Two Plays To Capitalize On The Next Downswing In Oil Prices
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Two Plays To Capitalize On
The Next Downswing In Oil Prices
- The crude markets remain very volatile but provide us with a ton of opportunities to play energy from the long and short perspectives.
- OPEC’s voluntary cuts have driven up prices and reduced broader demand as it puts pressure on crack spreads.
- Two opportunities offer some great downside exposure at a discount as both supply and demand fall.
The major agencies have adjusted their estimates for the supply/demand of crude oil following the surprising production cuts by OPEC+ announced on April 2.
Even with the adjustment, we are still going to see a pretty balanced 2023, which is tighter than initial estimates. The tighter assessment makes sense following the broad reduction in supply, but now demand is down as margins implode for refiners.
The biggest demand drivers are hurting, and the question shifts back to: “Was OPEC+ smart to make the cut because they saw it coming, or was the reduction in the supply the driver?” There is probably truth in both statements, but Saudi keeping the Official Selling Price (OSP) elevated is a much bigger problem for refiners. The crunch on margins has been our biggest concern, especially for Asian refiners.
There’s A Lot of Crude Out There
The crude markets remain very volatile but provide us with a ton of opportunities to play energy from the long and short perspectives. We believe the correction to the downside is a bit overstated, but the trend will move in that direction.
In the very near term, we should see Brent bounce from $77 back to $80 before we see the move back to $75 and likely stop at around $73. This provides a great opportunity to position for the next downswing as pressure mounts on demand.
We have highlighted in the past how difficult it is to truly nail down demand levels, but we are clearly seeing problems emerge when we look at some core leading indicators.
Crack spreads (how refiners make money) have been in a downward spiral as crude and products on the water surge. An interesting fact here- we have a RECORD amount of crude oil in transit (above 2020 levels) while still having a very elevated amount of crude in floating storage.
Crude Oil in Transit
Crude Oil in Floating Storage
This is significant for several reasons:
- Crude in transit can originate from floating storage. So, when something in floating storage is sold, it starts sailing toward its final destination and changing how we categorize it.
- If there is so much crude in transit, there is no need to purchase additional cargo in storage.
- As shipments in transit get to their location, they will transition to floating storage.
Each of these points to a breakdown in demand, which is supported by softness in physical spreads. When we put all these facts together, there is no shortage of crude available for the global market. There is a significant amount sloshing around, but not all crude is created equal.
Even with these levels available, we are seeing premiums for heavier grades- especially ones that have an elevated distillate cut. This is only leading to further degradation of crack spreads for refiners around the world, especially the U.S. Gulf Coast and Southeast Asia.
Crude Oil on the Water
Russian crude that can no longer flow by pipeline has to find a home on the water. So you might think, “Russian crude is flowing to Asia and not Europe; therefore Europe should be buying more”.
But when we look at European purchases, they are very lackluster given the economic pressure within the region. This means that U.S., CPC, and Libyan volumes are sufficient to meet their reduced demands.
Between China and Europe (main buyers of West Africa), there is no real buyer for Angola and Nigerian cargoes, which has caused floating storage to remain elevated. The lack of sales is also happening with broad price cuts and VERY reduced production levels.
We (finally) saw some purchases of Angola cargo pick up slightly when distillate heavy crude demand picked back up and buyers refused to pay Saudi prices. The next closest crude quality is Angola, and even with that need, Angola cargoes weren’t able to get any type of premium.
West Africa Crude Oil in Floating Storage
It’s interesting that China is importing crude at record levels, yet we are seeing West African and Middle East flows languish with more crude sitting in storage. It means that Russia is filling Asian needs and other buyers are facing a slowdown that more than offset the production cuts in these regions.
China Supertanker Crude Imports
Chinese Refiners Will Start Pulling Back
Chinese refiners hit records in March, but a lot of that was a push ahead of planned downtime in April and the beginning of May. We assumed that Chinese teapots were going to maintain runs, but they have also pulled down some of their utilization rates.
Our view was that activity would flatline at around 63%, but we had a bit of a drop to around 60% which should be the floor. The state-owned refiners are the biggest driver of the slowdown after having the big push. There is still a sizeable amount of the export quotas remaining, which will be used to balance out storage throughout April-May.
The below chart shows the level of activity that occurred during March in China. While some of this will be consumed locally, a large chunk of it will find its way into the market driving down spreads further.
However, an uptick in seasonal maintenance in April and May points to refiners reducing process rates in those months. A total of 62.4 million tons of capacity was under maintenance as of April 13, compared with 39.3 million tons two weeks earlier,
There has already been a sizeable reduction in April, with some of that carrying over to May. It’s not the full amount, but enough to move us back to a seasonally “normal” level.
