to lower output. As we move into Q2, OPEC is flooding the market with the energy commodity, which could cause bankruptcies in debt-laden companies. US output likely peaked at 13.1 million barrels per day in Q1, and we could see it begin to decline over the coming weeks and months.
With the 2020 election on the horizon, climate change is likely to be an important topic of discussion. In Q1, many of the candidates from the other side of the political aisle dropped out of the contest to oppose President Trump in November. At the end of Q1 former Vice President Joe Biden, a moderate Democrat held a commanding lead in delegates and was well on his way to his party’s nomination. In the interest of party unity, the Democrats have shifted their ideology towards the political left. If former Vice President Biden opposes President Trump, he is likely to adopt some of the initiatives, which include the “Green New Deal.” The election will likely serve as an energy referendum for the US. The Saudis and Russians decided to abandon production quotas and pump up the volume of crude oil and push the price to levels that do not support US production. The US replaced Russia and KSA as the leading oil-producing nation. The two former leaders could be counting on a Democrat in the White House in 2021 and a dramatic shift in US energy policy. We could see the price of oil begins to move higher and lower with political polls in the US as the election comes closer during the second half of the year.
The rise of the US has caused the influence of OPEC to decline dramatically. Russia became the most influential factor in the oil cartel’s decision-making process over the past years. After acting as a mediator or bridge between Iran and Saudi Arabia, the Putin government via their oil minister Alexander Novak may be the most influential force when it comes to production policy in the cartel these days. In Q3, the Saudis replaced their oil minister and the chairman of Saudi Aramco. Saudi Arabia needs Brent crude oil at the $80 per barrel level to balance its budget. In Q4, the Saudis brought Aramco to market in an IPO on the Saudi stock exchange. Saudi Arabia priced its IPO at a $1.7 trillion valuation. On the first day of trading, the demand was so high that the shares moved limit up, and the valuation rose to the $1.9 trillion level. Aramco became the company with the highest valuation in the world, which increased the profile of the Saudi Arabian stock exchange. The Saudis raised over $25 billion in the IPO, which will go into the Saudi sovereign wealth fund. Ironically, the Saudis are using the fund to diversify the economy away from a dependence on oil revenues. The dispute between KSA and Russia in Q1 and the decision to flood the world with cheap crude oil could either be the end of OPEC, the end of the US leadership role in production, or an elaborate plan by OPEC and the Russians to destroy the US business. OPEC has attempted to flood the world with the energy commodity in the past but failed on each attempt. This time, a confluence of events including Coronavirus, weak fundamentals for debt-laden oil companies, and the US election could have encouraged another try to chase marginal oil producers from the market. It appears that the Saudis and Russians are willing to take some medium-term financial pain to push the US out of the leadership role. Time will tell if they succeed, this time.
Trade issues between the US and China de-escalated at the end of Q4 2019. At the start of August, the US slapped new tariffs on China, and the Chinese retaliated. The fears of a worldwide recession as a result of economic weakness in China and contagion around the world sent the price of oil to the lows of the quarter at $50.52 per barrel during the week of August 5, 2019. However, some optimism returned to the market in September, and the attack was another example of the political risk in the world’s most turbulent region. On January 15, the US and China signed a “phase one” trade deal, which caused recessionary fears to decline, briefly. They came roaring back as Coronavirus broke out in China and spread around the world in February and March.
Iran continues to be a clear and present danger in the Middle East. Sanctions on the theocracy in Teheran took effect in November 2018. The US is attempting to choke the Iranian economy if they do not abandon their quest for nuclear weapons. Iran retaliated against the sanctions often during 2019 with attacks on oil tankers, and on Saudi production. The most severe incident came in mid-September with the drone attack on Saudi oil infrastructure. On January 8, hostilities reach another high between the US and Iran, but the situation calmed throughout the rest of the quarter leading to the price carnage in oil in early March.
The Strait of Hormuz is a narrow seaway that separates the Persian Gulf from the Gulf of Oman. While 2.7 million barrels of Iranian oil exports flowed through the Strait each day, a total of 19 million barrels heading for consumption points around the globe flow through the seaway, which represents 20% of the world’s daily demand. President Rouhani of Iran told the world in 2018 that if sanctions prevent Iranian exports, the theocracy will make sure that shipments from other oil-producing nations in the Middle East would not flow smoothly to their destinations. Iran followed through on those threats in Q2 2019 with attacks. In Q3 and Q4, there were fewer incidents.
