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Crude Reality - Views from the North

FICC Podcasts 23 juin 2022
FICC Podcasts 23 juin 2022

 

Disponible en anglais seulement

This week, Paul Knobl, BMO’s head of energy trading, joins me to discuss his views on energy markets, and to help make some sense of the wild volatility seen in recent days. I also discuss the latest Canadian CPI report, Bank of Canada, and broader rates backdrop.

As always, all feedback welcome.


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About Views from the North

BMO’s Canadian Rates Strategist, Ben Reitzes hosts roundtable discussions offering perspectives from strategy, sales and trading on the Canadian rates market and the macroeconomy. 

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Disponible en anglais seulement

Ben Reitzes:

Welcome to Views from the North, a Canadian rates and macro podcast. This week, I'm joined by Paul Knobl, BMO's head of energy trading. This episode is titled Crude Reality. I'm Ben Reitzes and welcome to Views from the North. Each episode, I will be joined by members of BMO's thick sales and trading desk to bring you perspectives on the Canadian rates market and the macro economy. We strive to keep the show as interactive as possible by responding directly to questions submitted by our listeners and clients. We value your feedback. So please don't hesitate to reach out with any topics you'd like to hear about. I can be found on Bloomberg or via email at benjamin.reitzes@bmo.com. That's benjamin.R-E-I-T-Z-E-S@bmo.com. Your input is valued and greatly appreciated.

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries.

Ben Reitzes:

Paul, welcome the show. First time on. I'm very excited to have you here. Energy is a huge topic and you can fill a lot of gaps on that front, not just for me, but for all of my listeners as well.

Paul Knobl:

Thanks for having me, Ben.

Ben Reitzes:

You know what? Let's go right into energy and I'll talk about the right stuff a little bit afterwards. Maybe I'll do a halftime show on CPI and the Bank of Canada, just because it is still related to energy. Paul and oil markets have been insanely volatile over the past few weeks, I guess really longer than that, but I don't know if everyone pays as much attention to them as you do, probably not. Rates markets have been crazy volatile as well. And I think that's, I mean, not unrelated by any means. Oil's gone from 120 bucks a week ago to 105 bucks right now it was almost at a hundred bucks this morning, all over the place. Let's start with the, I guess the latest news. What's the latest driver here, why is it down so much?

Paul Knobl:

So right now the energy markets are, like you said are very, very interesting. The general theme of the markets is very, very bullish. The markets are tight. However, currently we're seeing builds and inventories not significant builds, but enough builds in the last month or so due to the Chinese lockdowns, due to releases from the strategic petroleum reserve. And that is driving a little bit of, I don't want to say weakness, but softening in physical markets. And so as you see this very, very frothy market, took off after the war, after tanks started to roll. Now things are adjusting, governments have intervened and you're starting to see that impact in the physical markets.

Ben Reitzes:

Okay, well you're saying so citing specifically China and the SPR release in the US. Both of those are time limited though. I mean, China, I mean probably debatable there because COVID is probably not going anywhere. So more lockdowns are, feel like a certainty at some point, but let's just say China reopens at some point in the next few months, maybe weeks, fully. And the SPR release is only, I'm assuming a few months, it's a million barrels a day for-

Paul Knobl:

Through October.

Ben Reitzes:

Okay. So until October, so until the fall. What happens in the fall? I mean, it's not like Russia is just going to turn the taps back on or we're not going to let Russia back into the world economy and back into the global oil market. Does that mean this pull back in prices is just a temporary reprieve?

Paul Knobl:

Yeah. I mean, I think that this is an adjustment period and as you stated, the markets are very volatile. The markets are very illiquid. And so the way that I'm seeing it is that what governments have done and what the Chinese lockdowns have done is it's taken the edge off this market. You've heard calls for 150, $200 oil. Well, if you look at refined products, heating oil $180 a barrel currently, gasoline $150 a barrel currently, very, very expensive. And I don't necessarily think that you're seeing real hits to demand. As we spoke about earlier, we're seeing airlines cancel flights and not due to low demand, but due to staff shortages. And so that's taking demand out of the jet fuel market. In addition to that, you're seeing, you don't have as many truckers around, you don't have as many trucks on the road. And so that's taking diesel demand down as well. So generally speaking, you're seeing these demand weakness that are maybe not actual consumer financial conditions tightening, but more pandemic hangover type demand losses that will normalize over time as the economy normalizes.