China set a record last month for crude runs, but we have now seen a steady reduction in run rates as local demand disappoints against estimates. This is putting more product into the export market which is already getting very crowded.
This is only made worse by Russian product dumping into the market at pennies on the dollar. Russia has about 5M barrels of diesel sitting in floating storage that is waiting to find a home, which is going to hurt U.S. exports out of the Gulf of Mexico.
The Supply/Demand Dynamic Is Key
Another aspect of the OPEC report is their expectation of demand. They have reduced some of the estimates, but still see over 103M barrels of demand in the fourth quarter of 2023. Given the economic pressures, we don’t believe that we will hit these levels.
This will result in net builds for the year, but nothing as large as we were initially expecting. Because of the OPEC voluntary cuts, it has driven up prices and reduced broader demand as it puts pressure on crack spreads.
As demand wanes, it will force refiners to cut runs further and create a broad miss on demand as we progress throughout the year. OPEC+ is putting a lot of faith in summer driving and activity, but we remain cautious about demand.
The supply side is also complicated by the loss of Kurdistan flows through Turkey by way of the Ceyhan pipeline. Iraq needs to resolve billions of dollars in financial claims with Turkey before resuming oil exports via a Mediterranean port, threatening more delays in bringing almost half a million barrels a day back to the market.
This past Tuesday, Iraqi Prime Minister Mohammed Shia Al-Sudani said he hoped flows of the country’s crude from Ceyhan could restart this week after being blocked by Turkey in late March. But while Baghdad has struck a temporary deal with officials from Iraq’s Kurdish region to get the oil moving again, it’s yet to get Turkey’s approval.
The dispute is hurting Erbil and Baghdad alike, with oil worth hundreds of millions of dollars having been held back. While small in the context of the global market, it’s also another disruption for traders already grappling with OPEC+’s decision to cut production again and an outage in Nigeria.
Turkey and Iraq have a lot to work out, which will keep flows tight into Europe and support U.S. exports into the region.
When we look at gasoline demand around the world- we are seeing a broad reduction. As we have been saying, we believe gasoline demand in Asia and North America will remain well off “normal”, which is made worse by the sizeable drop in global distillate demand.
Distillate pressures will remain as economies face more headwinds with inflation persisting and underlying manufacturing flows are reduced. When we start looking at global trade flows, the concerns only grow when considering crack spreads and Russian/Chinese flows. Volumes of product into the U.S. is dropping to the beginning of COVID levels, indicating more pain ahead.
Not only are the inbounds weak, but the current market is getting hit hard when evaluating contract vs spot. The spread between contract and spot rates is near all-time highs at -$.92/mile. It is almost a dollar cheaper to ship a truckload through the spot market than it is to ship it in the contract market. These two markets are fungible. Contract rates have a lot further to fall.
Shipping Demand Is Also Down
When we turn to shippers, we can see that the demand indicators for the next few months point to more pressure on global trade.
The reduction in demand, which we are seeing globally based on export/import data, is also driving down basic rates.
The reduction in volumes is driving down rates across multiple shipping types and helps to drive home the weakening economy.
Even as the economy slows, we aren’t seeing prices fall in commodities to the same degree because of the broader supply shortfalls. We have them in grains as well as crude to a degree driven by OPEC+ cuts. Russia had no choice but to reduce its flows as its storage is maxed out and access to pipelines are diminished.
Crack spreads in two key hubs are getting hit hard, Asian gasoil being the most important and secondary to the Gulf of Mexico. The below chart looks at Asian gasoil, where you can see crack spreads have gotten hit hard.
For example, Singapore’s all-in margins have gone from $8 to $2, and we see another leg down in the gasoil crack spread from $14 to $10. This additional drop will move Singapore (and realistically the rest of Asia) negative, forcing economic run cuts. The added volumes from China and Russia make it much worse and will exacerbate the problem.
The U.S. Is Not Immune
The U.S. is no different as we expect exports from the Gulf of Mexico for diesel and gasoline to come under pressure and fall well below the 5-year average.
Gasoline Exports from PADD 3 (Gulf of Mexico)
Distillate Exports from PADD 3 (Gulf of Mexico)
The slowdown in exports is going to push storage levels higher quickly and ahead of seasonal norms. Said another way: the rate of change is going to send things higher MUCH faster than what happens every spring season.
The lack of exports and limited demand within the U.S. is going to push margins down for refiners- especially the coastal entities. We have also seen shipping rates soften for product tankers, which has unlocked an armada of gasoline from Europe into the U.S.
This will further weaken coastal margins. PADD 2 (Midwest refiners- especially CVI) will be insulated a bit, but it offers up a great shorting opportunity since volatility is still GROSSLY mispriced. We can get some great downside exposure at a discount.
