Summary
- The energy sector posts a 4.64% loss in Q3- WTI crude oil retreats 7.53% while Brent slightly underperforms with an 8.48% loss.
- Gasoline and heating oil reflect seasonal factors
- Heating oil crack spread gains 10.88% while gasoline refining spreads move 45.16% lower in Q3.
- Natural gas gains 0.95% in Q3 as the rally from the lows of the year fizzles
- Ethanol moves 4.45% higher in Q3 with a late rally on the back of corn futures
The energy sector posted a loss during the third quarter of 2019. 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 Q1 2019, the sector posted a 19.49% gain, but in Q2 it moved 1.54% lower. The loss was greater in Q3 as it fell by 4.64%. So far in 2019, the sector is 11.49% higher than at the end of 2018.
Crude oil rose to a higher high in April, but that gave way to selling in both the WTI and Brent futures markets. In Q3, both of the benchmark crude oil futures market posted losses. Ethanol is the best-performing energy commodity both in Q3 and over the first nine months of 2019.
In the natural gas market, the memories of the move to the highest price since 2014 in mid-November when nearby futures rose to $4.929 per MMBtu have faded into the market’s rearview mirror. In early August natural gas fell to a low at $2.029 per MMBtu, which turned out to be a bottom for the energy commodity. The price of nearby natural gas futures rallied and moved over the technical resistance level at $2.53 per MMBtu in September before failing at over the $2.70 level.
The energy sector of the commodities market will reflect the economic and geopolitical landscape as we move into the second half of 2019. 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 weak economy because of the trade war with the US increased the potential for a global recession in Q3, which weighed on the price. Meanwhile, the US is now the world’s leading producer of crude oil with a daily output climbing to a new record at 12.5 million barrels according to the Energy Information Administration during Q3.
Energy commodities power the world. Bullish and bearish factors on the economic and political landscapes were pulling the price of petroleum in opposite directions at the end of Q3. Nearby NYMEX crude oil futures experience a spike to the upside in Q3 after an attack on Saudi production on September 14. However, the price came back down by the end of the quarter as Saudi output returned to normal levels two weeks after the attack.
Crude Oil Review
Crude oil traded within the 2019 range in Q3 as the price traded from a low at $50.50 to a high at $63.38 on the nearby NYMEX futures contract.
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 compared to its price at the end of 2017. In Q1, NYMEX futures moved 32.44% higher for the three-month period. In Q2, it declined by 2.78%, and in Q3 it fell by 7.53%. Over the first nine months of 2019, the price of WTI crude oil was 19.07% higher than at the end of 2018. The nearby futures contract settled at $54.07 per barrel on September 30. NYMEX WTI crude traded in a range from $45.52 to $66.60 during the first three-quarters of 2019.
We have seen lots of price action in the crude oil market since October 2018.
Source: CQG
The weekly chart illustrates the fall in Q4 and price recovery in Q1 and Q2, 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 quarter at $63.38 on September 16. However, no retaliation or further event caused the price of oil to move back below the $55 level by the end of the quarter.
The US is now the leading producer of crude oil in the world as output reached a record high at 12.5 million barrels per day during Q3. The 1.2-million-barrel output cut by OPEC caused both Saudi and Russian output to move lower while US production continued to rise to new record levels. In a sign that US production has become more efficient, the rig count according to Baker Hughes fell over the past three months and stood at 713 as of September 27, 2019, 80 lower than at the end of Q2. Meanwhile, the production from the US was a reason why oil’s price spike did not cause a more dramatic move to the upside.
Fewer regulations under the Trump administration and a more favorable corporate tax policy have improved the economics for U.S. producers, and the American oil industry has become a significant exporter of crude oil in the future. The U.S. is now the world’s swing producer of the energy commodity. When the price declines, shale output will decline, and the U.S. will import cheaper oil from abroad. However, when the price rises, American shale production will flow, and the U.S. will compete with other world producers to supply the energy commodity around the globe, and even to the Chinese if the two nations can ever reach a deal on trade. The issues facing the Middle East remained a concern in Q3, which could impact global supplies of the energy commodity. However, the US achieved its goal of energy independence because of technology and a friendlier regulatory environment. With the 2020 election on the horizon, climate change is likely to be a significant topic of discussion. In Q3 many of the candidates from the other side of the political aisle have rolled out platforms for the environment. In September one of the leading candidates, Elizabeth Warren said she would ban fracking on day-one of her administration. A change in the regulatory environment would alter the dynamics of the oil market. We could see more volatility in the energy commodity as the election comes closer.
