Tensions With Iran Should Scare The Bears

Tensions With Iran Should Scare The Bears

Physical Market A Bit Weaker, But Plenty Of Geopolitical Support
 Tensions with Iran, combined with a more positive situation in Europe, are at the
fore of the oil market this week. European buyers continue to move towards a
boycott of Iranian crude, likely timed for once peak winter refinery demand has passed.
Last week’s storming of the British Embassy in Tehran has ratcheted tensions higher,
and increased the probability of the EU embargoing Iranian crude, possibly as soon as
their next Foreign Ministers’ meeting in January. But news of a possible downgrade of
numerous Eurozone countries provides further macroeconomic headwinds.
 Iran produces roughly 3.5-m b/d of crude, more than the total amount of spare
crude production capacity in the world. So it is hardly a surprise that the ratcheting
up of tensions is being accompanied by a ratcheting up of prices and a rebound in
Brent spreads. Latest developments include the downing of a US drone over the
weekend (reports are conflicting as to the cause), another explosion in Isfahan (site of
an Iranian uranium enrichment plant) last week, and the killing of an Iranian nuclear
scientist.
 European demand data for October in Spain and Italy is giving the first indication
that the economic slowdown is hitting product demand in Europe. Diesel
differentials collapsed weeks ago, and gasoil spreads continue to lose ground (and
underperform vs. Brent spreads). The available high-frequency weekly data has shown
inventories building for a few weeks now, but they remain low and winter has only really
just started so expect distillates to carry the refining margin for a while to come. That
said, we understand that US heating oil demand has gotten off to a very weak start to
the season with rack sales of heating oil in the US Northeast down about 20% y-o-y in
November, partly due to a significant numbers of households converting their heating
systems to natural gas. This was happening anyway because of the big price
differential and intense marketing campaigns by the natural gas utilities, but got an
extra kick with flooding in the area ruining oil boilers, making replacement necessary.
Bolstering support for middle distillates is the non-OECD demand data which remains
constructive, with India, Brazil and China all posting healthy demand growth for
October.
 Gasoline has been the bearish counterpoint to gasoil strength, but it got a lift last
week when Sunoco announced they were bringing forward the closure of their 175-k
b/d East Coast Marcus Hook refinery on the US East Coast. We think now is the time
to look at selling heating oil and buying gasoline for the summer. The outlook for
gasoline is challenging, but summer values for the spread are already extremely
cheap, the spread bottomed right in the mid-November seasonal window for bottoming,
and the closure of two (Trainer and Marcus Hook) and most likely a third (Philadelphia)
make Summer RBOB look too cheap vs. the rest of the complex.
 Crude inventories remain very low in Europe, global product demand remains
healthy, and the risks to supply are getting more rather than less acute. Bears
should be scared.

Tensions with Iran are coming to the fore of the oil market. European buyers
continue to move towards a boycott of Iranian crude, likely timed for once peak
winter refinery demand has passed. Last week’s storming of the British Embassy in
Tehran has ratcheted tensions higher, and increased the probability of the EU
embargoing Iranian crude by their next Foreign Minister’s meeting in January.
Latest developments include the downing of a US drone over the weekend (reports
are conflicting as to the cause), another explosion in Isfahan (site of an Iranian
uranium enrichment plant) last week, and the killing of an Iranian nuclear scientist.
Iran produces roughly 3.5-m b/d of crude, more than the total amount of spare
crude production capacity in the world, so it is hardly a surprise that the ratcheting
up of tensions is being accompanied by a ratcheting up of prices and a rebound in
Brent crude spreads (Figure 1). OECD European countries accounted for around
30% of Iranian crude in 2010, according to IEA and JODI data, with the breakdown
in Figure 6, putting European imports from Iran at around 550-600-k b/d, and
Western Europe as 400-450-k b/d of this.
Even if worries about the potential for conflict with Iran are considered overdone,
the region remains in flux. Syria is now a regional battlefield, with the Iranianbacked
Assad regime being sanctioned by the Arab league largely as a result of a
push by Saudi Arabia and other Sunni Arab states. EU sanctions on the Syrian oil
sector scored another victory this week with Shell exiting the country, the first oil
major to leave, and production in Syria has already reportedly slumped from 400-k
b/d to about 250-k b/d. Another major concern for the oil market over the next few
months is whether these regional tensions extend into Iraq, where US troops are
scheduled to leave by year-end. The point is that the threats to supply are many,
and the redundancy in the global oil supply system is low.
These threats to supplies come at a time of low inventories (Figure 2) and healthy
demand. The oil market is a good barometer of global economic activity, and the
demand data for some of the OECD European countries is reflecting their weak
economies (Figure 3) — confirming what the physical market was already telling us,
but the non-OECD demand data continues to come in impressively strong overall
(Figure 4 and 5). Indian demand was up 3.8% y-o-y in October, with diesel sales up
a robust 7.9%.

