Dwindling stocks brings explosive upside potential near-term with supply buffer all but disappeared, while global production outages hits 6-year lows.
The oil market has moved past the collapse in distillate without a blip. Strong macro signals and refined product stock draws keep refining margins above 5yr averages and supportive oil prices.
WTI-Brent arb doing a lot of the heavy lifting to fix global imbalances. Producer hedging dried up permitting CAL18 Dated Brent to cross the $58 bbl level.
TIGHTENING SUPPLY BUFFER:
The global inventory overhang is ~120mbbls, and falling. With ~100 mil of these barrels in the US. Since the beginning of the year, the combination of the OPEC/NOPEC production cuts and stronger than expected demand has removed ~200 mbbls of the “supply buffer” from the market.
The supply/demand margin of error (taking average EIA, IEA, OPEC balances) is a minor 200 kb/d for 2018. This is now becoming a rounding error for a near 100 mil bpd market and in the context of falling spare capacity and rising geopolitical risks.
We must also highlight a couple of other important observations on the 2018 supply/demand balances.
First, the inventory build is primarily in 1H 2018, driven by normal seasonality. While the magnitude of the build is in line with long-term averages, our calculations adjusting to recent leading indicators has these trending lower.
So the market perceives some seasonal builds as acceptable (1H of the year always weaker than 2H), especially in an environment at risk of supply outages.
This brings us to our second point that the “supply buffer”, or inventory overhang, has continued to dwindle while production outages are at 6-year lows – SEE CHART 1 – Geopolitical risks are increasing in Venezuela, KRG/Iraq and Iran. It is interesting that the returning production from Nigeria and Libya was an unwanted nuisance just a few months ago and how this has now changed. This production though, has limited room to move higher and susceptible to disruptions.
DERIVATIVE MARKET UPSIDE BETS
The front of the market has been complacent on geopolitical risk as highlighted by the consistent decline in front month derivative (implied) volatility since mid-September.
The options market, more recently, is readjusting, showing signs of interest with significant upside call buying in both WTI and Brent as the market is repricing probabilities for explosive potential. To many now buying a June18 $75 call for 25 cents in Brent for instance, appears a decent risk/reward as a way to proxy-hedge global risks.

Unplanned OPEC & NOPEC crude oil production outages | Source: EIA & CTC
DISTILLATE COLLAPSE OFFSET BY STRONG MACRO SIGNALS AND FALLING STOCKS:
Distillate cracks have given up most of the post-hurricane rally. This does not come as a surprise and the overextended net length in distillate remains our key concern. For the time being, the market is willing to look through this risk:
1) Distillate cracks and overall refining margins remain above 5yr averages,
2) Persistent stock draws now place distillate inventories below the 5yr average and
3) Macro indicators from global trade volumes, solid Q3 results with bullish sales outlook from industrial companies such as Caterpillar – SEE CHART 2 – point to a robust economic outlook.
Sentiment wants oil higher and will not change near-term but the middle distillate market remains key to driving oil to new and sustainable highs. Gasoil is still the leading indicator to us for Brent flat price direction.
WTI-BRENT WIDENING DOING THE HEAVY LIFTING TO REBALANCE THE MARKET:
WTI-Brent spread >$6/bbl is accomplishing three key things:
1) Keeps US shale volume growth in check. Pioneer’s CEO Tim Dove highlighted last week that shale’s opportunity set increased dramatically with oil prices closer to $60/bbl, rather than $50/bbl.
2) Economic incentive to increase US oil exports. OPEC is forcing the US to act as a swing supplier, which is effectively cleaning up the US inventory overhang. US exports are moving towards 2.0 mb/d with capacity expected to increase to 3.5mb/d by the end of 2019.
3) Locking in lower hedging levels. WTI’s discount to Brent is forcing shale producers to lock-in sub-optimal economics at levels $5-6/bbl below the market. US producer hedging was relentless as oil prices spiked in September and our estimates now see hedge ratios for 2018 in-line with historical norms. Earnings results from Range Resources and Whiting Petroleum support our analysis.
We think this normalization in US shale hedging volumes at lower prices as bullish for 2018 supply/demand as it gives producers far less flexibility to adjust to higher oil prices.
Moreover, the combination of recent investor activism pushing for returns over production growth will only compound the issue. Our read of the market points to estimates, which still factor in a best-case scenario, are at risk of downward revisions.
OPEC “TAPER” POTENTIAL DOWNSIDE RISKS IN 2018:
We highlighted this risk to our clients a couple of weeks ago and see OPEC “taper” as a key risk in 2018, particularly given the close to record paper length in Brent and refined products.
OPEC’s central bank approach to managing the market has downside consequences. The risk of a policy miscalculation increases dramatically into the OPEC meeting if prices move comfortably above $60/bbl. Our read of the market setup coming into the 30 November OPEC meeting:
• Brent below $60/bbl: Best case scenario for OPEC. Stick with the game plan. Extend OPEC/NOPEC production cut deal through the end of 2018. Russia and Saudi Arabia continue actions and comments to support oil prices. US shale concerns limited with investor focus on returns over production growth.
• Brent at $65/bbl and above: Worst case scenario for OPEC and chances for real fireworks into the OPEC meeting. First, OPEC will have to manage market expectations on how it exits the deal, overall compliance and whether there are “snap-back” provisions (i.e. inventory levels relative to 5yr averages, oil prices, etc). Second, US shale production growth may accelerate (with a lag) even with a $6/bbl WTI/Brent spread. Extended net speculative length increases the risk of a communication error or under estimation of market expectations. Volatility should he high.

Strong economic demand ahead ? | Caterpillar global machine sales growth
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