Ben Reitzes:

Okay. So sounds to me like my bullish thesis, which has clearly been wrong for, I don't know, 10 days, should remain intact. My expectation that 150 would come before a hundred, I guess that might be wrong still, but we still probably have higher prices at some point ahead unless we get a deep recession I feel like, is that fair?

Paul Knobl:

Yeah, I think that's very fair. If you look at past recessions, it's roughly about a million barrels per day in the United States of demand losses. With the financial crisis being somewhere closer to three million barrels a day. So, depending on your view on how steep of a recession we're in for, that can give you a good gauge of the type of demand losses that we'd expect to see given the varying degrees of severity of the recession. But I think it's really important that the markets, to understand that markets have structurally changed. When you look at US shale, for example, there's been a lot of negative sentiment towards the industry and capital has responded. Investors expect capital return. They expect capital to not be chasing significant decline rates and be significantly levered.

Paul Knobl:

And I think that's changing the way that the producer community is behaving. And so you only have to look to all of the different MD&As to see what management teams are talking about. And they're not talking about chasing decline rates and out control growth, they're talking about 5% compound annual growth rates, they're talking about returning cash to shareholders, and they're talking about running a responsible company.

Paul Knobl:

And I think if you also look at the hedge profiles of some of these big producers, you're going to find nothing, they have really throttled back on hedging. And I think that is also a game changer in terms of companies sticking to their strategy. And so when you think about supply being more responsive to price, I think it might be more responsive to price to the downside, because there is cost inflation in production, there are labor shortages. And so if you do see a price decline, I think you see production responses as opposed to the top side where I think producers want to maintain a steeply backwardated forward curve. They want to create an incentive to just be responsible and to keep the oil price high.

Ben Reitzes:

Can you quickly just explain for listeners out there, what a backwardated curve is? Because I'm not sure that everybody knows exactly what that means, just simple.

Paul Knobl:

Simple, sure. Backwardation is when the prompt futures prices are higher than the forward prices. So for example, if you're using $110 as your prompt futures price, prompt being the current month, which is August right now, December might be $100, so you'd have a $10 worth of backwardation. And so the steeper that curve looks the more urgent the supply issue is in the front. And so when you look at the, if you look at the curve from the war to now, I mean, it was extremely steep, when tanks rolled and we flattened a lot and that has to do with SPR releases and as I stated, lockdowns in China taking demand out of the market.

Ben Reitzes:

All right. So the more I guess, downward sloping the curve is from the front month further out, the greater urgency there is for barrels to come to market immediately. So it really incentivizes supply. I guess the lack of supply response is part of why I've been, and continue to be bullish on this. And I think that was clearly what you're trying to tell us here is that there just isn't the same supply response to higher prices that there used to be.

Ben Reitzes:

And that doesn't look likely to change either given the longer term outlook for oil and ESG and just the electrification of the world and that whole thesis suggests that oil is going to be a more challenging product to take out of the ground. Generally more expensive for various reasons. Curious about products, gasoline, diesel, jet fuel, all that stuff. I read as recently as today that some refineries I think in the US were taken offline permanently in the pandemic. Is that true? And I guess that explains to some extent why gasoline prices, why diesel prices, why other product prices have remained elevated despite oil prices coming down the way they have.

Paul Knobl:

Well, I think one of the interesting things is when the war broke out in the Ukraine, US refiners were in maintenance and so we were running at about 88% utilization at that point in time. And so there wasn't enough refinery capacity at that time to really make up for any supply losses. And so when you had Europe panicking for product, those product markets were crazy. And you had diesel well over $200 a barrel during that time period. Since then, as we've gone through May and through June, we've seen refinery utilization go from 88% to about 93.5%. And so we're starting to see some builds in product inventory and we're starting to see products prices come down a little bit. That's the mechanism of balancing, during refinery maintenance, typically you would see crude stocks build and then you would see product stocks draw. And as refineries come back, you would see product stocks start to build and you'd see crude stocks start to draw. Now what's not happening is the crude stocks aren't drawing and as mentioned, a lot of that has to do with the SPR.

