- A huge turnaround in energy in Q2, but not before carnage took a massive toll on the sector.
- WTI and Brent crude oil post incredible gains along with gasoline
- Heating oil is up marginally, and crack spreads reflect seasonal factors
- Natural gas posts a gain, but remains under pressure
- Ethanol makes a comeback
Energy was the worst-performing sector of the commodities market in Q1 2020. The most under siege markets during a period often turn out to be the best performers in the following period, which is what happened with energy prices in Q2. However, April was the ugliest month in history for the oil market. May was the best.
In 2014, the energy composite fell by 36.59% due to the swoon in crude oil, petroleum products, 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 posted a 51.02% loss. In Q2, it was 55.73% higher. Meanwhile, over the first half of 2020, the energy sector was 29.12% lower than the end of 2019.
WTI and Brent crude oil posted significant losses in Q1 after the outbreak of Coronavirus weighed on demand. OPEC’s failure 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. In April, the rising contango in the oil market and a tidal wave of petroleum sent landlocked NYMEX May futures below zero for the first time. On April 20, the price became a bearish hot potato and reached a low of -$40.32 per barrel. Brent reached its lowest level of this century at $16 per barrel. The prices turned around from the historic lows and rallied for the rest of the quarter. Oil product prices followed, with gasoline and heating oil moving higher in Q2. Processing spreads moved in opposite directions over the past three months, reflecting seasonal influences and optimism over the reopening of the US economy. In Q1, the US and global economies moved into a self-induced coma. In Q2, they began to awaken. At the end of Q2, the virus remained a clear and present danger in the US as well as in other parts of the world.
In the natural gas market, the withdrawal season ended in late March, and prices stabilized above the lows from that month, until June. 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 and Q2 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 $1.432 in June 2020. In Q2, natural gas futures made a series of marginally higher lows until it violated the March bottom. Ethanol rebounded on the back of gains in oil and gas markets.
The energy sector of the commodities market will reflect the economic and geopolitical landscapes as we move into Q3, but the progress of the global pandemic will determine if the demand for oil and gas makes a comeback. Any further shutdowns in the global economy could weigh on prices after the gains in Q2, but a rebound in business activity would keep the bullish party going. The plight of crude oil is the perfect example of how the cure for low prices in the commodities markets is low prices.
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. US and Chinese relations deteriorated in Q2 over China’s lack of information as the virus began to impact Wuhan and their actions in Hong Kong. Q2 ended with the relationship between Washington and Beijing at a worse place than at the height of the trade war in 2019.
OPEC, Russia, and other world producers cut production by an unprecedented 9.7 million barrels per day in April, which did not initially stop the falling knife in the energy commodity. In May, Saudi Arabia added another one million barrels to the daily reduction, and other OPEC producers announced minor cuts that took effect on June 1. The Saudis also encouraged other producers to extend the current quotas past the initial two-month period. The group agreed to a one-month extension until the end of July. The output from the US, the world’s leading producer of crude oil, fell from a record at 13.10 million barrels in March to 11 million barrels, according to the Energy Information Administration during Q2.
Energy commodities power the world. Bullish and bearish factors on the economic and political landscapes were pulling the price of petroleum in opposite directions throughout Q2 and that is likely to continue into Q3. 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 fall to the lowest level in history in April. The rally in May was unprecedented, which led to the incredible quarterly gain.
Natural gas was weak throughout the winter season. After falling to a quarter-of-a-century low in June, natural gas recovered slightly by the end of the second quarter. Meanwhile, the price of ethanol at the end of the quarter reflects the price action in the other energy commodities. The low price levels at the end of Q1 set the stage for the spectacular gains in oil, gasoline, and ethanol futures markets in Q2. However, the prices fell to unthinkable levels during the first month of the second quarter before they turn aggressively higher. Volatility was rampant in Q2 in the energy sector, which provided trading opportunities.
