THE FUNDAMENTAL ANGLE METHOD

Transcription

1 P a g e 1 THE FUNDAMENTAL ANGLE METHOD To increase your EDGE trading Energy and Commodity futures, take a cue from the fundamental analysis and research methods that have been used in the Equity markets for years to determine the valuation of a listed company. Taking this approach will allow you to not only weed out Headline Noise, but also identify high probability opportunities. Energy and Commodity futures represent prevailing market prices for an expansive set of business activities that include supply, demand and logistics similar to stock prices. Focusing on only one driver will hang you out to dry almost every time. Research and analysis has successfully been used to identify gaps in market valuations and profit from them. With over 20 years managing portfolios for large, integrated energy companies I have intuitively been applying fundamental analysis and research to every commodity I trade. In this report, I share with you the process I use to evaluate the economic and competitive drivers in Energy and Commodity markets. The following approach will kick-start your ability to identify and even get ahead of developing trends. With a little up-front effort you will develop a process for information seeking and gathering that will pay off. Here is the Method I use to create my edge: 1. Identify the Economic Drivers of Price and Industry parameters of the product you are trading (be thorough, don t rely only on easily obtainable headline news like inventory reports) a. Define the Scope of the market b. Define the Industry contract parameters of the product you are trading c. Identify key regional price relationships d. Identify key global price relationships 2. Identify the Competitive Aspects of the Industry a. Define relationships to, or dependencies on, other prices or business activities b. Define the key producers and consumers of the product and the storage system that that links them. 3. Define items that can singularly change price levels and those that influence price levels cumulatively over time. 4. Track and evaluate prices and relationships daily. 5. Constantly seek to expand or revise items on your list! Example Application: WTI Crude Oil Futures Cushing, OK 1. Define the Economic Drivers of Price a. Scope of the Market With minimal research you will discover that the Crude Oil complex has over 500 distinct global crude pricing hubs representing crude oil from all parts of the globe. However, this large and varied group of crude grades relies heavily on just a handful of markers, or benchmarks, within them. The Benchmarks: Brent Blend Roughly 2/3rds of all crude contracts around the world reference Brent Blend, making it the most widely used marker of all. Currently, Brent actually refers to oil from four different fields in the North Sea: Brent, Forties, Oseberg and Ekofisk (BFOE). Norway s Troll crude will be included in the blend starting Jan Crude from this region is light and sweet, making them ideal for the refining of diesel fuel, gasoline and other high-demand products. Because the supply is water-borne, it s easy to transport to distant locations and is used

2 P a g e 2 in pricing sales for Europe, the Mediterranean, Africa, Russia and Australia. (Dated Brent is a benchmark assessment of the price of physical, light North Sea crude oil. The term "Dated Brent" refers to physical cargoes of crude oil in the North Sea that have been assigned specific delivery dates.) Dubai/Oman This Middle Eastern crude is a useful reference for oil of a slightly lower grade than WTI or Brent. A basket product consisting of crude from Dubai, Oman or Abu Dhabi is somewhat heavier and has a higher sulfur content, putting it in the sour category. Dubai/Oman is the main reference for sales into Asian market. West Texas Intermediate (WTI) WTI refers to oil extracted from wells in the U.S. and sent via pipeline to Cushing, OK. The fact that supplies have been relatively land-locked has been one of the drawbacks to West Texas crude it s relatively expensive to ship to certain parts of the globe. WTI historically has been the benchmark for sales into North and South America. While the use of Brent and Dubai benchmarks far exceed that of WTI in global crude oil contracts, they are all priced in USD. Now that you have defined the major Crude Oil benchmarks, create a table to capture daily published settlement Prices available from all exchanges: *(source: You are immediately oriented to the relationship among benchmarks as well as the individual term structures of each curve. Tracking prices daily will allow you to identify changes in these relationships. As noted above WTI and Brent are defined as a Light Sweet crude oil grades. Dubai has a lower API density and higher sulfur content than WTI or Brent and we can see how that difference is being priced. The value of dealing with price tables versus charts is that you become intimately familiar with price levels and enhance memory in the process. The level of the contango or backwardation in the market is an indication of the value of storage. Contango and Backwardation can exist at any price level meaning that it is about the relationship of prices rather than price itself. Storage barrels are attracted to markets that are in steep contangos. The spreads between the benchmarks are an indication of where crude oil will logistically move. Said another way, the term structure of the market plays a role in