Ben Reitzes:

That makes good sense. You talked earlier about liquidity in the energy market and new trade energy markets. Liquidity has been a big theme in Canada, lack of liquidity, I guess, probably better term. And in the US, we've also seen US rates markets, we've seen liquidity deteriorate as well. How is positioning in your market, is liquidity an issue there? And could that have been a driver behind the decline in prices? Or I know a lot of people out there are very bullish oil, including me, is positioning skewed that way as well?

Paul Knobl:

Yeah, I think that there, I mean, I think positioning is definitely skewed long, but I think that the net length is not nearly as high as people might think. And open interest is also quite low, relatively speaking. And I would say that on days like today or days like Friday, when you saw a $9 decline in price, that it is the machine. It is very challenging to interact with the market. Bit offer spreads on options are astronomical and getting any meaningful size down in the market can be a real challenge right now. And it's broad based across markets. I'd say the products markets are even worse than crude proper and natural gas is also experienced phenomenal volatility over the last few months as inventories are relatively tight, weather is very supportive and the war in the Ukraine is putting significant upward pressure on European natural gas.

Ben Reitzes:

It's definitely hot outside today. So I'm sure my air conditioning is cranked as high as it can go. Me and everybody else in the city. Manni gas is clearly important in all of this. Why don't we broaden this at least a little bit, because this'll impact oil and gas. Hurricane seasons coming. It is June 22nd. Hurricane season starts in two months, give or take a little less, six weeks. So we're already tight on production. Refineries are running at full steam ahead pretty much, I think that's full steam, 90 whatever percent, I mean, they can get higher in theory, but not on any consistent basis and even running in the low nineties, I think is hard to do on a long term basis. What happens if there's a storm in the Gulf Coast?

Paul Knobl:

So yeah, I mean focusing on oil and products, I'd say that the market is in a very vulnerable spot with low spare capacity. We haven't talked about OPEX spare capacity, but on paper it's about two million barrels a day. So right now there's not a lot of wiggle room. If you do have-

Ben Reitzes:

What is it in reality? If it's two million on paper.

Paul Knobl:

I think it's up for debate, but I think that consensus would probably be between one and one and a half million barrels a day. So half of call it, half of what it is on paper, is maybe what the market expects it to be. And hurricanes can have a very different impact for different commodities. And I'll give you a few examples. And so if a hurricane like hurricane Harvey that hit a few years back, that came over Houston and just sat there and wasn't necessarily a storm surge or wind event, it just dumped rain on Houston and that region for days.

Paul Knobl:

And what the impact there was is refineries actually, they had generators that went down, they were flooded, they couldn't operate and it took weeks and months to get them back up operational. If you saw a market like that would be very challenging for the consumer because products prices would be, would skyrocket. Inventories are tight and that would be very, very bullish for the products market. And I mean, I wouldn't say it's necessarily bearish for the crude market, but crude inventories would build because you're not processing as much crude oil into refined products.

Ben Reitzes:

But that would be a big negative for the economy because you get product prices. I mean, oil's nice and all, but I'm not using much oil in my day to day life. Gas on the other hand, lots well, not always, but lots generally. And so that would clearly be an inflationary and a net negative macro event, I'd have to guess.

Paul Knobl:

Yeah, exactly. I think that to your point, natural gas and diesel are ingrained in most of our manufacturing processes. Gasoline, obviously a critical component to people getting around. So yeah, that would be a tough one to swallow.

Ben Reitzes:

I hope we don't have to, but I'm not in the business of predicting hurricanes, but unfortunately-

Paul Knobl:

On the other hand, if you had hurricanes that would knockout production in the Gulf of Mexico, either natural gas or oil, that would be a bullish crude oil event or a bullish natural gas event.

Ben Reitzes:

And still drive products higher as well. So either way-

Paul Knobl:

Yeah. Either way there's a lot. And depending on which side of the pond you're focused on here, to the point on flooding, if you had issues in the Houston ship channel or you had issues at LNG export facilities, that would be bearish for US natural gas. And it would be very, very bullish for European natural gas.

Ben Reitzes:

Which is what we've seen. We've seen that a couple times.

Paul Knobl:

So I guess the winter could be a very, very scary place for natural gas and for heating oil. For at least the consumers that are consuming those products.