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 2018, 2019, and during Q1 until prices collapsed and moved even lower in April 2020. The energy-related stocks recovered with the energy sector in Q2. Keep in mind that a percentage gain from a significant low always looks a lot more impressive. Energy commodities were over 29% lower than the level on December 31, 2019, as of the end of June.
Crude Oil Review
Crude oil traded within a wide range of -$40.32 to a high at $65.65 so far in 2020 on the nearby NYMEX futures contract. The high came on January 8 and the low on April 20, when storage capacity made it impossible for some longs to find a home for the May NYMEX futures contract as it expired.
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%, but it came roaring back by 91.75% in Q2 and settled at $39.27 per barrel on June 30, 2020. NYMEX futures were 35.69% lower over the first half of this year.
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. In Q2, the price continued to fall after OPEC, Russia, and other world producers announced the most substantial production cut in history of 9.7 million barrels per day. On April 20, the price fell below zero for the first time.
Crude oil then began to recover. In May, the Saudis announced a further one mbpd reduction as of June 1, and other Middle Eastern producers also trimmed output. Optimism over falling production and the reopening of the US economy during the peak driving season lifted prices starting in late April. The cure for the low price was the low price in the oil market. The Saudis, Russians, and other world producers extended the production cut to the end of July in Q2.
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. By the end of Q2, US production had declined to 11.0 mbpd as the low price made output a losing proposition for many producers in the shale regions. The rig count in the US, according to Baker Hughes, fell dramatically over the past three months and stood at 185 as of July 2, 439 lower than at the end of Q1 2020. Production fell with the decline in the number of rigs.
Fewer regulations under the Trump administration and a more favorable corporate tax policy improved the economics for US producers over the past years. Low interest rates encouraged borrowing and increased debt levels for many producers. The American oil industry has become the leading producer in the world. The decline in prices over the first half of 2020 may have handed some of the power in the crude oil market back to OPEC and Russia as US production fell. Many of the weaker capitalized oil-producing companies in the US faced bankruptcy at the end of Q2. The US remains the world’s swing producer of the energy commodity. When the price declines, shale output decreases, and the US can import cheaper oil from abroad. However, when the price rises, American shale production can flow again. The US is in a position to compete with other world producers to supply the energy commodity around the globe. The price action in the first half of 2020 caused a dramatic decline in US production.
The issues facing the Middle East remained a substantial concern early in Q1 as they reached a new peak in early January. However, it took a backseat to the global pandemic in Q2 as Iran suffered from many coronavirus cases. 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 and with the overall risk-off environment in all markets. As we move into Q3, demand will be the critical issue for the oil market. The recovery occurred as production fell, and optimism over demand rose. If business activity continues to increase, we could see crude oil head for higher levels. If widespread secondary outbreaks occur, and demand falls, selling is likely to return to the energy commodity.
With the 2020 election on the horizon, climate change will be an important topic of discussion. At the end of Q2, Vice President Joe Biden is the candidate that will face the incumbent President. In the interest of party unity, the Democrats have shifted their ideology towards the political left. Former Vice President Biden is likely to adopt some of the initiatives, including the “Green New Deal.” The election will be an energy referendum for the US. The lower US production falls, the more the power in the energy commodity will shift towards OPEC and Russia. In 2008, the price of NYMEX crude oil fell from over $147 per barrel to just under the $32.50 level. The central bank and government stimulus that followed the financial crisis pushed the price of the energy commodity back over $100 per barrel in 2011 as many other commodities rose to multiyear or record higher. The stimulus in 2020 is far higher than in 2008. As the liquidity weighs on the purchasing power of fiat currencies, we could see an inflationary backlash in the coming years. The decline in production could set the stage for a significant rally in the crude oil market over the coming years if 2008 through 2011 is a guide. Remember, in the world of commodities, the cure for a low price is that low price over time.
The rise of the US as a producer 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 2019, 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 have led to the end of OPEC, the end of the US leadership role in production, or it could have been an elaborate plan by OPEC and the Russians to destroy the US business. OPEC 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 seems that OPEC survived, and now will wait for the US election to find out if energy policy will undergo a significant shift starting in early 2021.
