Shocks and Differentials: How are the oil markets coping?
A combination of unprecedented demand and supply shocks are testing the oil market and its physical infrastructure to the limits. While the sharp fall in the futures price of benchmarks such as Brent and WTI over the last few weeks reflects the severity of the crisis, the recent movements in price levels and their volatility capture only part of the picture and do not fully reveal the extent of the large imbalances building in the system. To capture these imbalances, it is important to look at the evolution of some of the key differentials and spreads; as in the extreme market conditions that we are currently witnessing, it is the differentials which do most of the adjustment to reflect the underlying changes in the physical market and the shift in trade flows. Although price levels have exhibited extreme movement and high volatility in recent weeks, movements in price differentials and spreads have been even more acute, breaking most records set in previous cycles. In fact, one could argue that currently there is a disconnect between the futures prices and the physical differentials which is pointing towards a more distressed market.
Last week President Trump while advocating ‘free market’ principles in correcting the market imbalance, also called on Russia and Saudi Arabia to reach an agreement to restrict their supplies and in case they don’t, implicitly threatened to impose tariffs on crude imported from those countries. He also kept raising expectations by indicating that a deal is imminent and Russia and Saudi Arabia ‘will be cutting back approximately 10 Million Barrels, and maybe substantially more’ which was followed by another comment only a few minutes later that this ‘could be as high as 15 Million Barrels’. In response to President Trump’s tweets, futures Brent and WTI rallied, at a time when most of the physical prices and differentials are pointing in the opposite direction. In addition to the massive volatility that such tweets create, raising expectations will only increase the extent of dislocations and the disconnect between paper and physical markets, which means that differentials and spreads have to do even more stretching to send the correct signals to the physical players and operators and to allocate crude and products through the globe in the face of the most severe demand shock. These disconnections however are not sustainable and the alignment between physical and paper markets will eventually happen. Trump’s tweets risk making such an alignment abrupt and severe, introducing unnecessary volatility and extreme price movements, especially if the proposed producers’ meeting later this week fails to deliver an agreement on an output cut. The oil market is not broken; it is still functioning well, and this is despite some misguided interventions.