Meanwhile, the rise of the U.S. has caused the influence of OPEC to decline dramatically. However, 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. It appears that plans for an IPO of the world’s largest and most profitable company are once again on the table as we head into Q4. However, the attack on Saudi production will be a problem for any IPO as it increases the risk of an investment in Aramco.
Trade issues between the U.S. and China continue to threaten the overall health of the global economy. 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. 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.
Iran continues to be a growing problem in the Middle East, and sanctions took effect in November 2018. The U.S. is attempting to choke the Iranian economy if they do not abandon their quest for nuclear weapons. The Trump administration had issued exemptions to eight countries when it comes to purchasing Iranian crude oil late last year. The news of the exemptions caused speculative longs in the oil market to liquidate their risk positions, adding to the downward trajectory of the price in early November. However, those exemptions expired during Q2, and the US refused to grant extensions. In Q2, Iran retaliated by attacking several tankers near the Strait of Hormuz and firing missiles at targets in Saudi Arabia. Iran downed a US drone in June, but the US used restraint and did not respond with any military action. However, President Trump put new sanctions on Iran during the final week of Q2. Iran began enriching uranium according to some reports. Meanwhile, Iran’s fingerprints were all over the September 14 attack. While the price of crude oil moved lower after the initial price spike, the increased tensions in the region are likely to underpin the price of the energy commodity.
China is likely finding a way to buy some cargos of oil from Iran, but the sanctions continue to choke the theocracy in Teheran as we move into the final quarter of the year.
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 flow 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 with attacks. In Q3, there were fewer incidents. President Trump has said he is willing to meet with Iranian leaders, but Iran has said it will not have any discussions with the US until it lifts all sanctions resulting in a continuation of sanctions and a stalemate. 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 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 U.S., Russia, and the Saudis will likely work together 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. The realization of the decline of OPEC’s influence led the tiny but wealthy nation of Qatar, which is the subject of a Saudi blockade, to leave the cartel in January 2019. With the US election on the horizon in 2020, President Trump will likely seek to keep a lid on the price of oil via continued pressure on Saudi Arabia and other OPEC members. The NOPEC legislation in Congress that would outlaw the cartel could have significant ramifications if it were to find its way to President Trump’s desk for a signature. The President is no fan of OPEC, but it is questionable if the Democrat-controlled House of Representatives would hand the President a victory by outlawing OPEC before the 2020 election.
The Middle East is a region that always has the potential for issues. We saw tensions with Iran increase in Q3. 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. The two sides each have powerful backing as the US stands with KSA and Russia is behind Iran. 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 past year was 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 $55 per barrel. Trade and Iran have been the most significant factors for the oil market over the past three months.
Open interest in NYMEX futures moved higher over the third quarter. The metric reached a new record high at 2.714 million contracts on May 16, 2018. The metric moved from 2.017 million contracts at the end of Q2 to 2.071 million at the end of Q3, an increase of 54,000 contracts. However, since the peak, the metric declined by around 643,000 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 U.S. 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 U.S. 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.
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 Q1, Brent underperformed WTI as it posted a 25.61% gain over the three-month period. In Q2, it underperformed WTI as the price slipped by 4.2%. In Q3, Brent underperformed WTI as the price dropped by 8.48%. Over the first nine months of 2019, the price of Brent crude oil was 10.13% higher than at the end of 2018. December Brent futures closed on September 30 at $59.25 per barrel as the November contract rolled to December on the final day of the quarter. Brent traded in a range from $53.47 to $75.59 over the first three-quarters of 2019. After the September 14 attack, the price of nearby Brent futures moved to a high at $71 per barrel.
Brent’s premium to WTI decreased to $5.37 per barrel basis the nearby December contracts down $2.87 per barrel over the three-month period on the nearby futures contracts. The Brent premium traded to the highest level since March 2015 at $11.59 per barrel in May. In Q3, the range in the spread was from $3.48 to $7.50 per barrel, and it closed the quarter near the midpoint. The expansion of the US pipeline system has weighed on the spread, and the calm in the Middle East over the past three months also contributed to the decline in Brent’s premium over WTI crude oil.