Trade issues between the US and China de-escalated at the end of Q4 2019. At the start of August 2019, 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 Q2. The US-Chinese relationship deteriorated in Q2 as the Chinese held back information at the start of the pandemic and allowed their citizens to travel, spreading the virus around the globe. The second quarter ended with the relations between the two leading countries in worse shape than at the height of the trade war.
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 through late April.
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 to continue to enrich uranium, which could present problems over the coming months. Now that the price of oil declined significantly in Q1 and Q2, 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. In Q2, with the world focusing on the pandemic, there were no incidents. The relationship between the US and Iran has not improved as sanctions continue to choke the Iranian economy.
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 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. In April, the US, Russia, and the Saudis engaged in talks and came up with the 9.7 mbpd output cut. President Trump continues to walk a fine line when it comes to the cartel. 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 April was devastating to the US oil sector and national security. Job losses in the US were only exacerbated by the low price of oil, which devasted the shale business.
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 has the potential to cause price spikes in the oil futures market in the blink of an eye. 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. President Putin had said that he would like to see stability in the oil market at the $42 per barrel level on Brent, which was less than one dollar per barrel above the closing price on June 30.
The past two years were a highly volatile period in the crude oil market; the energy commodity took the elevator to the downside in Q4 2018, and the stairs higher in Q1 2019. In Q2 2019, it rallied until late April when selling once again hit the market. In Q3 2019, the price spike on September 16 gave way to selling that took the price back below $51 per barrel. In Q4 2019, oil rebounded on the back of a deeper OPEC production cut and a de-escalation in the trade war. In Q1 2020, 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. In Q2 2020, crude oil traded below zero, which says it all for the energy commodity. 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. Production cuts to balance the supply and demand equation pushed the price back to the $40 per barrel level at the end of Q2. In Q3 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. I expect volatility to continue, but the demand side of the fundamental equation is the most significant factor over the coming weeks and months.
Open interest in NYMEX futures moved lower over the second quarter. The metric reached a new record high at 2.714 million contracts on May 16, 2018. The metric moved from 2.341 million contracts at the end of Q1 2020 to 2.009 million at the end of Q2, a decrease of 332,000 contracts. Since the peak, the metric declined by around 705,000 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 more powerful position as US output is falling, and marginal and debt-strapped energy companies are likely to go out of business. OPEC and Russia could move back to a dominant position over the coming months and years. 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. The highlight of Q2 was the deal between OPEC, Russia, the US, and other world producers. The event in the midst of the pandemic amounted to an attempt to control prices with the US at the table. The US has likely played a role throughout the years via the Saudis, but the April agreement was the first time it participated directly and in full view of the market.
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 than 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%. In Q2, it was 80.77% higher, making it 37.46% lower over the first six months of 2020. Nearby Brent futures closed on June 30 at $41.27 per barrel as the August contract rolled to September on the final day of June. Brent traded in a range from $16.00 to $71.99 over the last six months. 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-quarter of that price at the April low. When NYMEX futures fell to a negative price, Brent moved to its lowest price of this century at $16 per barrel.
Brent’s premium to WTI decreased to $1.84 per barrel basis the nearby September contracts down $1.17 per barrel in Q2. The Brent premium traded to the highest level since March 2015 at $11.59 per barrel in May 2019. In Q2, the spread on the continuous contract rose to a high of $11.52 in April during the wild price swings that took NYMEX futures below zero. In the September contract the Brent-WTI spread hit a peak of $5.45 per barrel in mid-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. As US production falls, we could see periods of a WTI premium to Brent. In March, the Brent premium on the continuous contract fell to a low of 17 cents per barrel.
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 US dollar and commodities prices, and crude oil is no exception. The dollar index moved 1.76% lower in Q2 but was 1.34% higher over the first two quarters of this year. 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, 2019 meeting, the FOMC cut the Fed Funds rate by 25 basis points. The Fed met again 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. In May, the US Treasury announced it borrowed $3 trillion to fund the stimulus, over five times the amount needed during the 2008 financial crisis. Rates are not going up in the US anytime soon, which is a supportive factor for crude oil and all commodities.
