The Dynamics Have Shifted In Energy Markets As Inventory Levels And Geopolitical Environment Pressures Margins

Last week, the oil market and its byproducts experienced a sell-off across the board due to several factors, ranging from geopolitical to fundamental industry data. Traditionally, after a significant run-up of 8.2%, a pullback wouldn't be surprising. However, last week's move of -7.44%, especially in trade flow activity, is somewhat concerning for oil bulls. This decline has placed WTI within striking distance of the 200-week moving average, a key historical technical level that must hold to avoid a potential further drop in prices. Later, we will discuss the technical landscape in more detail. Due to the price action, shifting dynamics in the industry, and significant geopolitical shifts, it is appropriate to reassess the oil market.

Inventory Situation

As you might be aware, commercial oil inventories in the U.S. have been increasing steadily since the brief seasonal demand spike that subsided at the end of September. Subtle signs of demand destruction in certain segments of the industrial industry began to emerge in macroeconomic data towards the end of September, and domestic production continued to rise to a record level of 13.3 million barrels per day (mbpd), leading to what is now referred to as an short-term "inventory glut." It's important to note that the production levels of 2023 were the result of a resurgence in shale oil production, with new techniques emerging to improve extraction yields by targeting multiple layers and extending the production life of existing wells. Large integrated energy companies reaffirmed their investment in shale operations through several mergers and acquisitions last year, targeting smaller producers with exposure to the Permian Basin.

To start the year, inventory levels have declined, but with the recent Arctic Blast that affected much of the United States, the market cannot confirm if this trend is weather-related or indicative of the industry beginning to contain production levels. Seasonally, inventory levels tend to stabilize as refiners prepare for the summer driving season by topping off their gasoline and diesel reserves. In the short term, inventory builds are bearish for crude prices, but the healthy spread between the March/April and even May RBOB futures prices that existed through November of last year could turn profitable for some refiners in the coming weeks.

Next, let's discuss the Strategic Oil Reserve (SPR). For the casual observer, refilling the SPR is another fundamental reason for price support, as the U.S. still has approximately 300 million barrels to replenish to reach pre-distribution levels. However, the refilling process is more complicated and strategic than it appears. Before the major drawdown, the SPR predominantly stored light sweet crude, a blend abundant in the U.S. The Department of Energy has begun refilling the reserves with sour crude, a less prevalent but important blend for heavy byproducts like diesel and heating oil. This strategic shift is key for long-term sustainability in the event of a geopolitical or weather-related crisis. The pace of refilling the SPR has been slow for some, limited to roughly 3 million barrels a month due to logistical constraints and maintenance work at reserve sites. The demand for sour crude and the lack of U.S. production for sour crude is another bottleneck, making the SPR a consideration but not a main price driver in the coming months.

Now, onto the global landscape. China has been a positive catalyst that bulls have waited for the last 6 months, but its lackluster reopening efforts have disappointed many. Contrary to mainstream narrative, China IS growing, albeit not as fast as the market had hoped. Perhaps expectations were too high, as many have forgotten that the U.S. reopening efforts post-COVID were not spectacular either. China has announced several stimulus packages to spur consumer consumption and address issues within its real estate market. However, enthusiasm for these announcements was short-lived as the real estate market grabbed headlines again following a Hong Kong court ruling that Evergrande, China's second-largest real estate developer by volume, must liquidate assets after failing to reach an agreement with overseas bondholders. This situation has already pressured the Chinese economy and could burst the anticipated residential and commercial real estate bubble. With this looming over China's future, oil markets have priced in lackluster demand despite China increasing its oil import quota for the year.

Pressure to the downside this week came not only from China but also from the volatile nature of the API and EIA inventory reports. Two weeks ago, the United States experienced its first major cold snap of the season, impacting energy operations across the country. The Bakken region saw a reduction of 650,000 barrels of production per day due to infrastructure issues in North Dakota, along with Gulf operations facing challenges.

Geopolitical Landscape

The market has been attentive over the past month with the escalation in the Red Sea, impacting shipping lanes and increasing shipping costs. However, the impact on oil transportation has been minimal. Although prices seemed not to account for "geopolitical" risk at first glance, a glimpse into market sentiment was observed on Thursday after Al Jazeera reported a ceasefire deal between Israel & Hamas. This was later corrected to indicate ongoing talks, resulting in a $2 drop in crude prices. This is something to monitor in the coming weeks. If ceasefire talks break down, we could see a small rebound pricing the escalation premium back into contracts. However, from a long-term perspective, it is a bearish development for crude and could continue to fuel speculative selling.

Another geopolitical event under the radar but worth monitoring is Poland's Operational Command of the Polish Armed Forces warning of potential increases in military aviation activity within its airspace due to the Russia/Ukraine conflict, with necessary restrictions set from February 5th to March 5th. Military drones and artillery have been observed crossing over Polish airspace, indicating this may be a precautionary measure or a signal of escalating tensions along the border. The curveball in this situation is recent reports that Russia is ready to discuss selling gas directly to the EU again as the Ukraine transit deal expires at the end of this year, which does not signal a broader expansion of the conflict, but at this point, anything is possible.

U.S. Dollar Strengthening

Since the beginning of the year, the dollar has gradually strengthened, traditionally exerting pressure on almost all physical commodities. However, price action over the last two sessions signals a clear breakout to the upside following the FOMC meeting, regional bank issues beginning to possibly reemerge, and ISM prices for both manufacturing and services coming in hotter-than-expected, reigniting the "flight to quality" trade. Today, the Dollar Index broke above the key 104 level, so volatility should be expected.

Technical Setup

The year started with crude receiving a strong bid to the upside, although open interest at the beginning of the move was contracting, indicating short-positioned traders were offsetting their positions. The weekly charts highlight some key areas to focus on in the near term. The 200-week simple moving average has historically been a reliable area of support in the oil market, and a breach of this key support level could indicate continued selling pressure. A key resistance level is the 200-day SMA, which crude rejected on January 29th. Despite recent downside pressure, volume declined on Friday, suggesting sellers may be losing steam in the near term. Range-bound trading is common, so watch for support at the $71 level and resistance at $78. Until these levels break, expect volatile, range-bound action in the near term.

This article is from an unpaid external contributor. It does not represent Benzinga's reporting and has not been edited for content or accuracy.