Harvey Hurts Crude Rebalancing, Also Creates 'Opportunity'

 

Two weeks ago the Brent crude futures curve was backwardated, with the front-month contract commanding a premium over the following four months.

 

But by the close on Wednesday, the global benchmark oil was once again mainly in contango, with the front-month at $50.86 a barrel, a discount of 27 cents a barrel to the six-month future.

 

The very front of the curve was still in mild backwardation, with the second-month contract 13 cents cheaper than the front-month, and the third-month a mere 7 cents.

 

On Aug. 15 the front-month Brent future was at a premium of 17 cents to the second-month and 18 cents to the third.

 

Backwardation is usually seen as a sign that the market is re-balancing and that prices are likely to head higher in future months.

 

Backwardation, when the front-month contract is more expensive than subsequent months, makes it uneconomical to store crude, resulting in the drawdown of inventories.

 

It also makes it harder for marginal producers, such as many U.S. shale drillers, to effectively hedge future output, which may result in lower spending on exploration and developing new wells.

 

The move to a backwardated curve in mid-August was generally viewed by market participants as proof that crude oil was re-balancing, and that the efforts of the Organization of the Petroleum Exporting Countries (OPEC) and its allies to restrict their output were finally paying off.

 

But Hurricane Harvey has nipped this hope in the bud, at least for now.

 

With some 4.4 million barrels per day (bpd) of refining offline, representing about 24 percent of U.S. capacity, the storm represents a major demand shock to crude oil markets.

 

But also of importance is the idling of both offshore and onshore oil production in the region, with more than 320,000 bpd of offshore output remaining idled as of Wednesday.

 

Onshore production from shale formations such as the Eagle Ford, which S&P Global Platts said was producing about 1.34 million bpd of oil prior to the storm, is in the process of being restarted.

 

But even if output does return to pre-Harvey levels, it's unlikely that it will be able to move out of the Gulf Coast region for at least a few more days, as ports along the Texas coast remain shut and some pipeline operations are disrupted.

 

This dislocation of both U.S. crude imports and exports is likely to have an impact across global oil and product markets.

 

The immediate impact has been to drive U.S. gasoline prices sharply higher, prompting cargoes to move from regions as far away as Asia to the United States.

 

In crude markets, the impact from Harvey could linger for some months, and alter trade flows as market participants seek to take advantage of arbitrage opportunities.

 

Right now U.S. shale crude won't be leaving the U.S. Gulf Coast, meaning buyers will have to seek short-term alternatives, such as buying light grades from West Africa or Southeast Asia.

 

But once Gulf Coast terminals are able to resume exports, demand for this grade of crude could rise dramatically, given the widening discount of West Texas Intermediate (WTI) futures to Brent.