Meanwhile, Iran is likely continuing to enrich uranium, which could present problems over the coming months. Now that the price of oil declined significantly in Q1, the potential for a price spike is even greater if hostilities rise in the region or Iran makes any provocative moves. The Strait of Hormuz is likely to remain a hub of international concern over the coming weeks and months. Any increase in hostile actions in the Middle East that impact production, refining, or logistical routes like the Strait of Hormuz could cause availability problems around the world. As the Strait is now a focal point, we have witnessed a military buildup in the area, which raises the political temperature in the region.
Saudi Arabia depends on the US for military support in the region, given its ongoing battles with Iran. However, they have also been maintaining close ties with Russian President Putin. The position of Saudi Arabia and their relationships with the US, Russia, and their neighbors in the Middle East creates a complex puzzle that could impact the price of oil in the months ahead. The relationship between KSA and the Russians appears to have broken down in Q1 unless they agreed to pull a fast one on the US and flood the market to damage US production going into the 2020 election.
The three dominant oil producers in the world are the Saudis, Russians, and the United States. It is in the best interest of all three nations for the oil price to remain at a level that is high enough to allow oil and profits, but low enough to keep inflationary pressures in check. The US, Russia, and the Saudis are likely engaged in talks in some fashion, behind the scenes, to determine the global price of the energy commodity. Whether OPEC continues or ceases to exist, the influence of the three leading producers, two of which are not cartel members, has eaten away at the power of the cartel. Over the past two years, Qatar and Ecuador left the cartel. With the US election on the horizon in 2020, President Trump is walking a fine line. He has not been shy about encouraging OPEC and Russia to allow the price of oil to fall. However, a decline like we witnessed in March is devastating to the US oil sector and will cause a significant number of job losses over the coming months and going into the election.
The Middle East is a region that always has the potential for issues. We saw tensions with Iran increase throughout 2019 and into early 2020. The conflict between the Saudis and Iranians remains on five fronts. The front lines of war, if it breaks out, could be in Yemen, Qatar, Lebanon, Iran, or Saudi Arabia. Libya and Iraq could also become battlegrounds between the kingdom and theocracy if the conflict escalates. The potential for hostilities in the Middle East had kept a bid under the price of crude oil as there is always a potential for other price spikes if production, refining, or logistical routes in the area remain targets in the coming weeks and months. However, there are many shades of gray when it comes to allegiances in the Middle East as the oil market is a geopolitical chess game. The significant decline in the price of oil hurts Russia, the Saudis, and the US. I expect considerable price volatility in the oil market in Q2. The current environment could lead to an agreement between the US, KSA, and Russia on production to stabilize the price of crude oil.
The past year and six months were a highly volatile period in the crude oil market; the energy commodity took the elevator to the downside in Q4, and the stairs higher in Q1. In Q2, it rallied until late April when selling once again hit the market. In Q3, the price spike on September 16 gave way to selling that took the price back below $51 per barrel. In Q4, oil rebounded on the back of a deeper OPEC production cut and a de-escalation in the trade war. In Q1, it reached a peak at $65.65 on the back of hostilities between the US and Iran. Oil then worked its way lower and took an elevator shaft to the downside when the OPEC meeting did not address the demand destruction caused by Coronavirus. Trade and Iran had been the most significant factors for the oil market, but Coronavirus and OPEC’s inability to agree with Russia became the leading issues impacting the price of the energy commodity. In Q2 and over the rest of 2020, the future of US energy policy could take the center of the stage and cause price variance in the energy commodity.
Open interest in NYMEX futures moved higher over the first quarter. The metric reached a new record high at 2.714 million contracts on May 16, 2018. The metric moved from 2.146 million contracts at the end of Q4 2019 to 2.341 million at the end of Q1, an increase of 195,000 contracts. Since the peak, the metric declined by around 373,000 contracts.
Over past quarters I have been writing, “One of the most significant factors that investors need to remember about the developments in the crude oil sector over the past few years is that technological advances when it comes to US shale production have blessed America with a call option on energy independence. The fact that producers can quickly turn on and off the wells in response to price increases and decreases means that the US has become much less dependent on Middle Eastern oil during periods of high prices and political turmoil in the region that can affect production and logistics.” The path of least resistance for the price of crude oil remains a political and economic hornet’s nest. However, a change in administrations in early 2021 could impact US output. Since crude oil remains the energy commodity that powers the world, a new President could change the delicate balance affecting the price. Russia and Saudi Arabia are now in a position where they are attempting to deal a severe blow to US and other oil companies around the world. If successful, they could move back to a dominant position over the coming months and years. If not, we are likely to see a deal on production cuts to stabilize the price of oil, increase their revenue flows, and capitulate to the US. Whether by design or not, the decision to flood the market with oil is a massive wager by Russia and KSA that requires a significant cost in lost revenues.
