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Why Oil Recovery Appears On the Edge? ETFs in Focus
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After nosediving in April, oil prices bounced back in May, surging more than 88%.West Texas Intermediate (WTI) crude oil futures went negative for a while in mid-April for the first time in history, as the coronavirus pandemic led to a massive decline in demand and surging output caused scarcity of storage (read: 4 Energy ETF Areas Better Positioned Amid Negative Oil).
However, reopening of global economies and expectations of increased activities finally led to a fast rebound in prices. No wonder, energy ETFs like SPDR S&P Oil & Gas Equipment & Services ETF (XES - Free Report) and VanEck Vectors Oil Services ETF (OIH - Free Report) gained in the range of 60% to 66% past month (as of Jun 8, 2020).
But is everything rosy in the energy space? Probably not. Goldman Sachs believes that an oil price correction as deep as 20% "may already be underway.” Let’s tell you why.
Refiners Are Suffering Massively & Likely to Buy Less Oil
Data from global refineries shows weak margins, or crack spreads. Since crude is refiners’ input, the oil price rally has acted as a dampener for the space. “Very poor refining margins and the recent sharp decline in US crude bases now comfort us in our sequentially bearish outlook,” analysts at Goldman Sachs wrote.
OPEC and its allies, known as OPEC+, announced that historic production cuts of 9.6 million barrels per day across the group would run through July may make matters worse for refiners. Higher crude cost along with no increase in prices of the products from refineries is leaving refiners in a tough spot.
The crack spread for refined products in the United States was $9 last week compared to $21 at the same time last year, per Reuters . Margins for European diesel reached a record low of $2.90 per barrel last week, quoted on CNBC.
Moreover, Saudi Arabia has announced some of the biggest price increases for crude exports in at least two decades, removing almost all of the discounts it provided during its short-lived price war with Russia. Saudi selling prices will jump next month by $5 to $7 per barrel just for Asian buyers, which in turn would hurt “refining margins,” per analysts.
Both factors may lead refiners to buy lower crude volumes, resulting in lower crude prices in the coming days. Goldman Sachs expects Brent pulling back to $35 per barrel in the coming weeks compared to spot prices at $43.
Opportunistic Buying is a Risk to Recovery
Many oil-importing nations reserved oil strategically amid low prices. China recorded a massive rebound in crude imports in May with a record 11.3 million barrels per day, reflecting an increase of 13% from April. Many analysts are of the view that the buying has been done opportunistically, not to meet real demand.
Moreover, renewed U.S.-China tension over the latter’s imposition of new security legislation on Hong Kong and its apparent mishandling of the coronavirus incident may derail the oil market recovery. Although China purchased record volumes of crude oil in May, analysts do not expect the United States to be the key provider. China has fallen meaningfully short of “overly ambitious” energy import targets.
Shale Oil Production May Ramp Up Again
Crude’s recent rise may inspire the shale producers to boost drilling activities. In fact, the sharp gains in the price have already prompted EOG Resources (EOG) and Parsley Energy (PE) to plan a potential revival of production. U.S. crude inventories jumped 8.4 million barrels in the week through Jun 5, API data showed, while a Reuters poll of analysts had indicated a draw of 1.7 million barrels. This will weigh on the outlook for prices.
Economic Activity Yet to Pick Up Materially
Per Goldman, there is a surplus oil inventory of an estimated 1 billion barrels as global economic activity and travel have been far below the pre-coronavirus level. Some analysts believe inventory build would not reverse until the middle of 2021 that too in a steady demand and prolonged OPEC+ output cut scenario.
Bottom Line
At the end, it’s all about material demand growth. Oil has rallied a lot past month on hopes of a rebound in demand. But further rally from here seems dicey. VanEck Vectors Oil Refiners ETF (CRAK - Free Report) – the pureplay refining ETF – has gained about 16.6% past month, a lot less than the oil services and explorers’ gains.
