U.S. Inventory Reductions Probably Not Sustainable

The decline in U.S. comparative inventories since February is the most significant oil market development since prices collapsed three years ago. It means that U.S. demand has exceeded supply for most of the last 5 months. The main cause is lower net imports, not higher domestic consumption, and that is probably not sustainable.

Comparative Inventories: The Key To Understanding Oil Prices

Comparative inventory (C.I.) is the difference between current storage levels of crude oil plus a select group of refined products, and their 5-year average for the same weekly time period (Figure 1). It is an indicator that normalizes seasonal variations in production, consumption and refinery utilization.

Figure 1. Comparative Inventory Is The Difference Between Stock Levels & Their 5-Year Average. Source: EIA and Labyrinth Consulting Services, Inc.

C.I. is the key to understanding oil prices yet few analysts use or even discuss it. Instead they try to explain price fluctuations by events in the daily news cycle or by simple year-over-year comparisons.

The negative correlation between C.I. and WTI price is strong. The 121 million barrel (mmb) increase in C.I. that began in June 2015 corresponded with a decrease in oil prices from $60 to $28 per barrel (Figure 2). The subsequent decrease in C.I. from April to July 2016 corresponded to an increase in oil prices from $28 to $50 per barrel.

Figure 2. Strong correlation between Comparative Inventory and WTI Prices. Source: EIA and Labyrinth Consulting Services, Inc.

U.S. comparative inventories have fallen more than 104 million barrels since mid-February 2017. Average weekly withdrawals of 4.3 mmb of crude oil and refined products indicate that demand has exceeded supply by almost 600,000 barrels per day (b/d) over the past 24 weeks.

Figure 3 shows the same C.I. vs. price data as a cross-plot (with the time dimension suggested by the light blue connecting lines). The resulting “yield curve” (Bodell, 2009) offers a structure for organizing seemingly random variations in oil prices.

Figure 3. Comparative Inventory Provides a Framework and Context For Oil Prices. Source: EIA and Labyrinth Consulting Services, Inc.

The yield curve does not provide a precise solution to comparative inventory vs. price trends. Nor does it represent a simple regression fit although the data correlate systematically in time. Interpretation based on experience is required because much of the apparent data scatter is due to sentiment-based fluctuations in price.

Nevertheless, the C.I. vs. price yield curve presents a unique framework and context for prices and price trends. Because it reflects movement of oil volumes in and out of storage, it integrates true demand and supply variations with price. It also places probabilistic constraints on future price movements.

The yield curve shows that the March-June 2015 “false” price rally to more than $60 per barrel was a significant over-shoot. It reflected unwarranted optimism soon after oil prices collapsed that a return to $100 per barrel prices was likely. A short-lived fall in comparative inventory supported that optimism (Figure 2).

Similarly, the price collapse to less than $30 per barrel in late 2015-early 2016 represented a substantial under-shoot. Yet, it corresponded to the second phase of the largest increase in comparative inventory in history (Figure 2). Cushing storage capacity was greater than 80% during that period and it is a factor that generally puts downward pressure on prices.

The yield curve further shows the artificial uplift in prices from November 2016 through February 2017. This was based on unrealistic optimism that OPEC production cuts would result in a meaningful oil-price recovery to perhaps the $60-$70 range. Again, the anticipated mechanism was expected to be inventory reduction.

These price outliers reflect the daily decisions of oil traders who must trade, and the influence of sentiment and analyst narratives on short-term prices. Their causes were recognized as probable deviations from the yield curve norm at the time they were occurring.

The yield curve furthermore imposes constraints on the potential limits to future price trends. Its intersection with the y-axis is called the mid-cycle price, the price that the market deems necessary to maintain supply for a complete price cycle.

That price for the current cycle is approximately $75 per barrel. It represents the most likely price when stock levels are equal to their 5-year average. Barring fear premiums because of geo-political events, the mid-cycle price tempers overly optimistic price expectations as long as comparative inventories remain elevated.

I used July STEO forecasts to estimate a possible range of comparative inventory values and corresponding WTI prices for December 2017. These suggest C.I. in the range of 40 to 60 mmb above the 5-year average, and corresponding WTI prices between $48 and $53 per barrel. These may be conservative based on recent large inventory withdrawals—if those continue, oil prices could be in the mid-to-high $50 range by year-end.

Consumption and Net Imports

Ordinarily, higher demand is because of increased consumption but data suggest that year-to-date U.S. consumption (product supplied) is flat compared with 2016 (Figure 4). Record levels were reached in late June and July but first-half consumption was actually about 150,000 b/d less than for the same period in 2016.