Brent crude oil fell 34.97% in 2015, and in 2016 it rallied by 49.87%. In 2017 Brent outperformed WTI and moved 19.69% higher on the year. In 2018 Brent moved 19.55% lower compared to the close at the end of 2017 as Brent outperformed WTI for the year. In 2019, the price of Brent crude oil was 22.66% higher than at the end of 2018. In Q1, the price of Brent crude oil fell by 65.40%. Nearby Brent futures closed on March 31 at $22.83 per barrel as the April contract rolled to May on the final day of March. Brent traded in a range from $21.69 to $71.99 in Q1. During the January 8 hostilities between the US and Iran, the price of nearby Brent futures moved to a high at $71.99 per barrel, but the price was trading at less than one-third of that price by early March.
Brent’s premium to WTI decreased to $2.35 per barrel basis the nearby May contracts down $2.91 per barrel in Q1. The Brent premium traded to the highest level since March 2015 at $11.59 per barrel in May. In Q1, the spread closed the quarter closer to the low than the high. Brent-WTI tends to move lower when oil prices fall, and they tanked in early March.
Brent crude oil has traded at a premium to NYMEX crude since the Arab Spring in 2011. Even as violent flare-ups, disputes, and even war continue to plague the region, oil continued to flow. The long-term norm for the Brent-WTI NYMEX spread is a $2-4 per barrel premium for NYMEX crude over Brent. NYMEX crude is lighter and sweeter, meaning it has lower sulfur levels making it easier and cheaper to refine into products like gasoline. However, ongoing conflicts in the Middle East and increasing US shale production caused Brent to remain at a premium. The expanding US system of pipelines and record production in the US is likely to continue to weigh on the spread.
The dollar is the reserve currency of the world and is the benchmark pricing mechanism for crude oil. There is a long-term inverse correlation between the value of the U.S. dollar and commodities prices, and crude oil is no exception. The dollar index moved 3.16% higher in Q1, compared to its Q4 2019 closing level. The dollar index made a new high at the 103.96 level during Q1 but retreated from the peak. The dollar index was volatile because of risk-off behavior in all markets, which prompted an unwind of the cash and carry trade between the dollar and the euro currencies. The euro currency accounts for 57.6% of the dollar index.
At its July 31 meeting, the FOMC cut the Fed Funds rate by 25 basis points. The Fed met again on in September and October and reduced the short-term rate by another one-quarter of one percent at each meeting. At the same time, the Fed ended its balance sheet normalization program, which took upward pressure off longer-term rates. On March 3, as fear and uncertainty over Coronavirus gripped markets, the Fed announced an emergency fifty basis point reduction in the Fed Funds rate to 1.00%-1.25%. Less than two weeks later, the Fed cut the rate to zero and began quantitative easing to stabilize the financial system. Lower rates did nothing to support crude oil prices.
Term structure in both NYMEX and Brent crude can provide some clues as to the supply and demand fundamentals for the energy commodity. A widening backwardation where deferred prices are lower than nearby prices indicates that the market is concerned about the availability of the energy commodity. Contango, where prices of deferred futures contracts are higher than nearby values, is a sign of either oversupply or equilibrium where supply and demand are in balance. June 2020 NYMEX crude oil versus the June 2021 NYMEX futures (a one-year spread) settled at a $4.92 backwardation at the end of Q4 2019. The spread loosened by $16.73 per barrel compared to where the one-year June spread was trading at the end of Q1 when it was in contango of $11.81 per barrel. The flip from backwardation to contango in the spread reflects the flood of supplies in the crude oil market. We are likely to see oil traders fill tanks and storage all over the world to take advantage of the wide contango with financing rates at historic lows. Cash and carry trades in the oil market are now one of the only profitable areas of the market. The cash and carry trade will lift freight and storage rates. If storage fills to capacity it could have a significant bearish impact on future output.
The Brent, June 2020 versus June 2021 spread closed Q4 at a $4.67 backwardation and moved to contango of
$13.32, which was $17.99 loser as the backwardation flipped to contango. Any dramatic moves in the one-year spreads or shape of the forward curve could impact the path of least resistance for crude oil prices in Q2. The forward curves reflect a condition of massive oversupply in the oil market.
