What To Make Of This Oil Sell-Off?
Oil prices are getting badgered. Many of the things we wrote in our "Oil Continues to Climb the Wall of Worry" are coming to fruition, here's what we said:
Signals
Refining Margins
The future is uncertain, but we can be well prepared for what's ahead. The fall in refining margin is a good sign for us. Unlike 2022 when refining margins kept marching higher despite bad demand figures, the fall this year will help dampen some of the recent rise in crude.
For example, in late August when the 3-2-1 crack spread hit $40/bbl, crude ($80) + the crack was around $120/bbl. Today? It's around $121/bbl. So despite the crude rally, the end-user is still seeing the same price. This is why the next leg of the rally should see refining margins fall, while crude continues to rally.
This is one of the points we think the market is also missing. If demand is the biggest concern, refining margins should be the ones getting hit especially if the Saudis are targeting crude supplies.
So to validate our signal, we should see refining margins fall, while crude timespreads further tighten. In a perfect world, you would love to see both rally at the same time, but because the demand concerns are valid, we prefer the first scenario instead.
And as refining margins fall, the crude rally will have to climb another wall of worry. Traders are going to think, "Is demand bad?" But the reality is that demand is just okay, while crude supplies are tight.
Inventory Draws
As we approach the end of Q3 and into Q4, inventory draws should accelerate. In the near term, refinery maintenance will dampen some of those hefty draws the market expects, but once that's done (end of October), we should see ~2+ million b/d draws.
This will further validate that the voluntary cut is working and crude should move higher.
Price Itself
Finally, the best indicator is just the price itself. Crude has managed to break above all of its key resistance levels so far. As it approaches the next set of resistance levels ($93.2 to $94.2), you will see the wall of worries return. Will this rally be sustainable? Is this the peak? And all the while, we fully expect energy stocks to lag the move higher in oil. Recession is on the horizon, or as the market believes, so why would they buy energy stocks despite free cash flow yields of over 20%?
Again, the price itself has to be the one that ultimately convinces investors. As oil prices remain elevated and as energy companies demonstrate more free cash flows at these elevated levels, that's when the enthusiasm returns. We think a good timeline to expect a sudden increase in trading multiples is ~6 months (i.e. elevated oil for 6 months starts to push trading multiples higher).
At times like these, it's important to revisit some of the signals we laid out. Following WTI's rise to that resistance range of $93.2 to $94.2, prices have quickly retraced to the support range of $84.2 to $86.5. All the while, refining margins have fallen, while crude timespreads have increased. So is this it? Or was this pullback somewhat expected?