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. August 2020 NYMEX crude oil versus the August 2021 NYMEX futures (a one-year spread) settled at a $0.63 contango at the end of Q2 2020. The spread moved from a $7.02 contango on March 31 as the spread tightened by $6.39 per barrel. At the end of 2019, the spread was at a $4.49 backwardation, with the nearby at a premium to the deferred crude oil. The flip from backwardation to contango in the spread reflected the flood of supplies in the crude oil market. Oil traders filled 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 were highly profitable. The cash and carry trade lifted freight and storage rates. Storage capacity ran out, which left some longs holding a bearish hot potato on April 20. Crude oil fell below zero in one of the most incredible blow-off lows of all-time. Since April 20, the recovery was impressive, causing the contango to narrow and move towards flat.
The Brent, September 2020 versus September 2021 spread closed Q1 at a $6.46 contango and moved to contango of $2.36, which was $4.10 tighter over the past three months. 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 Q3. The forward curves reflect a condition of declining oversupply in the oil market compared to the end of Q1.
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. COVID-19 and a tidal wave of supplies sent the price of NYMEX crude oil. Below zero and Brent to a low of $16 per barrel. The blow-off low led to an impressive recovery. 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 91.75% higher over the past three months, and the XLE recovered in the second quarter. The ETF closed at $29.06 on the final day of trading in Q1 2020 and was at the $37.85 level on June 30, a rise of $8.79 or 30.25% over the period. The XLE lagged the price action in the crude oil market in Q2 on a percentage basis, which has been the trend over the past years.
Crude oil needs a rest, but the potential for price action in the oil market in Q3 will depend on events in the Middle East and the global pandemic. We could see the price continue to drift higher as demand increases with business activity. Uncertainty is likely to continue, which could cause periods of volatility. Few market participants expected the price of crude oil to trade below zero at the end of Q1. The market taught us to expect the unexpected in April. At the end of Q2, no one is talking about the potential for hostilities in the Middle East that could cause a price spike to the upside. At the price level at the end of Q2, problems in the region could create a head-spinning percentage move.
The cash and carry trade in oil that lifted freight and storage rates dramatically could begin to unwind as the spreads are near flat with the recovery in crude oil futures. Traders bought nearby crude oil, financed the energy commodity, sold for forward delivery, and stored 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 and job losses in the oil patch that will put tremendous pressure on banks and financial institutions. Coronavirus created a crisis in the first half of 2020, and the price action in crude oil, with the help of KSA and Russia, exacerbated the problems. Crude oil remains the energy commodity that powers the world. As we head into Q3, 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, in the short-term. As we learned in 2008, the risk-off conditions and stimulus could create a boomerang effect in the coming months and years. I am not bearish on the price of oil going into Q3, but a new outbreak of Coronavirus would weigh on demand and delay the eventual recovery. Stimulus at record levels is not bearish for crude oil in the long term.
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. Even though 2020 has been anything but an ordinary year, gasoline and heating oil prices reflected seasonal factors in Q2.
Both gasoline and heating oil futures rose in Q2. The bounce in crude oil increased demand because of the easing of social distancing guidelines, and the end of winter lifted the price of gasoline. Heating oil futures posted a smaller gain than in gasoline for the quarter. Refining margins in gasoline moved higher, while they fell for the distillate products.
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%, but they rallied by 102.72% in Q2. Gasoline was still 28.93% lower during the first half of 2020.
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 so far in 2020. The price pattern on the weekly chart since early 2016 had been positive as gasoline, but it shifted to the opposite pattern starting in 2018. 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. A gap in the chart developed from late February through early March from $1.2348 to $1.3562 per gallon. Price action tends to fill voids on charts over time. Nearby futures closed on June 30, at $1.2015 per gallon wholesale. Gasoline reached the lowest level since 1999 at 37.60 cents in late March before recovering in Q2. The gap could be an upside target in Q3 as the summer driving season should increase demand if there are no new outbreaks of Coronavirus. At the end of Q2, the price of gasoline worked its way into the void on the chart with a partial fill to the $1.3288 level, 2.74 cents shy of filling the gap.