Both WTI and Brent made significant recoveries in 2019 compared to the prices at the end of 2018. However, both benchmarks closed 2018 after a brutal correction. Oil worked its way higher until January 8, after falling back to the low end of the trading range in late February, the price dropped to a new low. OPEC’s refusal to address demand destruction caused the price to fall to $19.27 per barrel, which is now the level of critical technical support. The price carnage did lots of damage to the oil market, which could cause lots of two-way price volatility in Q2. The US election in November will also contribute to price variance as it will determine the future of US energy policy.
NYMEX crude oil moved 66.46% lower over the past three months, and the XLE tanked in the first quarter. The ETF closed at $60.04 on the final day of trading in Q4 2019 was at the $29.06 level on March 31, a decline of $30.98 or 51.6% over the period. The XLE lagged the price action in both the crude oil and stock markets throughout 2019 and early 2020. The potential for a shift in US energy policy starting in 2021 could have been weighing on the prices of oil-related shares last year, but it turned out to be a harbinger of the price carnage in the oil market in early March.
We could see lots of price action in the oil market in Q2. The low price will test the endurance of the Saudis and Russians as petroleum revenues will decline dramatically. In the US, the drop could cause a sudden increase in the unemployment rate as the flow of oil will dry up at current prices. The cash and carry trade in oil will lift freight and storage rates dramatically as interest rates are at low levels. Traders will buy nearby crude oil, finance the energy commodity, sell for forward delivery, and store the petroleum for a handsome profit. The Middle East remains a political tinderbox. President Trump wanted crude oil prices lower going into the election. However, his administration did not want to see the price of the energy commodity drop to a level that causes bankruptcies in the oil patch that will put tremendous pressure on banks and financial institutions. Coronavirus created a crisis in Q1, and the price action in crude oil, with the help of KSA and Russia, exacerbates the problems. Crude oil remains the energy commodity that powers the world. As we head into Q2, the turbulence in the oil market will continue to filter through to all markets across all asset classes like a tsunami. When it comes to the Fed and central banks around the world, the price destruction in oil pushed the rate of inflation significantly lower, which puts more pressure on the monetary authorities to lower interest rates. Crude oil contributed to the mess in the financial markets in Q1, and that is likely to continue in Q2. At the start of Q2, President Trump was in discussions with the Saudis and Russians to stabilize the price of the energy commodity, which lifted prices during the early days of Q2.
Oil Products Review
Oil products often reflect periods of seasonal demand, but they also are a piece of a complex puzzle when it comes to the price direction of crude oil, which is the critical input when it comes to the refining process. RBOB gasoline tends to rally in the spring and summer, and heating oil or distillates tend to do best during late fall and winter. However, they exhibit less seasonality than the gasoline futures market. Risk-off price action in the energy sector caused significant moves to the downside in oil products in Q1.
Both gasoline and heating oil futures fell in Q1. A combination of OPEC abandoning production cuts and demand destruction on the back of Coronavirus weighed heavily on prices. Refining margins on both moved lower with the crude oil futures market.
Gasoline was down by 13.66% in 2015 but rallied by 31.70% in 2016. Gasoline futures finished 2017 with a gain of 7.28% for the year. Gasoline futures moved 27.49% lower in 2018 compared with the price at the end of 2017. In 2019, the fuel moved 29.83% higher. In Q1, gasoline futures declined by 64.94%.
As the weekly chart highlights, gasoline traded in a range of 37.60 cents per gallon to $1.9924 on the active month contract on the NYMEX in Q1. The price pattern on the weekly chart since early 2016 had been positive as gasoline has made higher lows and higher highs. However, seven consecutive weeks of losses ended that bullish price trend in Q4 2018. In 2019, the price climbed higher from January through April and then made lower highs and lower lows until September. Gasoline traded in a range until late February 2020, when the price plunged alongside crude oil. Nearby futures closed on March 31, at 59.27 per gallon wholesale. Gasoline spiked lower with crude oil starting on March 9 and reached a low of 37.60 cents, the lowest level since 1999 as gasoline underperformed the price of crude oil, which fell to the lowest price since 2002.
