Opinion

Markets Have De-Valued Oil Prices: How Long Will It Last?


Comparative inventory: The most important approach to oil & gas price formation

  • Comparative Inventory (C.I.) is the difference between current stock levels of crude oil & select refined products, and their 5-year average.

  • C.I. has accurately predicted most of the changes in oil pricing since the 1990s when inventory data first became public.

  • C.I. explains the 2014 oil-price collapse and subsequent recovery.

  • Over-supply and weakening demand for oil led to lower prices and a build up of oil in storage.

  • As C.I. fell, prices increased and eventually led to the present C.I. deficit.

  • That appears to be ending as C.I. moves back toward the 5-year average.

  • This is the context for understanding the near- to medium term direction for supply, demand and prices.


Comparative inventory ordinarily correlates negatively with price

  • Comparative Inventory & oil price ordinarily correlate negatively.
  • At times, perception about supply security may cause markets to use price as a signal to producers to drill either more or less regardless of C.I.
  • Before the ramp up of tight oil production in 2010, markets drove prices higher because of fears about supply security following flat global output 1998-2002 and 2004-2007 despite a C.I. surplus. Similarly, price response was muted 1995-1998 despite deep C.I. deficits because markets were confident of adequate supply.
  • The recent price rally after July 2017 correlated with a period of flat production early 2016- early 2018.
  • March-July 2018 world crude + condensate output increased +1.5 mmb/d leading to market confidence. Preliminary August data suggests flat production with July & may account for recent price rally.
Markets devalued WTI and Brent ~35% during the last year
  • The C.I. vs oil-price yield curve intersects the y-axis at the 5-year average & is called mid-cycle price.

  • It is the market clearing price of the marginal barrel needed to maintain supply thru the price cycle.

  • Mid-cycle price for 2014 to mid-2017 was ~$75-$85 but a new yield curve has developed with mid-cycle price of $60-$70 but more significantly, with a much flatter trajectory than the previous yield curve.

  • August OECD C.I. of -56 mmb corresponds to a Brent price of $72.53.

  • A similar C.I. for June 2014 of -58 mmb corresponded to a Brent price of $111.80.

  • That represents a 35% price devaluation.

  • The 1995-2004 price cycle had a flat yield curve trajectory.

  • Despite very negative C.I. levels, prices remained correspondingly flat.

  • This was based on market sense of supply security.

Markets devalued WTI and Brent ~35% during the last year

  • Market devalued price of WTI partly because tight oil rig count tripled (2.9x) from 193 to 568 at prices less than $60/barrel from May 2016 to Apr 2018.
 
  • Tight oil production returned to pre-oil price-collapse peak level (4.1 mmb/d) at WTI prices of $47-$53/barrel Output has continued to increase at prices < lowest levels from 2011-2014.
  • Market devalued price of WTI partly because U.S. tight oil rig count tripled (2.9x) from 193 to 568 rigs at prices less than $60/barrel from May 2016 to Apr 2018.

  • Producers have been claiming profits at successively lower break-even prices since the 2014 oil-price collapse.

  • Markets hate to overpay.

  • Part of price discovery is to see what happens with lower prices.

  • Tight oil production returned to pre-oil price-collapse peak level (4.1 mmb/d) at WTI prices of $47-$53/barrel by July 2017.

  • Markets take that as confirmation that adequate supply will be available at relatively lower oil prices than before the 2014 collapse.

  • Output has continued to increase at prices less than the lowest levels from 2011-2014.

Managed money has been unwinding net long positions

  • From mid-June 2017 to Jan 2018, net long positions increased +615 mmb for WTI crude + products, and +776 for WTI + Brent.

  • Brent + WTI net long positions have fallen -335 mmb since Jan 2018.

  • WTI crude + refined product net long positions have fallen -225 mmb since January 2018 and -104 mmb since the week ending July 10.

  • Despite high frequency price fluctuation, the overall trend is down.


The U.S. export party seems to be losing momentum

  • Distillate exports have been the cash cow driving U.S. refined product exports.