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 U.S. 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 3.51% higher in Q3, compared to its June 2019 closing level. The dollar index made a new high at the 99.33 level and was near the high at the end of the third quarter. The rise in the dollar index came despite falling US interest rates as rates around the world continue to decline at a faster pace. At its July 31 meeting, the FOMC cut the Fed Funds rate by 25 basis points. The Fed met again on September 18 and reduced the short-term rate by another one-quarter of one percent. At the same time, the Fed ended its balance sheet normalization program, which took upward pressure off longer-term rates. However, economic weakness around the world and falling interest rates caused the dollar to rise as the greenback continues to offer the highest yield compared to other foreign exchange instruments.
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 are a sign of either oversupply or equilibrium where supply and demand are in balance. December 2019 NYMEX crude oil versus the December 2020 NYMEX futures (the one-year spread) settled at a $3.46 backwardation at the end of Q3. The spread tightened by $0.59 per barrel compared to where the one-year December spread was trading at the end of Q2 when it was in a backwardation of $2.87 per barrel. The tightening of the spread reflects some supply concerns for crude oil. However, an expansion of the US pipeline system could cause the spreads to loosen, and the Brent-WTI spread to decline as more storage and pipeline capacity lowers the bottleneck supply problems in the US.
The Brent, December 2019 versus December 2020 spread closed Q2 at a $3.32 backwardation, which was 94 cents tighter as the backwardation expanded. 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 Q4. The forward curves reflect a continuation of supply concerns.
Both WTI and Brent remained over 10% higher at the end of Q3 compared to the end of 2018. A continuation of the bullish price action will depend on a myriad of factors including economic growth, events in the Middle East, US output, and the state of markets across all asset classes. Lower interest rates in the US and a falling dollar provides support for the price of crude oil all commodities, but global economic growth could cause demand destruction for energy commodities. In Q4, the price of oil tanked starting on the first day of the quarter. The winter can be a bearish time for the energy commodity.
NYMEX crude oil moved 7.52% lower over the past three months, and the XLE also posted a loss in the second quarter. The ETF closed at $63.71 on the final day of trading in Q2 was at the $59.20 level on September 30, a decline of $4.51 or 7.1% over the period. The XLE kept pace with the price action in the crude oil market in Q3.
Bullish and bearish factors will continue to pull the price of crude oil in opposite directions in Q4 as the situation between Iran, the Saudis, and the US is not going away any time soon. The Middle East and even Venezuela are extreme hotspots in the world, and trade between the US and China will determine the health of the global economy. I believe that any price spikes in Q4 are likely to come on the upside because of the tension around the Strait of Hormuz and increased military presence in the region. The world continues to wait for a response to the September 14 attack, and it could be a case of all quiet before the storm in the region.
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, although they exhibit less seasonality than the gasoline futures market.
Both gasoline and heating oil futures declined in Q3 with the products reflecting their seasonal pressures. Refining margins moved in opposite directions as the gasoline crack posted a significant loss and the heating oil refining spread moved marginally higher.
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 Q1, gasoline posted a 44.58% gain for the three-month period making the fuel the best-performing commodity of all in Q1. In Q2, gasoline futures moved 0.75% higher. In Q3, the price of gasoline fell by 17.4%.
Source: CQG
As the weekly chart highlights, gasoline traded in a range of $1.3230 per gallon to $2.1559 on the active month contract on the NYMEX over the first nine months of 2019 as the fuel exited the peak season for demand in early September. 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 Q1, eight straight weeks of gains sent the price back to the highest level since last October. The price of gasoline futures moved steadily lower with crude oil after hitting a high during the week of April 22. Nearby futures closed on September 30, at $1.5665 per gallon wholesale. Gasoline spiked higher with crude oil on September 16 to $1.7785, but the price came down over the final two weeks of the quarter.
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. Heating oil futures moved 17.39% higher in Q1 2019. In Q2, heating oil posted a 1.62% loss over the three months. In Q3, the futures were 2.18% lower. 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.
Source: CQG
The weekly heating oil chart shows a constructive and bullish trend since early 2016. 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.
Nearby heating oil futures closed on the final trading day of Q3 at $1.9277 per gallon wholesale. Heating oil traded in a range from $1.6215 to $2.1377 per gallon over the first nine months of this year. Oil products fell with the price of oil in Q3, but both are higher through the nine months ending on September 30. Gasoline was 20.31% higher on the year with heating oil moving 12.97% to the upside.
Crack Spreads Review
The price action in crack or refining spreads shows that gasoline and distillate fuel processing margins moved in opposite directions reflecting the end of the summer season.