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Why Oil Recovery Appears On the Edge? ETFs in Focus
After nosediving in April, oil prices bounced back in May, surging more than 88%.West Texas Intermediate (WTI) crude oil futures went negative for a while in mid-April for the first time in history, as the coronavirus pandemic led to a massive decline in demand and surging output caused scarcity of storage (read: 4 Energy ETF Areas Better Positioned Amid Negative Oil).
However, reopening of global economies and expectations of increased activities finally led to a fast rebound in prices. No wonder, energy ETFs like SPDR S&P Oil & Gas Equipment & Services ETF (XES - Free Report) and VanEck Vectors Oil Services ETF (OIH - Free Report) gained in the range of 60% to 66% past month (as of Jun 8, 2020).
But is everything rosy in the energy space? Probably not. Goldman Sachs believes that an oil price correction as deep as 20% "may already be underway.” Let’s tell you why.
Refiners Are Suffering Massively & Likely to Buy Less Oil
Data from global refineries shows weak margins, or crack spreads. Since crude is refiners’ input, the oil price rally has acted as a dampener for the space. “Very poor refining margins and the recent sharp decline in US crude bases now comfort us in our sequentially bearish outlook,” analysts at Goldman Sachs wrote.
OPEC and its allies, known as OPEC+, announced that historic production cuts of 9.6 million barrels per day across the group would run through July may make matters worse for refiners. Higher crude cost along with no increase in prices of the products from refineries is leaving refiners in a tough spot.
The crack spread for refined products in the United States was $9 last week compared to $21 at the same time last year, per Reuters . Margins for European diesel reached a record low of $2.90 per barrel last week, quoted on CNBC.
Moreover, Saudi Arabia has announced some of the biggest price increases for crude exports in at least two decades, removing almost all of the discounts it provided during its short-lived price war with Russia. Saudi selling prices will jump next month by $5 to $7 per barrel just for Asian buyers, which in turn would hurt “refining margins,” per analysts.
Both factors may lead refiners to buy lower crude volumes, resulting in lower crude prices in the coming days. Goldman Sachs expects Brent pulling back to $35 per barrel in the coming weeks compared to spot prices at $43.
Opportunistic Buying is a Risk to Recovery
Many oil-importing nations reserved oil strategically amid low prices. China recorded a massive rebound in crude imports in May with a record 11.3 million barrels per day, reflecting an increase of 13% from April. Many analysts are of the view that the buying has been done opportunistically, not to meet real demand.
Moreover, renewed U.S.-China tension over the latter’s imposition of new security legislation on Hong Kong and its apparent mishandling of the coronavirus incident may derail the oil market recovery. Although China purchased record volumes of crude oil in May, analysts do not expect the United States to be the key provider. China has fallen meaningfully short of “overly ambitious” energy import targets.
Shale Oil Production May Ramp Up Again
Crude’s recent rise may inspire the shale producers to boost drilling activities. In fact, the sharp gains in the price have already prompted EOG Resources (EOG) and Parsley Energy (PE) to plan a potential revival of production. U.S. crude inventories jumped 8.4 million barrels in the week through Jun 5, API data showed, while a Reuters poll of analysts had indicated a draw of 1.7 million barrels. This will weigh on the outlook for prices.
Economic Activity Yet to Pick Up Materially
Per Goldman, there is a surplus oil inventory of an estimated 1 billion barrels as global economic activity and travel have been far below the pre-coronavirus level. Some analysts believe inventory build would not reverse until the middle of 2021 that too in a steady demand and prolonged OPEC+ output cut scenario.
Bottom Line
At the end, it’s all about material demand growth. Oil has rallied a lot past month on hopes of a rebound in demand. But further rally from here seems dicey. VanEck Vectors Oil Refiners ETF (CRAK - Free Report) – the pureplay refining ETF – has gained about 16.6% past month, a lot less than the oil services and explorers’ gains.
Want key ETF info delivered straight to your inbox?
Zacks’ free Fund Newsletter will brief you on top news and analysis, as well as top-performing ETFs, each week. Get it free >>