Ben Reitzes:

Winter is coming. I'm going to take a minute and talk about rates here because you just opened the door for inflation and then I'll come, come right back to you. We had Canadian CPI this morning came out at 7.7% year over year. The details were generally strong, big gain in clothing prices, furniture prices exploded higher again for the second time in just a few months, recreation prices were materially higher. Gasoline was up to 12%, we already knew that would happen. Food prices were actually one area that were kind of calm. I guess it wasn't as bad as we thought it would be, but it would, I mean, still trending pretty strong there. And the risks still seem on the upside generally for inflation. I think maybe a little bit of good news in oil prices coming down.

Ben Reitzes:

Hopefully that means lower gas price is very near term and that maybe helps June a little bit. But if what Paul is saying, here are the risks still remain squarely on the upside for energy, which means squarely on the upside for overall CPI as well. And I think the hope is that by the fall we start to see some pullback in inflation. And I guess that Paul was saying that, you know what, if we get a hurricane then it might not be that way. So I have something very much to keep on your radar. I think going forward and from a policy Central Bank perspective and from a rates perspective, the Bank of Canada is going to be worried about this. I mean, if you had any doubts, whether they'd go 75 or not in July, well, those should be gone now, between the Fed going 75 and this crazy hot inflation number, I think it's pretty much done at this point.

Ben Reitzes:

And just even if inflation wasn't hot, think about it this way, if the bank were to go 50 only when closer to 75 is priced, what would happen to the Canadian dollar? And I mean, it would get probably trashed. And in that scenario, that means more inflation pressure. So that's something they can't really afford at this point in time. So 75 looks pretty much down. I guess the question is but where do they go from there? More hikes for sure, how high I think we'll have to wait and see. And at this point, the market seems to be pretty satisfied with pricing I'd say, I mean, after the CPI print, we weakened a little bit on a relative basis. We got all the way up to fully pricing 75 basis points exactly for July at one point, that's backed off a little bit in the meantime.

Ben Reitzes:

And it just looks as though the market's satisfied with where pricing is for the near term. And we need to actually see some of these rate hikes. We actually need to get them before we can continue to price in even more into the front end there, the end point for rates right now is about 375 before it starts to flatten out in Canada. So still a long way to go from here. We'll see if the bank can actually achieve that as we are in for some choppy economic times, I think, especially as we get into the latter part of the year. But all of this depends on energy I think is probably the biggest factor for me, both upside and downside. If oil can back off, that means lower inflation, which means fewer rate hikes, maybe lower rates, maybe slightly lower terminal rate.

Ben Reitzes:

It also puts more money back in consumer's pockets. So I mean, that would be a big help for the outlook, I think, and really dampen recession risk. On the flip side, oil prices go higher again, more inflation, more rate hikes, less money in people's pockets, nothing good there. And that would only increase recession rates. So that's why energy is so important. That's why we have Paul here today to really explain things to us. Paul, something that I've seen in the news lately on oil in particular, and you spoke about the war in Ukraine, a number of times.

Ben Reitzes:

Initially, I guess, Russia, more or less or increasingly cut off as time has gone by here, but it seems like it's slowly trickling the other way now. I read today, India's now looking to import more cheap Russian oil. I think part of that's probably just to battle inflation, cheap oil certainly helps on that front and China, incrementally more and more Russian oil going into that country. Is that helping loosen the global oil market a little bit? Is there more to come there? How much Russian oil is really shut in at the moment?

Paul Knobl:

Great question. Currently, there's about call it 1.2 million barrels a day of Russian oil shut in. And I'd say that, that expectations when things initially took off, I think were probably for more like two to three million barrels a day of production losses due to sanctions. I think that you're very right, China and India are buying Russian oil at discounted prices. And I think that that's expected to continue. I think what'll be interesting is as we go through the fall and towards that end of your deadline with the European embargo, what does that look like? What does the net Russian production profile look like? Is it off two million barrels a day? Is it off 3 million barrels a day? And I think right now, I'd say over the last month, for example, I think consensus moved from 2.8 million barrels a day to two million barrels a day of Russian production offline at year end.