3 P a g e 3 the determination of inventory levels in the physical markets as a strong contango supports the accumulation of inventories and the selling of them forward. The flattening of the term structure then will eventually cause accumulated inventory to be released. For example, the WTI contango in 2015 was at its strongest in at least five years as a percentage of the flat price of crude oil, making a storage play in the US attractive. The duration of a strong contango has kept inventory levels high by continuing to provide an attractive rate of return on producing and storing barrels. Spreads between benchmarks can also define the global movements of crude oil. The front WTI-Dubai swap spread indicates how competitive WTI-based crudes are in Asia or how likely Dubai-based crudes are to head into the US West Coast which then impacts Alaskan North Slope crude prices. Additionally, the WTI/Brent spread impacts the incentive for movements into and out of the US Gulf coast. As Brent s premium began to wane over the past few years, WTIbased crudes started to lose their economic advantage against Brent-based crudes, and thus waterborne imports became more attractive for US refiners. b. Define the Industry contract parameters of the product you are trading Crude oil is differentiated by Grade and by Location. Grades are referred to as follows: High Low API Density "Light" "Heavy" Sulfur Content "Sour" "Sweet" US Gulf Coast refiners have in recent years been importing increasing volumes of heavy crude oil as this type of crude oil is not part of the US shale production boom equation and, depending on refinery margins, may at times be more economical to run in complex refineries like those in the US Gulf Coast WTI crude oil is classified as a Light Sweet grade of oil. Specifications as defined by the CME Nymex Rulebook are ( The WTI contract is defined as Seller s Choice. This means that the seller designates whether the delivered crude stream shall be domestic or a specific foreign crude oil stream as well designate a qualified incoming pipeline or storage facility. In addition, in the event that a Federal U.S. Superfund tax and/or Oil Spill tax is in effect at the time of delivery for foreign crude oil, the buyer shall reimburse the seller for all such taxes that have been or will be paid by the seller.

4 P a g e 4 c. Identify key regional price relationships Now that we have defined the 3 major benchmarks used for global crude oil pricing, it s time to drill down into the Regional (or local) influences within each benchmark. The WTI market is characterized by a large number of independent producers who sell their crude oil to gatherers based on posted prices for their specific grade and location. The oil is then brought into Market areas and directed either towards the Gulf Coast refining areas, towards Cushing, Oklahoma for storage or to other regional refining and processing areas. Key regional Benchmarks in the US and Canada are: *Source:

5 P a g e 5 As with the global oil benchmarks, you will want to create a table to capture several of the regional benchmark prices: Now you have an understanding of how the various regional benchmarks are priced relative to one another.

6 P a g e 6 Global benchmark spreads impact regional spreads and vice versa. For example, weakening of front-month WTI against Brent tends to lift regional cash crude differentials, particularly for light, sweet grades, which compete with Brent-based imports. It s also important to look at Spot prices and relationships since they are often times the first indicator of changing relationships and trends. The table below gives you an idea of the spot market volume in various regional grades of oil: The eia.gov website posts daily crude oil cash prices for the benchmarks WTI, Brent and LLS. In addition, refiners and gatherers across the country post their daily crude oil bulletins indicating the prices they are willing to pay for various crude grades in the US.

7 P a g e 7 Tracking posted cash prices not only gives you an indication of how spot market supply/demand factors are playing out, but also creates a reference database for average monthly cash prices. *Source: and In addition, this allows you to see the consistency of spreads between the various grades in the cash markets and identify any deviations that might carry forward in to the futures market