The rise in open interest during last week’s rally, along with the increase in noncommercial
net length indicates that the market is getting more bullish on these
threats to supplies. Similarly the rise in open interest in deep out-of-the-money calls
reflects investors looking to either profit from an oil price spike or to protect the rest
of their portfolio if things do take a turn for the worse.
Meanwhile, Iran has proposed a face-saving agreement for next week’s December
14 OPEC meeting, calling for a 30-m b/d production target for 1H’12. Maintaining a
30-m b/d production target (which is around current levels) for the first half of 2012
implies that Saudi production would need to cut output as Libyan production
increases, while remaining politically easier to justify by deeming current production
levels as appropriate for global needs. Whatever the final agreement – if any –
Saudi Arabia and the GCC members are likely to continue to supply the market
whatever is needed. Indeed, continuing at a 30-m b/d OPEC production level, IEA’s
forecasts for global balances next year would still see inventory draws – 0.8-m b/d
in 4Q’11 and 0.34-m b/d in 1Q’12 – before building 0.41-m b/d in 2Q’12, which
would help replenish low inventories.
The Physical Market Has Lost Some Steam
Refining margins remain poor in Europe (figure 10), and this is keeping bearish pressure
on crude oil differentials and timespreads. North Sea differentials have given back most
of last week’s gains and West African differentials have not followed through after
bouncing. Urals though remains impressively firm, buoyed by the potential loss of
Iranian barrels as it is a fairly close medium sour substitute. Bulls can also point to Dubai
spreads which remain in impressively strong backwardation.
Yesterday’s announcement by Saudi Aramco that it was raising the premiums for
Asian buyers of Arab Super and Extra Light in January by an unexpected $1.95 and
$1.75/bbl, respectively, should push more buyers into the spot markets and bolster
Dubai, and ultimately Brent spreads as refiners may come to the Atlantic Basin for
cheaper light crudes. The higher premiums may even help out the light end of the
product market, by cutting into refining margins for the lighter crudes.
Libyan production continues to surprise to the upside, with some market expectations
now reaching as high as 1-m b/d by year-end. The oil service companies on the ground
report little damage to their facilities or equipment, bolstering the optimistic view. The
Baker Hughes rig count as of October shows no resumption in drilling operations —
there were 15 rigs reported as operational in February, before the rebellion took off — so
the immediate focus is on restoring production from existing wells, but rigs are expected
to start drilling soon, so more oil will follow.

The weakness in crude comes from the weakness in products, via refinery margins.
Margins have deteriorated as ULSD premiums have stayed weak, and naphtha and
gasoline have effectively collapsed over the last few weeks. Gasoil cracks are
carrying the refinery margin and we expect that to continue for the next few months.
Light ends are struggling from weak OECD gasoline demand (seasonal and as a
result of economic weakness), an increase in OPEC NGL supplies, and weak Asian
petrochemical margins that are leaving naphtha unsold to weigh on the market —
combined sales of naphtha in China and Japan were down 13% y-o-y in October.
Gasoil inventories have started to build in Europe (and last week the US reported a
big 5.5-m bbl build), but the weakness in light ends is keeping gasoil firm in order to
incentivize refiners to run. More broadly, global observed middle distillate stocks, as
measured in high-frequency inventories data, have risen the past two weeks after a
low of 250-m bbls but remain low (Figure 7). Meanwhile, global observed light
distillate stocks have been building the past two weeks and are now above 2010
levels for the first time since March, reflecting weakness in light ends (Figure 8).

Summer Gasoline Looks Cheap
In the short term light ends are expected to stay under pressure, but looking down
the curve gasoline looks too cheap to us. The chart below is the June spread for
RBOB (gasoline pre-2006) minus heating oil, in cents/gal. Clearly for 2012 a lot of
bad news for gasoline is already in the price. Deferred gasoline to heating oil
spreads often blow out because there is a natural buyer for distillates — truckers
and airlines that want to hedge their diesel or jet fuel exposure and use heating oil
as a more liquid hedge — while there is no similar natural buyer for gasoline.
Drivers do not hedge their gasoline exposure. We think that another reason that this
spread has blown out so far was that too many traders entered the trade too early,
before the usual mid-November bottoming for the trade, and their painful exit took
the spread wider.

Even though light ends look challenged on a global basis, summer specification
NYMEX RBOB remains a tricky product to make, and we will have lost two or
perhaps three refineries that are well accustomed to producing it. Supply logistics
will adjust but we think it will take both time and spiking prices to induce the arb
barrels. The fact that June 2012 RBOB – Heating oil seems to have bottomed right
in its typical mid-November timeframe (using the 10-year average of the spread)
bolsters our conviction, as does the resilient way in which RBOB took some big
bearish builds in the weekly EIA statistics.