Oil markets are experiencing a notable disconnect between paper trading and physical market realities. While futures contracts indicate a tight market, physical signals suggest a different scenario, raising concerns about market stability. Brent crude spreads and gasoil cracks appear robust on paper, yet North Sea grades are struggling to maintain premiums, and U.S. crude is arriving in Europe at discounted rates.
The market is essentially operating on two fronts. Futures prices reflect some ongoing tightness, but the physical market’s indicators are weakening significantly. The current structure remains in backwardation, where prices for future delivery are lower than those for immediate delivery. Traders have added protective measures following sustained strikes on Russian refineries and export infrastructure, leading to increased gasoil and naphtha cracks, reminiscent of the post-invasion period that began in February 2022.
Despite these developments, average free-on-board (FOB) premiums for light sweet grades in the North Sea are not particularly strong. The Forties blend, for instance, has struggled to gain traction against Dated Brent prices, while WTI is once again entering Northwest Europe with appealing economics. This situation illustrates a market divided: one side pricing in geopolitical disruptions, and the other suggesting an oversupplied environment.
Renewed Refining Capacity and Global Supply Dynamics
The confusion surrounding oil prices is compounded by evidence of increased refining activity. Saudi Arabia has significantly ramped up crude processing, channeling a substantial volume of barrels into gasoil exports. Brazil achieved a decade-high throughput in August 2023, and refiners in OECD Asia have also increased utilization rates. Meanwhile, India’s large refining sites remain operationally busy. Remarkably, despite this uptick in processing, margins have not collapsed, indicating that operational capacity may be nearing its limits.
When everything operates smoothly, the oil market remains stable; however, even minor disruptions can reveal underlying weaknesses. Refining flexibility, rather than crude availability, is the critical issue. Global conversion units are already functioning near their practical limits, and reliability remains inconsistent. Notably, ongoing challenges at Dangote’s Residuum Fluid Catalytic Cracking (RFCC) unit highlight how fragile this balance can be.
As winter approaches, diesel stocks remain below longer-term seasonal norms, leaving little room for additional shocks. When geopolitical tensions intersect with limited conversion capacity, product cracks can rise without a surge in demand; all it takes is another operational outage.
Future Market Dynamics and Key Indicators
The current discrepancy between paper and physical markets cannot persist indefinitely. The physical weakness in North Sea grades contrasts sharply with the backwardated Brent spreads. Freight rates have amplified movements in the paper market, with Very Large Crude Carrier (VLCC) strength and shifting arbitrages distorting regional clearing prices. Over time, physical premiums should either rebuild as risks materialize or the paper market will cool if anticipated losses do not restrict flows.
Currently, global crude exports are averaging at multi-year highs, contributing to an increase in oil stored at sea. Traders recognize that the market is heading into a more well-supplied period in Q4 2023. The challenge lies in timing and effectively managing geopolitical risks within the paper market.
Three key indicators will shape the next phase of oil market dynamics. First, the resilience of Russian product exports following repeated refinery attacks will determine whether current risk premiums translate into actual shortages. Second, the pace and stability of refinery restarts during global maintenance periods will signal whether conversion capacity can meet winter demand. Lastly, the relationship between WTI and Brent prices, alongside North Sea FOB premiums, will indicate whether physical barrel availability supports paper market strength or necessitates a reevaluation.
As these factors evolve, traders must remain vigilant and exercise disciplined risk management to navigate the complexities of the current oil landscape.