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 distillate futures contract fell by 50.49%. In Q2, it recovered by 18.47% and was 41.34% lower over the first six months of this year. 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 distillate outperformed gasoline in Q1 but underperformed in Q2. So far this year, distillates have done worse than gasoline.
The weekly heating oil chart shows a constructive and bullish trend since early 2016 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 oil price. Heating oil fell below the 2018 low in Q1 and tanked with crude oil and gasoline prices. The gap in heating oil futures is from $1.3023 to $1.3783 per gallon. The price was below the bottom end of the void at the end of Q2. There was also a gap on the continuous NYMEX crude oil futures chart from $36.35 to $41.05 per barrel. Price action filled that void in Q2.
Nearby heating oil futures closed on the final trading day of Q2 at $1.1865 per gallon wholesale. Heating oil traded in a range from 58.00 cents to $2.1195 per gallon over the past six months. Oil product prices made a comeback in Q2, but they still have room on the upside if demand returns. The gaps on the weekly charts could act as a magnet for prices in Q3.
Crack Spreads Review
The price action in crack or refining spreads shows that seasonal factors sent the gasoline processing margin higher while it declined in heating oil during the second quarter of 2020.
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%. In Q2, it rounded by 159.26% and was 11.89% higher so far in 2020.
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. the wild trading conditions sent it to a high of $24.65 when crude oil moved into negative territory on the NYMEX May contract. The crack spread closed Q2 at $11.20 per barrel. We are now in the peak season for demand, which should provide some support for gasoline and the refining margin over the coming months.
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%. In Q2, it fell another 50.72% and was 55.77% lower through the first six months of this year.
The weekly pictorial of the heating oil refining spread illustrates that it closed Q1 at $21.45 per barrel. In Q2, it fell to $10.57. 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 $10.57 at the end of Q2, the refining spread was much lower than it was last year at the time, as it closed Q2 2019 at $23.08 per barrel. Heating oil refining spreads underperformed gasoline because of seasonal factors.
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 $45.36 per share at the end of Q1 2020 to $58.82 at the end of Q2. The shares recovered by 29.7% as gasoline, crude oil, and the gasoline crack spread all experienced significant rebounds. VLO shares fell to a low of $31 per share on March 18 as the stock market hit its low. Last year at the end of Q2, VLO shares were higher at $85.61 per share.
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%, in Q2, it recovered by 6.77%. In 2020, natural gas was 20.01% lower through the first six months.
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. In Q1 2020, natural gas fell to a multiyear low. In Q2, it declined to an even lower low.
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. In late June, the price fell to a lower low at $1.432 per MMBtu. Since the most recent low, natural gas bounced a bit higher as the price action ran out of steam on the downside.
Inventories rose to all-time highs in 2015 when they surpassed 4 trillion cubic feet before the withdrawal season. In November 2016, stockpiles climbed 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, which was the low at the end of the withdrawal season. Since then, injections into storage lifted inventories to 3.077 tcf as of June 26, 30.1% above last year’s level, and 17.8% over the five-year average. Stockpiles have not been a supportive factor for natural gas, but low prices are likely causing production to decline.
Nearby natural gas futures closed Q2 2020 at $1.7510 per MMBtu. Technical support is at the June low at $1.423level. Resistance is at $2.162 level, the high from early May, as we head into Q3. 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 over time.
Open interest in NYMEX natural gas futures contracts moved from 1,224,791 at the end of Q4 to 1,316,452 at the end of Q2, an increase of 91,661 contracts, or 7.48% during the second 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. In Q2, as the injection season got underway, natural gas recovered at first, but then fell to a lower low.
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 slightly higher at the end of Q2 2020 than at the same time last year when it was at the 1.292 million contract level. The price action likely encouraged shorts to push the price lower on June 25 and 26.