Paul Knobl:

And so even that number is moving a lot and 800,000 barrels a day is a lot of oil and it's meaningful to balances and it's meaningful to how we view price in solving the overall problem. And so I think that, that number will continue to be volatile. And there are logistical constraints that shipping, insurance, those types of matters that are really going to impact how much oil Asia can buy from Russia. But ultimately I think that the relationship between those countries is going to be, is when they want to maintain. And so I do think that you'll see continued buying and probably increased buying of Russian oil by China.

Ben Reitzes:

China can do what they want. I've said that for a long time, if they want more Russian oil, they'll find a way to do it, build more takers, build more trucks, build another highway, all that stuff. Believe it or not folks, Paul trades energy. And there are all sorts of trade ideas that he has and he puts out there. I am not familiar with the energy trade myself outside of going to the gas pump and giving them my credit card. That's a one way trade. They take my money, I smile. But Paul has good ideas here. So I'm going to ask him to share a few of those with us today. And Paul, what do you have for us?

Paul Knobl:

Yeah, so I think we talked a lot about liquidity and we talked and how volatile this market is. And so what kind of trades you decide to put on are really dependent on how much pain you can take on days like Friday and days like today, because the market is ruthless and it will move on thin volume. And so I'd say right now, a lot of market participants have focused on the options market. Generally they like the defined risk profile of the trade. It gives them upside participation to the market without betting the farm. And so to that extent, I'd say that like the most popular trades of, I mean, they're not all that glamorous, but the market's chosen really to their own call spreads because as I mentioned earlier, hedging has been limited from producers and producers are generally vol sellers as a rule.

Paul Knobl:

And so without them in the market, implied vols have actually been a lot higher. Not only because realized have been higher, but because the flows have been more option buyers and option sellers, which is very, very different than I'd say the last decade where you see a lot of selling of vol. And so, one of the biggest trades that's been put on over the last couple of weeks has been the June 23, 150 $200 call spread, and it's traded from high to low $2,20 down to $1,70. So to give you some context in terms of the risk, when you see an almost $20 sell off in the front, that's the risk profile you'd experience on something like that. And so you could see that you can deploy a lot more capital into a trade like that than you could just being long futures and just due to the nature of the product.

Paul Knobl:

So, yeah, I mean, the other thing that's pretty interesting, depending on your long term view of oil, as you wade through the noise here and get into the structural changes in demand and supply in the long run, the back end of the curve is a lot lower than the front, given the backwardation. And so, as you see volatility there are opportunities to buy futures in the back end and they move a lot less than the front end of the market does for obvious reasons, as the supply and demand pictures changing pretty quickly in the front and a lot less quickly in the back. So those would be some of the things that I would think about as I was putting a position together right now.

Ben Reitzes:

All right, cool. That interesting. I'm not sure that I'm familiar enough with oil options to really comment on that. But I think it's interesting that you're looking at it from a bullish perspective. I think that just reinforces that view that we share, I guess, that oil prices are, the risks are skewed to the upside. We'll see how things pan out for the rest of the year. I hope that we're wrong because that's the better outcome for the global economy, but we'll have to wait and see. Thanks for coming on the show, very much appreciate it. And I do very much hope to have you on again, because energy will continue to be topical, I think, through the rest of this year.

Paul Knobl:

Thanks for having me.

Ben Reitzes:

Thanks for listening to Views from the North, a Canadian rates and macro podcast. I hope you'll join me again for another episode.

Speaker 2:

This podcast has been prepared with the assistance of employees of the Bank of Montreal. BMO Nesbit Burns Incorporated and BMO Capital Markets Corporation. Together, BMO who are involved in fixed income and foreign exchange sales and marketing efforts. Accordingly, it should be considered to be a product of the fixed income and foreign exchange businesses generally, and not a research report that reflects the views of disinterested research analysts. Notwithstanding foregoing, this podcast should not be construed as an offer or the solicitation of an offer to sell or to buy or subscribe for any particular product or services, including without limitation, any commodities, securities, or other financial instruments. We are not soliciting any specific action based on this podcast. It is for the general information of our clients. It does not constitute a recommendation or a suggestion that any investment or strategy referenced herein may be suitable for you.

Speaker 2:

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Speaker 2:

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Benjamin Reitzes Directeur général, spécialiste en stratégie – taux canadiens et macroéconomie

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