Heating oil was down by 38.71% in 2015 but rallied 53.88% higher in 2016. In 2017, the oil product gained 19.58%. In 2018, the fuel posted an 18.80% loss for the year. In 2019, heating oil futures moved 20.45% higher on the year. In Q1, the distillates futures contract fell 50.49%. Heating oil futures are a proxy for diesel and jet fuel as the oil products are all distillates and have similar characteristics. Heating oil futures have some seasonal features, but less than gasoline as jet, diesel, and other distillates are year-round fuels.
The weekly heating oil chart shows a constructive and bullish trend since early 2016 that ended in Q1. The price carnage in the crude oil market took the price to a low at $1.6424 per gallon in late December 2018 on the continuous contract before recovering with the price of oil. Heating oil fell below the 2018 low in Q1 and tanked with crude oil and gasoline prices.
Nearby heating oil futures closed on the final trading day of Q1 at $1.0015 per gallon wholesale. Heating oil traded in a range from 93.43 cents to $2.1195 per gallon in Q1. Oil product prices were ugly in Q1 as OPEC flooded the world with the energy commodity at a time when Coronavirus caused significant demand destruction.
Crack Spreads Review
The price action in crack or refining spreads shows that gasoline and distillate fuel processing margins moved lower during the final quarter of 2019.
In 2016, the gasoline processing spread was down only 0.06%, and in 2017 it lost 8.88% of its value. The gasoline crack moved 37.50% lower in 2018 from the closing level at the end of 2017. In 2019 the refining spread moved 7.63% higher on the year. In Q1, the gasoline crack fell 56.84%.
As the weekly chart shows, demand destruction on the back of Coronavirus pushed the gasoline crack spread substantially lower during the week of March 9. The gasoline crack traded to a low of -$3.85 and closed Q1 at $4.32 per barrel. At a time of the year where the spread should be preparing for the spring driving season, the US economy was tanking, sending gasoline and gasoline refining spreads to a level where refiners were suffering as much as the rest of the oil patch.
Meanwhile, the heating oil crack moved 83.66% higher in 2016 and 38% to the upside in 2017. In 2018, the heating oil crack spread posted a 5.11% loss on a year-on-year basis since the end of 2017. In 2019, the distillate processing spread fell 4.74%. The losses continued in Q1, with a decline of 10.25%.
The weekly pictorial of the heating oil refining spread illustrates that it closed Q1 at $21.45 per barrel. The heating oil crack spread had been under pressure since 2013, but the price action in 2016 and 2017 broke the pattern of lower highs. The processing spread between crude oil and distillates made a higher high in mid-November 2018 at $32.53 per barrel before turning lower. At $21.45 at the end of Q1, the refining spread was a touch lower than it was last year at the time, as it closed Q1 2019 at $22.55 per barrel. Heating oil refining spreads outperformed gasoline because the global and US supply chains continued to operate bringing essentials to markets.
Crack spreads are real-time indicators for the profitability of those companies that turn raw crude into oil products. Volatility in gasoline and heating oil crack spreads directly impacts the earnings of those companies involved in refining oil.
As the chart of Valero Energy Corp (VLO) highlights, the stock has moved from $93.65 per share at the end of Q4 2019 to $45.36 at the end of Q1 2020. The plunge of 51.56% was in concert with the rest of oil-related shares, crude oil, and oil products. While I continue to believe that VLO will survive, the risk in the current environment is very high as the stock and oil markets crashed in Q1.
Natural Gas Review
The price of natural gas dropped 32.88% in 2014 and was down 19.11% in 2015. In March of 2016, the price of the volatile energy commodity fell to the lowest level since 1998 at $1.611 per MMBtu. However, in a reversal of fortune, natural gas exploded higher and posted a 60.21% gain in 2016. In 2017, gravity took the price of the energy commodity back down as bearish sentiment and ample supplies weighed on the natural gas futures market throughout the year. In 2017, natural gas futures lost a total of 21.13% of their value compared to the end of 2016. In 2018, natural gas was just 0.44% lower on the year. The price fell by 25.54% in 2019. In Q1, the selling continued, and the price of the energy commodity plunged by 25.08% over the first three months of 2020.
Natural gas was a wild ride in Q4 2018 as the price traded to a high at $4.929 per MMBtu in mid-November and then fell like a stone reaching a low at $2.543 per MMBtu in mid-February 2019. Natural gas rallied at the beginning of the peak season of demand in 2018 on the lowest level of inventories in years, but the price came back down to earth in December and fell steadily throughout 2019. Natural gas only managed to reach a high of $2.905 per MMBtu in early November 2019. The price fell steadily throughout the winter season on the back of inventories that were higher than the previous year and the five-year average and warmer than average temperatures that weighed on the demand.