  • Distillates comprise ~17% of product exports

  • Distillate exports remain strong and above the 5-year average but have declined compared with record levels in 2017.

  • Big drop off in exports to Mexico and Brazil where refinery expansions have occurred.

  • Exports may increased again when Latin American refineries begin maintenance toward the end of the year.

Distillate and gasoline inventories have been building

  • U.S. storage reports in recent weeks have featured substantial crude oil withdrawals but sizeable distillate, gasoline and other products builds that have led to disappointing overall outcomes.
  • Distillate comparative inventory (C.I.) is -4.3 mmb below the 5 year avg but at the highest level since the week ending Mar 30, 2018.

  • Stocks & C.I. have increased dramatically since June.

  • Gasoline comparative inventory (C.I.) is +17.6 mmb above the 5 year average and at the highest level since mid-June 2017.

  • Gasoline stocks have been flat-to-rising during the normal destocking period.


Crude exports are lower but the Brent-WTI differential sends another message

  • Crude oil exports remain strong but have fallen sharply from 2-3 mmb/d levels from April through July.

  • Last week's exports were 1.6 mmb/d, 200 kb/d less than the 2018 YTD average of 1.8 mmb/d.

  • At the same time, the Brent-WTI premium vs 5-yr average is up from $0.13 to $3.43 (25x) since week ending Aug 17.

  • Premium increased +$4.46 from $3.67 to $8.13.

  • These changes reflect increased market concerns about supply security.

  • This could mean increased U.S. exports on the horizon.

  • Yet foreign refiners have begun to understand the limitations of high-gravity U.S. crude.


WTI and Brent spreads are moving in opposite directions
 
  • WTI 6-month calendar spreads and front-month prices are falling.
  • Brent spreads and price are generally increasing.
  • WTI spreads have fallen -$6.78 since July 8, from $7.77 to $0.99.
  • Brent spreads went into contango in July but have increased from -$0.81 to $1.95 in August and early September.
  • Increasing Brent backwardation and positive pricing relative to WTI reflects supply security concerns.

Markets have been sensitive to supply concerns in recent weeks

  • The price rally that began in mid-August reflected renewed market concerns about tighter world supply.

  • This is an artificial problem created by U.S. sanctions on Iran but real nonetheless.

  • Iran, Nigeria, Libya & Venezuela production has fallen 1 mmb/d since January & 0.5 mmb/d since May 2018.

  • Saudi Arabia, Kuwait & UAE have increased production 542 kb/d since April but there is considerable doubt about true spare capacity.

  • Maximum output was 16.84 mmb/d just before the 2016 production cuts.

  • If that represents spare capacity then, there is little left to overcome tighter supplies in the future.


Two Different Views of Supply-Demand Balance
  • IEA and OPEC world supply balance forecasts suggest different potential scenarios for the remainder of 2018 and for 2019.
  • IEA suggests that markets have been more-or-less in balance in 2018 and are likely to move into substantial over-supply in 2019.

  • OPEC forecasts show 2017 deficits continuing through 2018, and reaching a maximum in Q4.

  • OPEC indicates over-supply by mid-2019 returning to deficit for the rest of that year.

  • No wonder investors are confused!


Closing thoughts and observations

  • Oil fundamentals are only part of the story–the global economy is the main factor going forward.

  • Current U.S. interest rates of 1.9% are 15 times higher (1483%) than the average 0.12% from 2009 through 2015.

  • Emerging markets are taking the blows for now & a recent study by Oxford Institute for Energy Studies places global economic growth risks above geopolitical risk or shale growth risks for oil price.

  • Oil supply threat from Iran probably over-stated: sanction relief likely and Iran will find ways to export crude through Iraq & black market.

  • OPEC spare capacity may be greater than assumed.

  • Above all, it is critical to recognize that oil markets remain in a period of secular deflation that begain in 2014.

  • However things turn out, they are not going to return to the old normal.

  • I expect prices to remain range-bound near or below current levels for the near term and will probably fall in 2019 (but nothing would completely surprise me!)



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