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 Q1, the gasoline crack spread posted an impressive 103.44% gain. In Q2, it was only 0.75% higher. In Q3, the end of the driving season caused the gasoline crack to decline by 45.16% but was 25.59% higher compared to the price at the end of 2018.
Source: CQG
As the weekly chart shows, the nearby NYMEX gasoline processing spread exploded higher in Q1 as the market looked forward to the season of peak demand. In Q2, the gasoline crack spread retained most of its gains, but the seasonal pull caused the spread to move into winter mode as the end of summer approached. The nearby gasoline crack spread closed Q3 at $11.68 per barrel on September 30. The gasoline crack spread was lower at the end of Q3 in 2019 compared to Q3 2018 when it closed at $14.29 per barrel.
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 Q1, the distillate processing spread fell by 10.12% from its closing level on the final day of December 2018. In Q2, the distillate crack spread rose by 2.35%. In Q3, it posted a 10.88% gain.
Source: CQG
The weekly pictorial of the heating oil refining spread illustrates that it closed Q3 at $25.59 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 $25.59 at the end of September, the refining spread was marginally higher than it was last year at the time as it closed Q3 at $25.28 last year.
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.
Source: Barchart
As the chart of Valero Energy Corp (VLO) highlights, the stock has moved from $85.61 per share at the end of Q2 to $85.24 at the end of Q3. The decline of 0.43% reflects then change of season and the overall weakness in oil-related equities throughout 2019. VLO trades at a 14.04 P/E ratio and pays shareholders a 4.22% dividend. While I continue to believe that VLO offers value at its current price level, the potential for volatility in both the oil and stock market has kept me on the sidelines when it comes to the refining stock. The seasonality coming into the winter is also a reason why I am not long the stock.
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. In Q1, natural gas lost 9.46% of its value compared to the closing price of nearby futures at the end of December. In Q2, the price tanked and fell to the lowest level since 2016 and was 13.3% lower for the quarter. In Q3, after making a new low, the price recovered by 0.95% after the summer came to an end and was 20.75% lower over the first nine months of this year.
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 late last year on the lowest level of inventories in years, but the price came back down to earth in December and during the first three months of 2019. During the third quarter, the selling continued taking the price to a low at $2.029 per MMBtu in August.
Source: CQG
As the weekly chart shows, the highs in natural gas came in mid-November when a combination of short-covering and cold weather took the price to a lower high at $4.929 per MMBtu. Record production caused some market participants to short the commodity, but low stocks and an increase in demand for power generation, and growing shipments of LNG supported the demand side of the fundamental equation for the natural gas market. Additionally, a pairs trade of long crude oil and short natural gas at the beginning of October as sanctions on Iran and record output of natural gas caused some traders and hedge funds to buy oil and sell gas on spread. The trade wound up being one of the most painful spreads of 2018 as longs scrambled to sell oil and shorts chased natural gas higher in Q4, resulting in significant losses on both sides of the pairs trade. However, warmer forecasts brought the price back below the $3 level by the end of 2018. The selling continued during the nine months of 2019. Natural gas picked up a head of steam on the downside as the price fell below technical resistance levels at just above the $2.50 per MMBtu level. The price found a bottom at $2.029 per MMBtu during the week of August 5.
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. Late in Q3, stocks had risen to 3.205 tcf as of September 20, which was 16.1% above last year’s level, but still 1.4% below the five-year average for the same time of the year. The approach of Hurricane Dorian ignited the price of natural gas, but the storm did most of its damage in the Bahamas. The end of the summer and approaching peak season of demand supported gains even though inventories injections began to pick up some steam on the upside in September. The price rose to $2.71 in mid-September when it ran out of upside steam.
Nearby natural gas futures closed Q3 at $2.330 per MMBtu. Technical support is at the recent low at $2.029 level. Resistance is at the $2.90 and $3 level as we head into the fourth quarter when the withdrawal season begins in mid-November.
Open interest in NYMEX natural gas futures contracts moved from 1,289,412 at the end of Q2 to 1,148,234 at the end of Q3, a decrease of 141,178 contracts or 10.95% during the third quarter of 2019. 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 in August 2019. In 2017 and 2018 the low was at just above the $2.50 level which became technical resistance when the price fell to just above the $2 level during the summer. The approach of the winter season caused natural gas to move above the resistance level in September.