As the weekly chart shows, the highs in natural gas in late 2019 came in early-November at $2.905 per MMBtu. The price moved progressively lower from the November peak, eventually reaching a low of $1.519 per MMBtu during the week of March 23. The low was the lowest price since 1995.
Inventories rose to all-time highs in 2015 when they surpassed 4 trillion cubic feet before the withdrawal season. In November 2016, stockpiles rose to a higher high and a new record at 4.047 tcf. At the start of the 2017/2018 withdrawal season, stockpiles of natural gas reached a lower high at 3.79 tcf. In early November 2018, natural gas stockpiles peaked at the lowest level in years at 3.247 tcf, which likely led to the rally late last year. At the start of the 2019 injection season, stocks of natural gas stood at 1.107 trillion cubic feet, which was 20.5% below the prior year’s level and 33.2% below the five-year average in March. After rising to a start of peak season peak at 3.732 tcf in early November, stocks declined to 1.986 tcf as of March 27, which was 76.8% above last year’s level and 17.2% above the five-year average for the same time of the year. Stockpiles are moving into the off-peak season with a combination of the highest stockpiles in years and the price at a quarter-of-a-century low with demand destruction in energy and risk-off in markets across all asset classes.
Nearby natural gas futures closed Q1 2020 at $1.6400 per MMBtu. Technical support is at the recent low at $1.519 level. Resistance is at the $1.998 and $2.025 level as we head into Q2. A bearish island gap formation from early November 2019 from $2.738 to $2.753 stands as a target on the upside in the natural gas futures market. Price action tends to eventually fill voids on charts.
Open interest in NYMEX natural gas futures contracts moved from 1,291,160 at the end of Q4 to 1,224,791 at the end of Q1, a decrease of 66,369 contracts or 5.14% during the first quarter of 2020. The open interest metric hit a new record high at 1,699,571 contracts on October 4, 2018. Natural gas punished shorts in late 2018 and punished longs throughout most of 2019 and into Q1 2020.
Both the supply and demand sides of the fundamental equation in natural have expanded as had the number of speculators participating in the market. The price explosion in late 2018 caused the open interest metric to decline significantly as shorts scrambled for an exit, and longs took profits. Meanwhile, open interest was higher at the end of Q1 2020 than at the same time last year when it was at the 1.171 million contract level. Higher open interest and lower price tend to be a validation of a bearish price trend in a futures market. However, in a risk-off environment, it tends to lead to short-covering, which likely prevented the energy commodity from falling to an even lower low in March. The forward curve in the natural gas futures market continues to point to an overall bearish orientation when it comes to the price of the energy commodity.
The nearby price of natural gas closed Q1 at $1.6400 per MMBtu level at the end of March. The term structure in the natural gas market illustrates that the energy commodity was trading at the $2.739 per MMBtu level in January 2021. The highest price on the forward curve is at $3.114 in January 2032, which is significantly lower than the high in November 2018 at $4.929 per MMBtu. In 2016, the price peaked at $3.994 per MMBtu, and during the winter of 2018 at $3.661. In Q4 2018, the price blew through those levels like a hot knife through butter. At the end of Q4, I wrote, “The natural gas curve is telling us that sentiment in the natural gas market continues to be bearish.” Stockpiles of natural gas were 879 bcf above the level at the end of the 2019/2020 withdrawal season compared to the previous year, which weighed on the price of the energy commodity. At around 2.0 tcf in storage across the US at the end of Q1, we are heading into the injection season at a high level and could see stockpiles rose to a new record peak at over four tcf by November 2020. However, production could decline as debt-laden producers experience financial woes.
The shape of the forward curve is an indication of comfort with massive supplies in the Marcellus and Utica shale regions of the United States for the coming years and even decades. Additionally, fewer regulations as a result of the Trump Administration’s commitment to energy independence and technological advances in fracking have caused the production cost of natural gas to move appreciably lower. Meanwhile, the Presidential election in 2020 could impact the natural gas market. As we move closer to the contest, support for the “Green New Deal” will also serve as a referendum on the future of US energy policy, which could add to volatility next winter.