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 Q2 at $1.7510 per MMBtu level at the end of June. The term structure in the natural gas market illustrates that the energy commodity was trading at the $2.883 per MMBtu level in January 2021. The highest price on the forward curve is at $3.129 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 3.077 tcf in storage across the US at the end of Q2, we are now in the heart of the summer season at a high level and could see stockpiles rise to a new record peak at over four tcf by November 2020. However, production could decline as debt-laden producers experience financial woes. The number of natural gas rigs operating has declined substantially since the end of Q2 2019, according to Baker Hughes. As of June 26, 76 rigs were operating in the US compared to 174 at the same time I. 2019.
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.
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 is a bargain. Natural gas will move into the third quarter of 2020 at a level that is below the lowest for the century after risk-off conditions in all markets. Many producers are on the verge of bankruptcy. The price action in Q2 was not bullish, but we are likely to see future attempts to move above the $2 per MMBtu level.
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 second half of the year. 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. However, the cure for low prices in commodities markets is low prices as production tends to decline.
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. In Q2, ethanol rebounded by 33.92% and was 11.27% lower since the end of 2019. The biofuel fell to an all-time low at 79.9 cents it Q2 before turning higher. The price of nearby ethanol futures closed on June 30 at $1.220 per gallon, while corn was 0.66% lower, and gasoline rallied by 102.72% in the second quarter. Gasoline tends to trade at a premium to ethanol. 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. In Q2, ethanol was 1.85 cents higher than the oil product. Ethanol traded in a range from 79.9 cents to $1.420 per gallon so far in 2020.
Ethanol declined to a new record low in Q2. The price turned higher as crude oil and gasoline recovered. The ethanol mandate requires a blend with gasoline in the United States. In Brazil, another leading ethanol-producing country, the biofuel a primary fuel that powers automobiles.
Margins for ethanol producers moved higher over the second quarter. The price of the output, ethanol, was up by 33.92% with the price of the input, corn 0.66% lower. Companies involved in refining corn into the biofuel paid less for the input but received more for the output. Meanwhile, weakness in grain and agricultural commodity prices and strength in the stock market resulted in a higher price for the shares of Archer Daniels Midland (NYSE: ADM), a company that processes corn into ethanol. ADM moved from $35.18 per share at the end of Q1 to $39.90 on June 30 or 13.4%. ADM shares outperformed grains but underperformed ethanol and the stock market.
As we head into Q3, ethanol could become an issue in the 2020 Presidential election as the Democrats embrace the “Green New Deal” to reduce the carbon footprint.
The bottom line on energy
Crude oil fell from the high in early January at $65.65 to a low at negative $40.32 on April 20, the price in history. 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. In Q2, NYMEX crude oil fell into negative territory because it is landlocked petroleum with a delivery point in Cushing, Oklahoma. Storage filled to capacity, and there was nowhere to put the crude oil when the May contract approached zero. Some market participants believed that the price would not trade at a negative price, but they turned out to be tragically wrong. Brent is a seaborne crude oil, so its price only fell to a low of $16 per barrel, which was still the lowest level of this century. The lows came after OPEC, Russia, and other world producers agreed to the most substantial production cut in history at 9.7 million barrels per day. The cut was too little, too late for the oil market. The Saudis and other OPEC members trimmed production further by over one million additional barrels starting on June 1. OPEC met on June 4 and extended the output reductions for one month until the end of July. Meanwhile, US output dropped naturally as low prices made production a loss-making business. After reaching a record 13.1 mbpd, output was at 11.0 mbpd at the end of Q2. As demand from China rose and businesses began opening up again in June, the price of oil moved higher. The potential for a supply deficit rises as production declines. Moreover, the falling dollar and record level of central bank and government stimulus that weighs on all currencies is a bullish cocktail for inflation, which is supportive of the price of crude oil.
The oil market could move into a wait and see mode as the US election unfolds. The Trump administration supported energy independence and a drill-baby-drill policy with fewer regulations on producers. If Joe Biden becomes President, we could see a return to an environment that does not favor production, which could hand power back to OPEC and Russia. As US production falls, the potential for higher prices will rise, perhaps dramatically.