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. Open interest was significantly lower at the end of September in 2019 than at the same time last year when it was at over the 1.68 million contract level. 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.
While the nearby price of natural gas closed Q3 at $2.330 per MMBtu level at the end of September, term structure in the natural gas market illustrates that the energy commodity was trading at the $2.622 per MMBtu level in January 2020. The highest price on the forward curve is at $3.559 in January 2031, 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 the price blew through those levels like a hot knife through butter. At the end of Q1, I wrote, “The natural gas curve is telling us that sentiment in the natural gas market continues to be bearish.” Stockpiles of natural gas are rising during the injection season of 2019, but at the current rate, it is unlikely that we will see them rise to the four trillion cubic feet level by the time they begin to fall in mid-November. However, we will see higher stocks at the end of the injection season compared to last year when they stood at 3.247 tcf.
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. One of the leading candidates, Elizabeth Warren has said she would ban fracking immediately, which would reduce supplies and could support the price of the energy commodity in the United States.
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 U.S. 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 if the US and China ever agree on a trade deal. 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 after the 2020 election. Meanwhile, political polls over the coming months could also cause an increase in price volatility for natural gas prices for deferred delivery.
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 $4.00 became a bargain for a time in late 2018. Natural gas will move into the final quarter of the year after reaching the lowest price since 2016 and bouncing higher. As the winter peak season approached, call options for the coming winter season will limit risk while opening up the upside in case of a significant price recovery.
Keep your eyes on inventory levels over the coming months. The higher they rise, the less likely upside we could see on the price of natural gas. At the recent rate of injections, we will likely go into the peak season with 3.7-3.8 tcf in storage, which is lower than record levels but higher than last year.
Ethanol
In the US, ethanol is a biofuel — a product of corn. The price of nearby ethanol futures fell by 4.24% in 2018. In Q1, the biofuel turned higher and posted a 6.41% gain for the first three months of 2019. In Q2, ethanol prices exploded to the upside, making the biofuel the best-performing member of the energy sector with an 11.9% gain. In Q3, the price rose by 4.45% on a rally on the final day of the quarter on the back for corn prices. Ethanol was the best-performing energy commodity in Q3 and so far in 2019. Ethanol outperformed the price of gasoline and corn in Q3. The biofuel fell to an all-time low at $1.198 during the final three months of 2018. The price of nearby ethanol futures closed on September 30 at $1.572 per gallon while corn was 7.67% lower and gasoline moved 17.4% to the downside for the quarter. Gasoline tends to trade at a premium to ethanol, and at the end Q4 2018, the spread was trading at a level where gasoline was at a 3.81 cents premium to ethanol. The spread blew out in Q1 to 53.75 cents, 49.94 cents higher than at the end of 2018. At the end of Q2, the spread stood at 39.16 cents, 14.59 cents lower than at the end of Q1. In Q3, the spread was at a 0.55 cents premium for ethanol, 39.71 cents lower than at the end of the previous quarter. Ethanol traded in a range of $1.252 to $1.645 per gallon over the first nine months of 2019 and settled closer to the top end of the trading range.
One of the reasons for the recovery in the price of ethanol in Q2 and Q3 was the Trump Administration’s move to lift a summer ban on the sale of gasoline with a blend of 15 percent ethanol or E15. The prohibition had been in place for three decades. Meanwhile, the decline in the price of corn and gasoline in Q3 did not prevent the price of the biofuel from moving higher at the end of September.
Margins for ethanol producers moved higher over the third quarter. The price of the output, ethanol, was up by 4.45% but the price of the input, corn was 7.67% lower which means those companies involved in refining corn into the biofuel paid less for the input and received more for the output on a relative basis. However, shares of Archer Daniels Midland (NYSE: ADM), a company that processes corn into ethanol, moved only marginally higher from the end of Q2 to the end of Q3 2019 rising from $40.80 to $41.07 per share or 0.66%. The increase in the ethanol refining margin was not enough to offset lower overall agricultural commodities prices because of the ongoing trade war between the US and China.
Another issue to keep in mind when it comes to ethanol is the political push for a “Green New Deal” by Democrats in Congress and the candidates for President. Rising support from a move away from fossil fuels and hydrocarbons could boost the demand and price of ethanol and other alternative energy products as we witnessed in the second quarter of 2019. The 2020 election could inject lots of volatility into the ethanol market as well as all in energy commodities.