LNG is the demand vertical for the energy commodity that offsets some of the vast reserves in the Marcellus and Utica shale regions of the US. Additionally, many coal-fired power plants have switched to natural gas which, has increased demand for the energy commodity that burns cleaner than coal. Meanwhile, LNG shipments could accelerate as the US and China agreed to a “phase one” trade deal in mid-January 2020. Record production of natural gas in the US has led to record demand as the LNG business continues to expand exponentially. Changes in energy policy could impact the price of natural gas in early 2021. Meanwhile, political polls over the coming months could also cause an increase in price volatility for natural gas prices for deferred delivery. At the same time, the lowest prices in twenty-five years and carnage in the energy sector could cause a rise in bankruptcies and falling output of natural gas, which is ultimately supportive of the price.
The price range in natural gas has been from lows of $1.02 to highs of $15.65 per MMBtu since 1990. A twelve-year price at below $3.12 is a bargain. Natural gas will move into the second quarter of 2020 at a level that is below the lowest for the century with risk-off conditions in all markets. Many producers are on the verge of bankruptcy. The price action at the end of the peak winter season remained decidedly bearish.
Politics rather than inventories and the weather could be the most significant factor when it comes to the path of least resistance for the price of natural gas over the rest of the year. However, debt-laden producers could go out of business unless government assistance and bailouts support the energy sector. Coronavirus did lots of damage to the energy sector in the US, and OPEC’s production policy gave it a swift kick while demand destruction presented the most significant challenge in years.
In the US, ethanol is a biofuel — a product of corn. The price of nearby ethanol futures fell by 4.24% in 2018. Ethanol futures moved 8.78% higher in 2019. In Q1, price carnage in the energy sector pushed the price 33.75% lower. The biofuel fell to an all-time low at 86.1 cents during the first three months of 2020. The price of nearby ethanol futures closed on March 31 at 91.10 cents per gallon, while corn was 12.12% lower, and gasoline plunged 64.94% to the downside for the first quarter. Gasoline tends to trade at a premium to ethanol, and at the end of Q4 2019, the spread was trading at a 31.55 cents premium for gasoline. In Q1, the spread flipped to a 31.83 cents premium for ethanol. Ethanol traded in a range of 86.1 cents to $1.420 per gallon in Q1 2020.
Ethanol declined to a new record low in Q1 as the price of gasoline, and crude oil fell on the back of demand destruction because of Coronavirus and a flood of crude oil by OPEC Plus-one after the cartel abandoned all production quotas on March 6.
Margins for ethanol producers moved lower over the first quarter. The price of the output, ethanol, was down by 33.75% with the price of the input, corn 12.12% lower, which means those companies involved in refining corn into the biofuel paid less for the input but received even less for the output on a relative basis. Meanwhile, the carnage in the stock market in a risk-off environment that is worse than the 2008 financial crisis sent shares of Archer Daniels Midland (NYSE: ADM), a company that processes corn into ethanol, appreciably lower from the end of Q4 2019 to the end of Q1 2020. ADM shares fell from $46.35 to $35.18 per share or 24.1%. ADM shares plunged with stocks and markets across all asset classes.
As we head into Q2, ethanol could become an issue in the 2020 Presidential election as the Democrats embrace the “Green New Deal.”
The bottom line on energy
Crude oil fell from the high in early January at $65.65 to a low at $19.27 in March, the price of the energy commodity reached the lowest level since February 2016. The OPEC production cut and “phase one” trade deal pushed the price back above the $60 per barrel on nearby NYMEX futures in December. The hostilities between Iran and the US pushed WTI oil to over $65 and Brent to just below $72 per barrel. Brent marginally outperformed WTI even though OPEC abandoned production cuts and flooded the market with oil during a period of demand destruction. The price differential between the two benchmarks is a sign that OPEC and Russia achieved its goal of putting pressure on US producers. As we head into Q2, Iran could still create supply problems, but Coronavirus has wreaked havoc with the US and global economies.
OPEC is flooding the market with crude oil to push marginal producers in the US out of the market. Meanwhile, President Trump instructed the US Department of Energy to purchase crude oil for the strategic petroleum reserve on March 13. In the risk-off environment, the move did little to support the price of the energy commodity. At the end of the quarter he was taking with KSA and Russia about a plan to stabilize the price of oil, which lifted futures prices from the recent low.
Meanwhile, OPEC ministers had said that the “comfortable” level for Brent crude oil is in a range from $60 to $70 per barrel in 2019. They are far from comfortable with the price below the $25 level for Brent at the end of Q1. Saudi Arabia and Russia are making a high-risk wager to force US production into bankruptcy. Many debt-laden oil companies could need a government bailout to survive. Time will tell if Washington DC views the oil and gas production as a matter of national security. The pursuit of the “Green New Deal” could change the landscape for US energy producers over the coming months.