8 P a g e 8 With the data compiled so far, there are already a lot of good comparisons to make. An example of this can be seen in Bakken prices. The futures strip prices for Bakken crude are for oil derived from the Bakken shale formation that are injected into the Enbridge pipeline at Clearbrook, MN via lateral gathering lines, yet the spot posting price from refiners and gatherers is related to the well-head location. The difference highlights the cost of transportation out of the region to the pipeline. Something to keep in mind watching the news regarding the Dakota Access Pipeline play out. d. Identify the key global price relationships By now, you are starting to see which relationships are more volatile and which relationships have greater impact on WTI futures prices. Producers and Refiners are always looking for the highest price for their product and will move them to the market with the most value whenever possible. Examples of these relationships include: WTI/Brent Relationship Historically (prior to 2010) these two crudes of similar (light sweet) quality enjoyed a close pricing relationship governed by the U.S. need to import light sweet crude to meet domestic demand with Brent trading at a slight discount to WTI mostly reflecting freight costs. Huge increases in domestic light crude production from shale have changed the relationship since 2010 including a WTI discount to Brent averaging $18/Bbl during 2012 as new production was stranded at Cushing. Spreads at that level provided the financial incentive to construct a lot of new pipeline capacity from Cushing to the Gulf Coast. LLS/Brent Relationship The Gulf Coast is home to roughly 50% of US refining capacity and a traditional hub for light sweet crude oil imports. The two key benchmark prices for light sweet crude in the Gulf are Brent and LLS. The ability to move shale production out of Cushing and into the Gulf has a direct impact on prices of both Brent and LLS. The LLS/WTI and LLS/Brent spreads indicate movements of imports and exports in the region. A wide LLS/WTI spread relative to LLS/Brent will favor moving bbls from Cushing to the Gulf for refining or export. A wide LLS/Brent spread relative to LLS/WTI will favor importing Brent bbls for refining.

9 P a g e 9 2. Identify the Competitive Aspects of the Industry a. Define relationships to, or dependencies on, other prices or business activities Since crude oil is generally not directly consumed in its raw form by anyone other than refiners, the value of crude oil comes from the value of the products into which it can be refined. The margin for refining crude oil into gasoline and heating oil is expressed as the Crack Spread in the market. Hence the prices of these products tend to be highly correlated to movements in crude oil. For one side of the complex (crude oil) to move significantly without the other (products) generally requires a shift in the margin expectations the market is willing to give to refiners and is highly impacted by supply/demand factors of the products themselves.

10 These spreads are very valuable to track as they contain a lot of information regarding logistics, seasonality and supply/demand balances. P a g e 10 *Source: The HOGO spread referenced above refers to the difference between New York Harbor Heating Oil prices and Rotterdam Gasoil prices. Because Heating Oil is priced in $/gallon and Gasoil is priced in $/Metric tons the spread is calculated using a 3:4 contract ratio in order to achieve volume parity. This spread helps determine which market refiners will choose to deliver their finished product to. Another interesting piece of the puzzle is to review Refinery Netback reports to see the spreads being realized by refiners relative to the Crack spreads in the futures market: As is the case of most commodities, understanding the paper market, logistics and shipping is key to many successful strategies, which evolve around the arbitrage of locational prices. Refiners around the world are always in search of the highest margin for their products. If they can obtain a better margin by exporting, local prices either have to rise to keep the products in the country or the relative prices at the export location will eventually come down as supply

11 P a g e 11 floods into that market. Understanding these relationships will give you an advantage in your positioning and will even open up the world of spread trading within the Petroleum complex. You begin to understand that the market is much more than weekly inventory reports. Headline oversupply news should be evaluated against the many spread relationships (locational and term structure), spot market prices (including refinery posting prices) and refining margins to asses any impact beyond market sentiment. Locational arbs are key to determining the flow of oil and its products around the world. b. Define the key producers and consumers of the product and the storage system that that links them. Production:

12 P a g e 12 Consumption: According to the EIA, the United States consumes more energy from petroleum than from any other energy source. In 2015, total U.S. petroleum consumption was about 19 million barrels per day (b/d), the equivalent of about 36% of all the energy consumed in the United State. This consumption breaks down as follows: Total world consumption of petroleum in 2014 was about 93 million b/d. The five largest petroleum-consuming countries in 2014, and their share of total world petroleum consumption are: United States (21%), China (12%), Japan (5%), India (4%) and Russia (4%) Driven by the US shale revolution and restructure in world refining industries, global oil trade is shifting towards the East. Asia-Pacific has become the world biggest oil consumer and refinery center, and also the largest target market of crude oil. In addition, the Asia-Pacific holds the world s largest refining capacity. Seasonality: Seasonality influences crude oil prices under normal supply and demand conditions. But compared to geopolitical tensions, supply levels, or prevailing economic conditions, the seasonality factor could have a minor effect. The over-riding seasonal supply/demand influences on crude oil prices tend to focus on summer driving season and refinery turnaround seasons. Turnarounds are scheduled events at a refinery in which the plant closes down for an extended time for operations and inspections. This generally has an impact on both the crack spreads and the term structure of the futures curve. In markets where crack spreads are high, turnarounds tend to be deferred as long as possible. This has been the case the past year or so as refining margins were the savior for many integrated oil companies. Turnaround season has typically resulted in a reduction in demand for, and large builds of, crude oil as refining capacity is reduced. However, with the new Export abilities in the US, it remains to be seen how these barrels could move to refiners in other countries that are not on the same turnaround schedule as the US if spreads are economic.

