This is a guest post by J. M. Bodell modified from a comment he wrote on my recent Oil Price Crossroad post. He has extensive experience in petroleum market analysis, natural resource cost structure, scenario planning and strategic planning for Strategic Energy Research & Capital, Cambridge Energy Research and Associates, and Unocal.
Comparative inventory (CI) is a term that falls out of systems dynamics. System dynamics considers all the feedback loops by which the market prices a commodity based on relative “extant” supply including an expectation for domestic production, net imports and critically, absolute storage.
The CI value–based on how it is calculated–is automatically adjusted for seasonal variation by month or week. In that way, CI is normalized. The moving 5-year average therefore becomes a proxy in system dynamics for a hypothetical relative benchmark volume compared to what the “market expects.” The market is typically either short or long, passing through a null point or fulcrum at zero on the y-axis (Figure 1).
This temporal trend I termed a yield curve (YC) in 2001 based on my work for an oil company on pricing fundamentals for natural gas, crude oil and coal. This so-called YC trend is a collection of price-quality (price-CI) positions over a period of time or a cycle. I used the term “yield curve” because I believe the curve shows when in deficit, under certain circumstances, the need for demand to yield to price lower consumption and producing a powerful signal to producers to invest in new supply, and conversely, when in surplus, low prices stimulate consumption while causing producers to yield their investments.
To regress for a moment, classical Economics 101 deals with fundamental supply and demand, and shows also a price-quantity relationship. Along that P-Q relationship all parties in theory absolutely make an equilibrium transaction. Economists call this process to equilibrium tatonnement, an iterative Walrasian auction process by which an exchange equilibrium is imagined to be achieved. Furthermore, in classic economics storage is NOT considered. Unfortunately, that is not how the real market works.
In the real world, oil producers are pure price takers. They own many, many wells, in different parts of a field (to keep it simple) and of different ages, depths, and cost structures, and actually have little real-time knowledge of their unit costs. Over time, they know when they make or lose money, but they see that their stock price is relative to production growth. Producers are also loathe to shut in production, for many reasons, but one is need for cash flow. Also, very few have tank storage or are willing to hold the physical commodity for any length of time. As a consequence, the tatonnement process or “price searching” to equilibrium never happens, producers are at the mercy of bid-ask spreads. Period. Also, producers employ traders whose job is to place their physical production in the monthly cash market and the daily spot market. They want to get that right, not have to buy the physical to fulfill a contract. They may or may not use NYMEX futures to create a notion of price stability.
Given the seasonal nature of demand for crude oil and supply in this convention, storage then is critical in balancing the overall market. Any surplus in production to consumption is stored and that grows storage, with a recent safety valve in exports. Any deficit in production to consumption, typically, draws storage down, depletes it, and that always leads to a decline in the CI surplus and movement into a deficit.
Since a particular phenomenon was mentioned above, I would like to address a special case since I need to make a point or two. Let's say that production is maintained for a long time at a level higher than consumption. That increases the amount in absolute storage. We know this has occurred in the recent past. Let's assume also that this high level of storage lasts for five years. And let's also say, to make it simple, that relative weekly or monthly production, net imports and consumption remain the same for each equivalent period (January to January on a monthly basis or the first week of January to the first week of January on a weekly basis) for five years. Since above I mentioned that CI is normalized, in this special circumstance, given static storage volumes, CI will decline by definition.
Think about it, if we have exactly the same total supply each week and the same total consumption, storage will be exactly the same for each period. On a normalized basis, each year that this unusual condition persists, CI moves closer and closer to the null point, completely normalized. At some point, the market is neither long or short, and is at equilibrium.
That brings us to the null point, zero on the y-axis, that I call the mid-cycle price. What is the meaning of this mid-cycle price on the yield curve?
In system dynamics theory, that price is the value of the marginal unit of production, the cost of the last barrel to clear the market. If we knew the actual unit costs of production from the entire system, we could construct–in an Econ 101 sense–the supply curve. The price of the commodity at any point, in an equilibrium market, is the intersection of all supply (including delivered imports) and exact demand. In Econ 101, too costly supply might not even exist, but all pricing follows a demand curve intersecting along the supply cost curve. Producers would have a say, they would no longer maintain ‘out of market' supply. And that is where and why storage is critical to a functioning market.
Beginning in 2004, the U.S. market began to raise the crude price at WTI. It did this because it sensed that future domestic production was in some peril; conventional resources were reaching a peak. At that point, the market raised the price to induce producers to invest and ultimately to find new resources. Producers responded developing and attempting to make economic unconventional resources known earlier but considered too costly to be produced. That process continued until approximately 2014. As a consequence, the market raised the YC mid-cycle price to higher and higher price levels, peaking in 2008, where finally, the mid-cycle price was about $100± per barrel.
This price is not the “cost of the last barrel to clear the market.” We will never know that value. The market simply raised the price to get producers to do what producers do when they are so incentivized. And consumption did what consumption does when it encounters too high prices. We witnessed beginning in late 2004 and early 2005 what happens to per-capita driving miles as WTI prices skyrocketed. They dropped and have only recently begun to rise toward late 2008 levels (Figure 2).
At the moment, two forces are lowering CI along the YC. They are the fact that storage has been high for a handful of years, as discussed directly above, and because storage levels are actually being drawn down. Both contribute to a massive, historic depletion in the CI surplus over the last 14 months. Also, now the convention, unconventional crude production is growing. The market is no longer concerned about the production side of fundamentals (even if it should be). The U.S. some claim is moving to energy independence and the amount of crude production approaches the peak in the early 1970s. Furthermore, the U.S, is so awash in crude that it can export it as crude and product, and a change in legislation makes that possible. Moreover, the rig count over the last 18 or so months has increased by 153%, all with spot prices below $65 per barrel, and most of that when prices at WTI were between $45 and $55.
Bottom line, from my seat, the market believes it can get what it needs by way of production at a mid-cycle price $40 lower than during the earlier crisis. That is how I see it. $60 per barrel, maybe $65 is the emerging fulcrum price of the latest dynamic YC.
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US 28 May 2020