The above chart shows you how the bond and CDS (Credit Default Spread) on U.S. Treasuries are pricing in a serious problem as the equity market is asleep at the wheel.
This is the time to pounce and pick up some cheap equity volatility.
Today’s Recommendations:
The best way to play these constraints resulting in tighter margins is by buying puts on the following companies.
Opportunity #1
Valero Energy Corporation (NYSE: VLO) is a Fortune 500 manufacturer and distributor of refined transportation fuels, other petrochemical outputs and energy.
Its main business units consist of Refining, Renewable Diesel and Ethanol.
The Refining unit consists of the operation of refineries, related marketing activities and logistics operations in support of refining.
Valero was founded in 1980 and its headquarters are in San Antonio, Texas. The company has over 10,000 employees and has a market capitalization of $41.81 billion. Its principal competitors are Marathon Petroleum, Phillips 66, ConocoPhillips and Occidental Petroleum.
The company operates 15 petroleum facilities in the United States, Canada and the United Kingdom.
Recently, the U.S. Environmental Protection Agency (EPA) announced a settlement with Valero Refining-California to resolve violations of the Clean Air Act’s Chemical Accident Prevention regulations at their Benicia Refinery.
The company will pay a $1.2 million penalty and make changes to improve process safety at the refinery. Although this is only a mere fraction of its revenue, it could make some shareholders shaky.
Valero previously relied on Russia for nearly 13% of its crude oil imports, behind Mexico and Iraq, which provide the highest percentage of the company’s imported oil. It is making up any supply with Latin American imports as well.
But as mentioned earlier, the lack of exports and limited demand within the U.S. is going to hit refiners like Valero hard and push down margins.
We believe Valero’s recent downward trend in its stock price will continue.
***Action to take: “Buy to open” the VLO January 19, 2024 $110 put option up to $12.25 per contract.
- The symbol is VLO240119P00110000
- Search for options under the stock’s ticker: VLO
- Make sure you choose the right option (expiring on Jan. 19, 2024)
- Choose the $110 strike price
- Select “PUT” option
- Select how many contracts to buy
- Once you have the right contract, click “buy to open”
- Choose “limit order.” This sets the price for the trade
- Use a limit of $12.25
- Click “buy” to transmit the order.
If you place a limit order near $12.25, your order should be filled.
Opportunity #2
Devon Energy Corp (NYSE: DVN) is an energy company engaged in hydrocarbon exploration in the United States. It was founded in 1971 and is organized in Delaware. Its corporate headquarters is in Oklahoma City, Oklahoma.
The company is ranked 520th on the Fortune 500 and its chief products are petroleum, natural gas, and natural gas liquids. Its market cap is $34 billion.
This is not our first recommendation to buy puts on DVN. We made the same recommendation back in January 2023 with very good results for readers. We’re not shy about repeating recommendations when the entry point looks right, and the market setup favors the trade.
The risks mentioned above are playing out across the energy patch, and we believe the recent run-up in pricing is a good entry point to short some overvalued names like Devon.
The rise in supply and drop in demand has resulted in a multi-year high storage backdrop for propane and will impact pricing over the next several months.
Asia is facing an increase in Russian and Chinese exports that will put pressure on crack spreads and result in economic run cuts in Asia.
This will reduce crude demand in the region so even if Chinese demand increases, it will be offset by a reduction in demand for the rest of the area. This is an opportunity to buy puts on a company that is experiencing rising costs and a capped hydrocarbon price that will pinch margins.
We’re not saying that Devon is going bankrupt or that they are a terrible company. Instead, we’re saying they’re overvalued. A large part of the E&P sector is experiencing something similar, but we believe the end markets for Devon are in must worse shape given their structure and liquids/natural gas-rich portfolio.
The market continues to “ignore” recessionary fears and now with demand on a downward trend, it’s again time to capitalize before it’s too late.
***Action to take: “Buy to open” the DVN January 19, 2024 $47 put option up to $5.15 per contract.
- The symbol is DVN240119P00047000
- Search for options under the stock’s ticker: DVN
- Make sure you choose the right option (expiring on Jan. 19, 2024)
- Choose the $47 strike price
- Select “PUT” option
- Select how many contracts to buy
- Once you have the right contract, click “buy to open”
- Choose “limit order.” This sets the price for the trade
- Use a limit of $5.15
- Click “buy” to transmit the order.
If you place a limit order near $5.15, your order should be filled.
Note on risk: Options plays can be volatile, and all involve plenty of risk. And although these ideas are well-researched, nothing is guaranteed. Don’t bet the mortgage money here. And remember, it’s up to you to decide how much you’d like to put into each play. Please be sure to diversify your risk, and don’t put all of your money into one play.
I am expecting great returns from these two plays over the next several months.
Best of luck with these trades!
Good Hunting,
Freedom Financial News