13 P a g e 13 There are many estimates out there that forecast the Planned Spend for turnarounds in 2017 will be up 50% from last year levels. Turnaround seasons are often times associated with the narrowing of contango between the month(s) preceding the season and the month(s) in the season. Storage: US Inventory levels have been a topic of much discussion and headline news. To avoid getting caught in an inventorylevel hype trade, it s important to put some context around the issue. The petroleum complex is an operational system that consists of production, refining and consumption whose life-cycle is much shorter than that of traditional goods manufacturing. Once the 'consumption' takes place the process starts over so there needs to be immediate replacement of supply in the refining system. THIS is the differentiator. What we experienced in 2014/2015 was a rapid increase of inventory levels in the overall system above and beyond the norm. This resulted in a fear that production would overwhelm the system beyond it's capacity and the market sold off accordingly In reality, while we have seen inventory levels sustain at higher levels since then, there have been measures taken that have kept us from exceeding capacity including production cuts and additions to overall storage capacity (especially in the Gulf Coast). Looking at the weekly EIA Inventory report, it becomes more important to focus on the percent Utilization of the system capacity:

14 P a g e Define items that can singularly change price levels and those that influence price levels cumulatively over time. Transportation: The Petroleum complex relies heavily on transportation by rail, pipeline and ship to move crude oil and products to the markets with the highest value. Changes in transportation rates or disruptions in transportation capacity can have immediate impacts on short-term prices. Some examples of this are: Colonial Pipeline is the largest US refined products pipeline system that carries more than 3 million bbls of gasoline, diesel and jet fuel between the US Gulf coast and the New York Harbor area. Disruptions on this pipeline have historically led to large and swift price movements Cushing take-away capacity - expansions that increase the ability to move shale production in the north through Cushing and on down to the Gulf Coast (watch the WTI/LLS spread on this one) New pipelines or pipeline expansions o Keystone XL pipeline, once built could transport 830,000 bbls/day of crude oil from Alberta, Canada into Cushing, OK that was previously being moved by more expensive rail transport. This Canadian oil is primarily a heavy, sour grade that Gulf Coast Refineries use and therefore will compete with or displace Mexican and other crudes coming into the Gulf (watch Argus ASCI sour index on this one) o Dakota Access Pipeline, one built could transport 470,000 bbls/day of crude oil from the Bakken shale region to the oil tank farm in Pakota, IL. Currently around 70% of Bakken crude is moved by rail car which is more expensive. Spreads between prices in the US Gulf coast and those on either the East or West Coast Currency Rates: Since the global crude oil complex is priced in US dollars significant strengthening or weakening of the US Dollar relative to other currencies can impact outright crude prices. The strength of the Euro relative to the USD in 2008 had this type of effect on crude oil prices. Examples of other items: Renewables legislation (i.e. RIN s and Ethanol blending) Adoption of electric vehicles NGL prices (represents other income sources from bbls produced) Commodity Index benchmark adjustments (i.e. GSCI Commodity Funds)

15 P a g e 15 Items will be continuously added and removed to this list. The key is to identify them and include them in your daily analysis (i.e. RIN and Ethanol futures) 4. Track and evaluate prices and relationships daily or weekly. Now that you have identified the global and regional price benchmarks as well as the relationship to various product prices, you will be able to focus in on the key prices you should track daily or weekly to help you identify trends. I follow a rigorous process of updating my price tables daily for key benchmarks and weekly for certain regional benchmarks. If I find that certain prices aren t relevant any more, I drop them off my list. Having managed energy portfolios for a variety of large, integrated energy companies I can tell you that the most important information is the relationship of prices. I rarely spent time staring at individual price charts for any other reason than a historical look at where prices have been. The good news is that most information is readily available without an expensive market data subscription. At a minimum, exchanges are required to publically post settlement prices for all of their listed and cleared products. 5. Constantly seek to expand or revise items on your list! As you move up the learning curve with the knowledge base you are building, you will quickly be able to identify new price drives into your model. This Overview using WTI crude oil as an example is intended to help you get started in your analysis of the commodity you are trading. There is tremendous opportunity for you by creating your own information edge!