September 19, 2019 / 2:29 PM / 25 days ago

COLUMN-Oil traders reassess interruption of Saudi output: Kemp

(John Kemp is a Reuters market analyst. The views expressed are his own)

* Chartbook: tmsnrt.rs/31uXMgF

By John Kemp

LONDON, Sept 19 (Reuters) - Brent oil futures prices have gyrated wildly as traders have tried to assess the impact of last week's attacks on Saudi Arabia's oil infrastructure on the actual availability of crude.

Brent's six-month calendar spread surged to a backwardation of more than $5.50 per barrel on the first trading day after the attacks, the highest for six years, showing oil traders were anticipating severe shortages in the very short term.

Since then the six-month spread has fallen to trade around $4 per barrel, though it is still significantly higher than the $2.70 reported before the attacks.

The gap between short- and long-dated futures prices is believed by many traders to be a more useful indicator of the global production-consumption balance than the spot price (tmsnrt.rs/31uXMgF).

Backwardation, when spot prices trade at a premium to prices for later delivery, is associated with under-production, a tight market and low and falling oil inventories.

Contango, the opposite market condition when spot prices trade at a discount, is associated with over-production, a slack market and high and rising stockpiles.

Even in the weeks before the attacks, Brent's backwardation had been ratcheting up as traders anticipated stocks would fall with continued output restraint from Saudi Arabia and the world economy dodging a recession.

But the attacks supercharged the backwardation after Saudi Arabia's national oil company announced it had been forced to suspend production of 5.7 million barrels per day.

More recently, the backwardation has eased as Saudi Arabia said output will return to normal by the end of the month, earlier than originally expected.

In the meantime, Saudi Arabia has been supplying customers from its own inventories, which amounted to 180 million barrels at the end of July, to cover the shortfall in output.

The United States and the International Energy Agency have also promised to make additional oil available from their emergency reserves if necessary, all of which has helped calm fears about shortages.

REASSURANCE

Strategic stocks are not normally considered accessible to the market but by pledging to make them available if needed, governments have eased concerns about adequate supply in the short term.

OECD countries hold 4.5 billion barrels in industry stocks to meet their operational requirements (3.0 billion) and government-owned stocks to cope with emergencies (1.5 billion).

Non-OECD countries also hold significant commercial stocks for operational purposes and China holds a major strategic reserve, though its exact size is unknown.

In addition to these "primary stocks", more oil is in tankers going from producing to consuming countries and there are also refined products held by distributors ("secondary stocks") and end-users ("tertiary stocks").

Altogether, global crude and products stocks in various stages of the supply chain probably total between 6 billion and 8 billion barrels.

Even if the attacks cut Saudi production by an average of 3 million barrels per day for three months, or 270 million barrels in total, there are plenty of stocks to cope with the shortfall.

PRICES AND STOCKS

The market can respond to a short-term interruption of supply by drawing down inventories, pushing prices temporarily higher to restrain consumption, or some combination of both.

Ordinarily, the principal response would come via higher prices, especially in the near term, which is why futures prices tend to move into backwardation when supply is disrupted.

Policymakers in producing and consuming countries usually allow prices to rise to restrain consumption and limit the drawdown in inventories, relying on price signals to rebalance the market.

In this case, the military nature of the supply disruption, the expectation it will be short-lived, and concern about the impact on a global economy that is already slowing, have encouraged a different approach.

Policymakers have offered stock to the market "if necessary" in the hope of blunting price rises — employing the same strategy they used after the interruption of Libya's supplies in 2011 and the U.S. attack on Iraq in 1991.

Emergency stocks are maintained precisely to deal with this form of short-term disruption and avoid a spike in prices that could have a major adverse impact on the economy.

The aim is to ensure the United States and other OECD countries cannot be coerced by any threat to disrupt or withhold oil supplies to drive prices higher, as happened during the Arab oil embargo in 1973/74.

So far, the offer of stock, in combination with reassurance from Saudi Arabia about a rapid resumption of production, has been enough to calm the market, without any emergency inventories actually being released.

NOT TOO TIGHT

In the immediate aftermath of the attacks, Brent's backwardation surged to a level only rarely seen in the last 30 years. The last time it became so severe was back in 2013, 2011, 2000 and 1996, and then only for a few days each time.

Brent's calendar spread soared into the 98th percentile for all trading days since 1990, as traders expected the market to become exceptionally tight.

More recently, the spread has eased back down to the 95th percentile, which points to a market that is expected to be tight but not extremely so.

The spread is set to remain volatile as traders assess the speed with which Saudi Arabia is able to return production to normal and what price might trigger the United States and other governments to release emergency reserves.

Saudi Arabia's energy minister has outlined an ambitious timetable for the early normalisation of output by the end of the month.

Some outside observers are more sceptical given the extent of the damage to oil installations and the challenge of sourcing replacement parts.

So new information about the normalisation of production levels and stock draws will drive spread trading over the next few weeks and is likely to create considerable volatility.

Related columns:

- Saudi Arabia draws down oil stocks to maintain supply after attack (Reuters, Sept. 18, 2019)

- U.S. SPR oil release would be a mistake (Reuters, July 19, 2018)

- Should we worry as oil stocks hit 3 billion barrels? (Reuters, Nov. 20, 2015)

- Despite fiscal cliff, U.S. should not sell SPR (Reuters, Oct. 4, 2012) (Editing by David Clarke)

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