Crude oil is the world’s most liquid and closely watched commodities. The energy that continues to power the world is a barometer for the health and wellbeing of the global economy. Economic growth leads to increased demand and a higher price, while contraction can weigh on requirements and prices. Therefore, macro-economic factors contribute to the path of least resistance for the price of crude oil.
Analyzing the crude oil market to come up with clues about the price direction is like putting together a jigsaw puzzle. Macro issues impact all markets, but each has distinctive characteristics that can cause price strength or weakness. In the world of crude oil, three factors can, at times, signal the direction of price. A quality and location spread, the forward curve, and refining data can be enormously helpful when it comes to making assumptions about the path of the price of the energy commodity. The United States Oil Fund (USO) and the United States Brent Oil Fund (BNO) reflect the price action in the two benchmark crude oil futures markets.
Brent versus WTI
Brent and WTI crude oil are the pricing benchmarks in the petroleum market. The price differential between the two is both a location and a quality spread. When it comes to Brent, crude oil from Europe, African, and the Middle East use the price of Brent futures that trade on the Intercontinental Exchange. Around two-thirds of the world’s producers and consumers of petroleum use Brent as their pricing mechanism. West Texas Intermediate or WTI crude oil comes from North America, which is the locational factor for the spread. When it comes to quality, WTI is a lighter and sweeter crude oil, meaning it has a lower sulfur content than Brent. WTI is less expensive to process into gasoline, while Brent is preferable for processing into distillate products.
The Brent-WTI spread also serves as a barometer of risk for the Middle East, which is the world’s most turbulent region. The Brent-WTI spread tends to rise when tensions rise in the Middle East as it is home to over 50% of the world’s crude oil reserves. A rise in the Brent premium over WTI is often a bullish sign for the price of crude oil.
The market’s term structure
Term structure is the shape of the forward curve in a futures market. The term structure in crude oil can provide clues about the fundamental supply and demand balance. When nearby prices are lower than deferred prices, commodity traders refer to the market as in contango. Contango is a sign of oversupply or equilibrium and tends to occur during periods of price weakness.
When nearby prices are higher than deferred prices, a market is in backwardation. Backwardation is a sign over of deficit or rising supply concerns. Backwardation tends to occur when the price spikes.
(Source: CQG)
As the daily chart of the price of December 2019 minus December 2020, NYMEX crude oil futures shows the spike from a backwardation of $3.06 per barrel on September 13 to $7.73 per barrel on September 16 occurred after a drone attack on Saudi oil fields stoked supply concerns. Shifts in crude oil’s term structure can tell us about the market’s sentiment when it comes to the supply and demand equation for the energy commodity, which often leads to changes in price direction.
Processing spreads
Processing spreads measure the cost of refining a barrel of crude oil into oil products such as gasoline and distillates. The differential between the price of raw crude oil and an oil product is a crack spread because the process occurs in a catalytic cracker.
Most consumers do not purchase or use raw crude oil; they require oil products each day. Drivers are direct consumers of gasoline. Distillates include heating oil, and jet and diesel fuels. Heating our homes, flying on planes, or buying products that come to market via trucks, ships, or other modes of distillate-powered transportation make us indirect consumers of the oil product.
When crack spreads rise, it can be a sign of increased demand for products. At the same time, since crude oil is the primary ingredient in the products, rising crack spreads often translate into a growing demand for crude oil impacting the price of the energy commodity.
When trying to figure out the path of least resistance of crude oil, quality and location spreads, term structure, and processing spreads are an excellent place to start the analysis.
The United States Oil Fund LP (USO) was trading at $11.94 per share on Monday afternoon, up $0.25 (+2.14%). Year-to-date, USO has declined -0.58%, versus a 15.62% rise in the benchmark S&P 500 index during the same period.
USO currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #1 of 109 ETFs in the Commodity ETFs category.
About the Author: Andrew Hecht
Andrew Hecht is a sought-after commodity and futures trader, an options expert and analyst. He is a top ranked author on Seeking Alpha in various categories. Andy spent nearly 35 years on Wall Street, including two decades on the trading desk of Phillip Brothers, which became Salomon Brothers and ultimately part of Citigroup. Over the past decades, he has researched, structured and executed some of the largest trades ever made, involving massive quantities of precious metals and bulk commodities. Aside from contributing to a variety of sites, Andy is the Editor-in-Chief at Option Hotline.