The U.S. over-supply of oil is ending.
Comparative inventory (C.I.) has been dramatically reduced in 2017. Levels have fallen 159 mmb since February and are now approaching the 5-year average for the first time in nearly 3 years (Figure 1).
An interpreted yield curve that correlates C.I. and WTI price is developed by cross plotting the same data without the time dimension (Figure 2). The yield curve may provide price solutions to inventory reduction assumptions in the near term.
Accordingly, if C.I. continues to fall at the 9-month average of 4 mmb/week, oil prices may be approximately $67 per barrel by the end of December. If C.I. falls at the 8 mmb/week average since late September, WTI could approach levels not seen since before the price collapse in late 2014.
Exports and The Brent-WTI Spread
The causes of the U.S. inventory drawdown are clear: increased exports of crude oil and greater domestic consumption.
Crude oil exports for the first half of 2017 averaged 766 mmb/d but rose to 1.8 mmb/d in September and October. Increased exports now average more than 12 mmb/week and contribute substantially to reduced inventory levels.
Higher export levels correlate with the increased spread between Brent and WTI prices that began in late July (Figure 3). Traders can sell U.S. crude oil overseas at less than international prices but at levels higher than domestic pricing allows. Record exports of 2.13 mmb/d occurred during the week ending October 27.
Tight oil production levels, crude oil quality and U.S. refinery blending needs are behind the WTI discount to Brent price. Most U.S. refineries are designed for international grades of oil like Brent which is heavier and contains more sulfur than WTI.
The U.S. has had a surplus of light sweet oil since the tight oil boom began, and the Brent-WTI spread reached almost $30/barrel in September 2011 as a result (Figure 4).
The spread decreased to about $2.25 with the advent of rail shipments of WTI to East Coast refineries, and associated reduced light oil imports. The transport cost was reasonable when oil prices were $100 per barrel but lower oil prices after 2014 resulted in a progressive decline in rail shipments (Figure 5). East Coast refiners increasingly relied again on imported light oil mostly from West Africa to blend with heavier grades of oil.
A surplus of tight oil returned as production recovered as a result higher oil prices in 2016 and 2017. Surplus supply caused discounted WTI prices, and the recent increase in the Brent-WTI spread. Some of excess oil has been exported in recent weeks but the price spread persists because import levels are so far unaffected.
The second major cause of the U.S. inventory drawdown is increased domestic consumption of refined products.
Consumption reached a 10-year record of 21 mmb/d during the summer of 2017 (Figure 6). August 2017 consumption was 300 kb/d more than in August 2016 and that difference accounts for more than 2 mmb/week of incremental inventory reduction. In fact, the increase in consumption that began in January coincided with the beginning of comparative inventory reduction that in February (red dots in Figure 6).
The greatest portion of consumption is from transportation. The declining growth rate of vehicle miles traveled (VMT) that began in early 2016 reversed in the second quarter of 2017 despite somewhat higher gasoline prices (Figure 7).
VMT data is only available through July but it is likely that growth continued at least through August based on consumption data that is more current.
The Possible Downside of Consumption
It is reasonable to question the capacity of the rest of the world to continue to absorb U.S. exports. Exports have increased in each of the last 6 weeks except the week ending October 6, and exports that week were still a robust 1.3 mmb/d. It is impossible to get reliable inventory data for most of the rest of the world but OECD data suggests inventory reductions similar to those described in the U.S.
Continued high U.S. consumption is the only area of concern for sustained higher oil prices. September and October consumption were considerably lower than in August. It is normal for consumption to decline after the summer driving season but the magnitude of the decline is disturbing.
October consumption was 1.2 mmb/d (38 mmb/month) less than in August (Figure 8). That is almost as much as the total August-to-January seasonal decline during the previous year (1.4 mmb/d, 42 mmb/month).
The data may be biased by the effects of hurricanes Harvey and Irma, and two months do not define a trend. It is, nevertheless, a troubling observation despite the fact that it will probably not affect inventory levels or oil prices in the rest of 2017.
Consumption becomes a greater concern if oil prices increase as much as I expect because gasoline prices will increase accordingly–consumption and gasoline price are negatively related (Figure 9). Higher oil price means higher gasoline price and lower consumption.
$70 WTI will result in almost a $1/gallon price increase above the current average retail price of $2.53 and that may depress consumption.
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US 28 May 2020