I am going into Q2 with extreme caution in the crude oil market. I will look for short-term opportunities on the long and short side of the market but will not build any positions for the medium or long-term until some stability returns to the oil sector. For existing positions, prices have declined to levels that are too low to sell. I will wait for the dust to settle before I decide to add to those long positions, sell them, or hold at the current levels. It is a time for caution in all markets. For those who do not venture into the futures arena, the UCO and SCO products offer double leverage on a short-term basis on the long and short side of the market. I would not hold these products for long as the leverage causes them to decline rapidly if the market moves against them or the price sits at a level for an extended period.
When it comes to natural gas, the price goes into Q2 after reaching a new low for this century at $1.519 per MMBtu. At the end of 2019, I wrote, “It looks like natural gas could head for prices below the $2 level over the coming months. A challenge of the March 2016 low at $1.611 per MMBtu could be in the cards for the volatile energy commodity. However, the US election could add an unusual dynamic to natural gas throughout 2020, increasing price volatility and trading opportunities.” Risk-reward does not favor the downside as we head into Q2, but anything is possible in the current market environment where volatility has increased to unprecedented levels.
The price of coal tends to be a seasonal commodity that follows the price of other energy products. Coal prices tanked with the rest of the sector in Q1.
As the chart of the price of May coal futures for delivery in Rotterdam, the Netherlands shows the energy commodity closed Q4 at $54.90 per ton and moved lower to $50.15 at the end of Q1 2020, a decline of 8.65% in Q1. The price of Rotterdam coal futures outperformed both crude oil and natural gas in Q1 but continued to drop after a long period of underperformance over the past years. The price fell further during the first days of Q2. Meanwhile, the KOL ETF product, which holds shares in many of the leading coal-producing companies fell from $9.89 on December 31, to $6.29 on March 31, a decline of 36.4% as the carnage in the stock market weighed heavily on all energy-related shares.
The energy sector always offers some of the most exciting and profitable opportunities. We enter Q2 with the price of crude oil, natural gas, ethanol, and coal under extreme pressure. March thrust the world into the most significant risk-off environment in modern history as a global pandemic threatens the health and wellbeing of the world.
The price of oil could become a function of behind the scenes agreements and arm-twisting in Washington DC, Moscow, and Saudi Arabia, with the latter having the least influence on prices given the military positions of the United States and Russia. The situation in the Middle East threatens stability in the region and has the potential to cause price spikes in the oil market. With the price at the lowest level in years, the potential for a price strike becomes more dramatic if Iran decides to increase provocative actions in the area.
Domestically, as the US Presidential election draws near, we are likely to hear a lively debate on the climate and role of fossil fuels. The Democrat’s platform will include the “Green New Deal” and concentrate on the carbon footprint in the US. The Republicans will continue to be more friendly to the energy business and US independence from Middle Eastern oil as well as expanding its position as the Saudi Arabia of natural gas, a term coined by the late T. Boone Pickens. The energy sector should experience a continuation of volatility through the rest of 2020. A victory by the challengers could cause even more price variance if the US energy policy undergoes a significant change.
Oil-related stocks lagged both the stock and oil market throughout 2019 and into 2020. The price carnage in March threatens the survival of many companies in the energy sector.
Ethanol is likely to continue to follow the corn and gasoline markets in Q2. The biofuel was another victim of risk-off action in all markets.
The Vanguard Energy Index Fund ETF Shares (VDE) correlates with the price of crude oil, but it had lagged the energy commodity. During Q4 2019, it underperformed the energy commodity, as it appreciated by 4.45% compared to a rise in the price of NYMEX crude oil futures of 12.93% turned out to be a harbinger for the price of the energy commodity. VDE underperformed crude oil on the upside and did the same on the downside. VDE holds shares in many of the leading energy commodities in the world, including:
Source: Yahoo Finance
In Q1 2020, VDE tanked as the price moved from $81.49 on December 31 to $38.22 on March 31, a decline of 53.1%. Many of the companies in VDE have levels of debt that threaten their survival.
Keep those stops tight and take profits when they are on the table in energy commodities, which are excellent trading markets for disciplined traders and investors who approach the markets with logical plans for risk and reward.
Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the potential complete loss of principal. This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein, or any security in any jurisdiction in which such an offer would be unlawful under the securities laws of such jurisdiction.