The bottom line on energy
Aside from the price spike on September 14, the price of NYMEX nearby crude oil futures traded in a $10 range between $50 and $60 per barrel for most of Q3. Brent underperformed WTI as the pipeline system in the US, expanded and allowed for increased exports. However, the trade war with China caused the price to make a lower high and marginally lower low over the three months. As we head into Q4, Iran and trade remain the two issues pulling the price of crude oil in opposite directions. However, it is possible that they could reverse rolls. If the US and Iran begin to talk, it will take the upside pressure off of the energy commodity, but optimism over a trade deal between the US and Chinese could serve to increase demand. A rising dollar and falling US interest rates are also factors pulling the price of crude oil in opposite directions.
OPEC will meet at the end of Q4, and if the price remains at the current level, the cartel is likely to continue to keep the 1.2-million-barrel production cut in place. OPEC ministers had said that the “comfortable” level for Brent crude oil is in a range from $60 to $70 per barrel, and the energy commodity closed Q3 at the lower end of that band. In September, the Saudis replaced its oil minister with one of the King’s sons. They also replaced the Chairman of Aramco as they seem ready to make another attempt at an IPO if they can agree on a valuation. It appears that the market may be telling them that $1.5 trillion is possible for the world’s most profitable oil company, but Crown Prince MbS continues to believe that it is worth over $2 trillion. However, the September attack will take another haircut off the valuation as it adds to the risk of holding the shares of the Saudi company. I will continue to trade crude oil buying dips and selling rallies so long as the price remains above $50 and below $64 per barrel on the nearby NYMEX futures contract. 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.
When it comes to natural gas, the price goes into Q4 after breaking to the upside above resistance at the $2.53 level and failing. September was too early for a significant rally, but I believe the energy commodity will make at least one attempt at the $3 per MMBtu level or higher as the winter season approaches. It is doubtful that a rally like we witnessed last November that took the price to a high at $4.929 per MMBtu will materialize, but anything is possible in the volatility natural gas futures market. I would buy dips early in Q4 and use options to position for any potential upside moves during the 2019/2020 withdrawal season when inventories decline. I expect that stocks will peak at the 3.7-3.8 level, above last year, but below the record highs at over 4 trillion cubic feet from the recent years.
The price of coal tends to be a seasonal commodity that follows the price of other energy products.
Source: Barchart
As the chart of the price of November coal futures for delivery in Rotterdam, the Netherlands shows, closed Q2 at $49.60 per ton and moved higher to $60.90 at the end of Q3, a rise of 22.8% in Q3 on the October contract. The price of Rotterdam coal futures outperformed both crude oil and natural gas in Q3, but seasonality played a role in its rise. However, the KOL ETF product which holds shares in many of the leading coal-producing companies only fell from $13.28 on June 28, to $10.87 on September 30, a decline of 18.1%.
The energy sector always offers some of the most exciting and profitable opportunities. Both the global economic and geopolitical landscapes will guide prices in Q4 and into 2020.
The price of oil is likely to continue to be 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 can always threaten stability in the region and has the potential to cause price spikes in the oil market.
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 positions as the Saudi Arabia of natural gas, a term coined by the late T. Boone Pickens. The energy sector could experience lots of volatility through the election season based on political polls. A victory by the challengers could cause even more price variance if US energy policy undergoes a significant change.
International trade is likely to continue to dominate the news cycle over the coming weeks and months until the US and China have a breakthrough. Based on the events of the past months, we should expect more ups and downs when it comes to tariffs and retaliatory measures. Q4 in 2018 was a bearish period for crude oil and the stock market and a time when natural gas took off on the upside. We could see wider trading ranges in both energy commodities compared to Q3.
Ethanol is likely to continue to follow the corn and gasoline markets throughout the rest of 2019.
The Vanguard Energy Index Fund ETF Shares (VDE) correlates with the price of crude oil, but it has lagged the energy commodity over the past months. During Q3, it underperformed the energy commodity, as it declined by 8.2% compared to a drop in the price of NYMEX crude oil futures of 7.53%. VDE holds shares in many of the leading energy commodities in the world, including:
Source: Yahoo Finance
The VDE moved from $85.02 at the end of Q2 to $78.02 at the end of Q3.
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. We are likely to see lots of action in natural gas as the winter season approaches, and the oil market is always susceptible to significant moves. A break below $50 or above $64 could trigger follow-through price action in the petroleum market.
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.
