Is This Rebound in Oil Prices Sustainable?

• Crude oil rises to a new short-term high
• Gasoline lags sending the crack spread lower
• Heating oil weakness as the distillate processing spread declines

The price relationship between crude oil and oil products in the futures market tells us two important things about the energy sector and the companies involved in processing oil into gasoline and distillates. Petroleum is the primary ingredient in the products. The crack spread or financial measure that defines the cost differential between oil and gasoline and oil and heating oil is a barometer of the demand for the products. Demand for products translates to demand for the raw oil. Heating oil is a proxy for other distillates such as diesel and jet fuels.

When it comes to refining companies, the crack spreads are a real-time indicator of profitability. Refineries do not take risks when it comes to purchasing crude oil or selling products. They buy the input and sell the output at the market price. When the crack spreads rise, processing crude oil becomes more profitable, and profit margins decline when they fall. When the cracks fall below a refineries breakeven level, they lose money.

The crude oil market’s wild volatility has caused significant price variance in product prices and crack spreads over the past weeks. The United States Oil Fund (USO) and the United States Gasoline Fund (UGA) follow the price of NYMEX crude oil and gasoline futures higher lower on a short-term basis.

Crude oil rises to a new short-term high

On April 20, the expiring May NYMEX crude oil futures contract traded at a negative price for the first time. The next day, June futures fell to a low of $6.50 per barrel. At the end of last week, the price of the expiring June contract was just below $30 per barrel, a significant reversal of fortune under one month.

(Source: CQG)

As the daily chart of the expiring June futures contract on NYMEX shows, the price traded to a high of $29.92 on May 15. The rise in the price of the energy commodity came on the back of a new one million barrel per day reduction in output from Saudi Arabia starting on June 1. Other Middle Eastern producers are following the Saudis. Signs of Chinese demand were emerging, and traders tightened up risk management after the debacle on April 20 that sent crude oil into negative territory.

Moreover, the oil rig count in the US, according to Baker Hughes, was at 258 as of May 15, which was 544 lower than last year. The Energy Information Administration reported that daily output stood at 11.6 million barrels per day, as of the week ending on May 8. The daily production steadily dropped from a high of 13.1 million in mid-March. The EIA reported its first decline in oil inventories since January last week.

The fundamentals for oil improved, and the price was back knocking on the door at $30 per barrel at the end of last week. However, crack spreads, or the margin for processing oil into gasoline and distillate have declined over the period. The action in the crack spreads could be a sign that the energy commodity may run out of steam on the upside.

Gasoline lags sending the crack spread lower

The price of gasoline outperformed crude oil from mid-March until May 11, but the price action in the gasoline crack spread could be a warning sign for petroleum prices.

(Source: CQG)

The chart of the now active month July gasoline processing spread illustrates that the processing margin declined from a high of $15.46 on May 11 to below $12 last week. The crack had recovered from negative $2.96 in late March. 

Heating oil weakness as the distillate processing spread declines

The distillate crack spread has been falling since late April.

(Source: CQG)

The July heating oil crack declined from $16.82 per barrel to below $10 in May and was at below $11 per barrel on May 15.

The weakness in processing spreads could be telling is that crude oil is reaching an unsustainable level at the $30 per barrel level. Demand has been the factor that has weighed on the price of the energy commodity over the past months. Keep an eye on the processing spreads as they often are real-time barometers for crude oil demand, which is the input in refining gasoline and distillate fuels.

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The United States Oil Fund LP (USO) was trading at $24.64 per share on Monday morning, up $2.25 (+10.05%). Year-to-date, USO has gained 105.16%, versus a 11.00% rise in the benchmark S&P 500 index during the same period.

USO currently has an ETF Daily News SMART Grade of F (Strong Sell), and is ranked #65 of 112 ETFs in the Commodity ETFs category.