I am going into Q3 with a favorable view of crude oil as the trend in the energy commodity turned higher in late April. The critical factor over the coming three months will continue to be demand. Any outbreaks of Coronavirus that shut down businesses and force people back into their homes would weigh on the price of crude oil. However, the summer driving season should keep demand robust so long as the number of infections and deaths from the virus continues to decline. I will be looking at opportunities on the long side of the market, with tight stops. We cannot forget that Iran continues to pose a clear and present danger to crude oil supplies for consumers worldwide. Any hostilities could cause price spikes to the upside if production and inventories fall over the coming months. 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 Q3 after making a new twenty-five-year low on the weekly chart. I will look to trade from the long side of the market with very tight stops. The increase in open interest could be a sign of an overabundance of shorts in the natural gas futures market. The summer season is a time when demand for natural gas rises because of the hot temperatures and the increasing demand for cooling. Natural gas replaced coal as the primary input in electricity generation. With the price below the $1.80 per MMBtu level and a significant drop in the number of natural gas rigs in the US, production is likely to decline. Risk-reward does not favor the downside as we head into Q3. However, I do not expect any significant price moves to the upside. I will be taking profits on rallies. I will be using at least a 2:1 reward versus risk ratio on any long or short positions in the natural gas market using futures or the UGAZ and DGAZ ETN products.
The price of coal tends to be a seasonal commodity that follows the price of other energy products. Oil and gas prices posted gains in Q2, but coal continued to move lower.
As the chart of the price of July coal futures for delivery in Rotterdam, the Netherlands shows the energy commodity closed Q1 at $50.75 per ton and moved lower to $49.85 at the end of Q2 2020, a decline of 1.77% in Q2. The price of Rotterdam coal futures underperformed both crude oil and natural gas in Q2 after a long period of underperformance over the past years. Meanwhile, the KOL ETF product, which holds shares in many of the leading coal-producing companies, climbed from $62.90 on March 31, to $71.17 on June 30, a rise of 13.15% after falling over 36% in Q1. KOL experienced a reverse 10-1 split in Q2, and the price of the ETN moved higher along with the stock market and other energy-related shares.
The energy sector always offers some of the most exciting and profitable opportunities. We enter Q3 after a rebound in the markets. However, the demand side of the fundamental equations for oil, oil products, natural gas, ethanol, and coal will drive prices higher or lower. Falling output is likely to continue to provide support for the energy commodities. We could see consolidation among producers and bankruptcies over the coming months.
OPEC members and Russia could sit on the sidelines and wait for the US election, which will determine the future of energy policy in the nation that became the world’s leading producer over the past years. President Trump will continue a policy of energy independence, which would keep the US in a leadership position when it comes to output. The Democrats are likely to favor increased regulation and lower production, which could hand more pricing power back to the international cartel and Russians in the coming years.
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 and expand 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. We could oil and gas prices begin to move with the political polls in the early fall.
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. However, they made a significant comeback from the mid-March lows and the share prices at the end of Q1. Energy companies will follow the prices of the commodities and the stock market, but we could see M&A activity increase as some of the weaker companies will fall victim to the global pandemic and low prices over the first half of 2020.
Ethanol is likely to continue to follow the corn and gasoline markets in Q3. The biofuel made a comeback in Q2, but the price remains at a low historical level.
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. In Q1, NYMEX crude oil fell by 66.46%, and VDE moved 53.1% lower as the shares outperformed the carnage in the oil market.
VDE holds shares in many of the leading energy commodities in the world, including:
Source: Yahoo Finance
In Q2 2020, VDE moved from $38.22 on March 31 to $50.30 on June 30, a rise of 31.6%. NYMEX crude oil was 91.75% higher, so VDE underperformed the energy commodity for the quarter.
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. As we learned when May futures fell below zero on April 20, always expect the unexpected in the energy sector on the downside as well as the upside.
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.