Figure 4. Late June-July Consumption Has Reached Record Levels But Year-to-Date 2017 Consumption Is Flat With 2016. Source: EIA and Labyrinth Consulting Services, Inc.

Although the last 5 weeks of data indicate approximately 440,000 b/d of additional consumption, comparative inventory began to fall in mid-February and this recent increase, therefore, cannot account for most of the C.I. reduction.

Net oil imports provide a more consistent but still incomplete explanation for increased U.S. demand and C.I. reductions. Since mid-February, average net imports of crude oil and refined products have decreased about 334,000 b/d (Figure 5).

Figure 5. Lower Crude & Refined Product Net Imports Are Responsible For ~55% of Comparative Inventory Decline. Source: EIA and Labyrinth Consulting Services, Inc.

That translates to 2.4 mmb/week or about 55% of the average C.I. decline of 4.34 mmb/week. Lower crude oil net imports account for about 65% of that total decrease. Year-to-date crude exports have averaged 757 kb/d compared to 445 kb/d in 2016.

Unaccounted-For Oil

Lower net imports and higher consumption account for all of the comparative inventory reductions since late June but only for a little more than one-half of reductions for the previous 4 months. It is disturbing that this important development cannot be more fully understood.

Last October, my colleague Matt Mushalik and I wrote a post about the large and growing volume of unaccounted-for oil in U.S. storage. We showed that implied stock changes based on input and output volumes published weekly and monthly by the EIA could not be reconciled with reported stock changes to U.S. crude oil storage.

That situation has not changed. Implied stock levels (field production + net imports – refinery intakes) are consistently less than reported stock levels. The cumulative difference is now 137 million barrels from a common starting value in January 2015 (Figure 6). That is the amount of unaccounted-for crude oil in U.S. storage.

Figure 6. 137 Million Barrels of Unaccounted-For Oil in Storage (28% of total). Source: EIA and Labyrinth Consulting Services, Inc.

An EIA representative initiated dialogue about the points raised in our post just after its publication. The EIA contends that its methods for estimating stock changes are more reliable than its published flows we used to calculate implied stock changes. Although this may be valid for relatively recent data, it seems that revisions should largely cancel those differences after some reasonable number of months have passed.

The representative also noted relative agreement between EIA and API stock estimates as validation of its methodology. It seems, however, that differences between what EIA and API report are common and sometimes large.

The main point is that these stock levels are estimates. Storage volumes are not directly measured by the EIA. Circumstances change and algorithms that may have been reliable in the past have become progressively undependable.

Although I agree with the EIA that absolute stock levels are probably more correct than the underlying flows, unaccounted-for oil is a problem that the EIA has chosen not to acknowledge. Either inventory reductions are less than reported or the underlying flows are not accurate enough to account for those reductions.

Lacking unambiguous percentages, most of increased demand is because of exports. The potential to continue reducing inventories in this way is, therefore, limited by world capacity to absorb excess U.S. supply. Much of the increase in U.S. exports was possible because of temporary outages in places like Nigeria.

Meanwhile, the outlook for meaningful reductions in world over-supply seems questionable. OPEC's output jumped almost 1 mmb/d above its target in July. Wood Mackenzie anticipates that global supply may increase almost 2 mmb/d in 2018 if the agreement does not hold.

Figure 7 is a synthesis of supply-production and demand-consumption data from the principal international reporting organizations. It suggests that the world supply surplus is likely to increase during the rest of 2017 and the first half of 2018. It further indicates that the second quarter of 2017 may be the only period of supply deficit for the next 17 months—that the last quarter was as good as it gets for quite awhile.

Figure 7. World Market Balance Suggests Increasing Over-Supply Going Forward. The Second Quarter of 2017 May Be The Only Under-Balanced Quarter Through 2018. Source: IEA, EIA, OPEC, BP and Labyrinth Consulting Services, Inc.

None of this is good news for continued high U.S. export levels. The last 5 weeks of data suggest that increased consumption may become more important going forward. It is more likely, however, that these elevated levels reflect temporary, higher seasonal consumption after lower-than-normal usage in the first half of the year.

The U.S. oil industry is justifiably proud of the ingenuity it used to survive the last 3 years of reduced commodity values. Technology, efficiency and lower oil-field service costs enabled increased production since September 2016 despite low oil prices.

Production growth, however, does not solve the underlying cause of low prices namely, over-supply. It makes it worse and prolongs lower prices.

I have no illusions that tight oil producers will willingly resort to business discipline. Only reduced access to capital will impose that necessary change on their behavior.

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