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Don't Believe The Hype: Oil Markets Far From Recovery

Tank farm Kuwait

Global oil inventories are falling because of OPEC and non-OPEC production cuts, but the road to market balance will be long.

Production cuts have removed approximately 1.8 million barrels per day (mmb/d) of liquids from the world market since November 2016 (Figure 1).

(Click to enlarge)

Figure 1. OPEC-NOPEC Have Cut 1.8 mmb/d Liquids Since November 2016. Source: EIA April 2017 STEO, EIA International Data and Labyrinth Consulting Services, Inc.

Saudi Arabia has cut 619 kb/d (35 percent of total) and the Gulf States Cooperation Council—including Saudi Arabia—has cut 1,159 kb/d (65 percent of the total). Other significant contributors outside the GCC include Iraq (12 percent), Russia (12 percent) and Mexico (9 percent) (Table 1). Nigeria’s cuts are probably involuntary since it was exempted from the OPEC agreement. Iran and Libya–also exempted–and both increased production.



Table 1. Summary table of OPEC-Non OPEC production cuts, November 2016 through March 2017. Source: EIA April 2017 STEO, EIA International Data and Labyrinth Consulting Services, Inc.

Inventories and The Forward Curve

OECD inventories began falling in July 2016, four months before the OPEC production cuts were finalized. Stock levels have declined approximately 107 mmb according to recently revised EIA STEO data (Figure 2). That includes the January 2017 increase recently noted in the April IEA Oil Market Report.

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Figure 2. OECD inventories have fallen more than 100 million barrels since July 2016. Source: EIA April 2017 STEO and Labyrinth Consulting Services, Inc.

Although this represents progress toward market balance, stocks must fall at least another 260 mmb to reach the 5-year average level to support oil prices in the $70 per barrel range.

Almost three-quarters (73 percent) of OECD decline was from non-U.S. inventories. Perhaps the intent of OPEC’s November cuts was to stimulate a decrease in U.S. inventories (about 45 percent of the OECD total). U.S. stocks and comparative inventories were increasing at the time of the cuts and did not start to fall until February 2017 (Figure 3). Since mid-February, U.S. stocks and comparative inventory have each declined 20 percent.

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Figure 3. U.S. Comparative Inventories Have Fallen 20 percent Since Mid-February 2017. Source: EIA and Labyrinth Consulting Services, Inc.

Still, U.S. inventories must fall another ~143 mmb to reach the 5-year average (Figure 4).

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Figure 4. U.S. Crude Oil + Refined Product Inventories Must Fall 143 Million Barrels. Source: EIA and Labyrinth Consulting Services, Inc.

The immediate results of the OPEC cuts were an increase in oil prices and an important change in the term structure of crude oil futures contracts. Before the cuts were announced, the term structure of the WTI oil futures curve was in contango (prices are higher in the near-future). That favored storing rather than selling oil and contributed to growing inventory levels (Figure 5).

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Figure 5. The Term Structure of WTI Futures Contracts Changed From Contango To Backwardation After the OPEC Production Cut in Late November 2016. Source: CME and Labyrinth Consulting Services, Inc.

In early March 2017, however, oil prices fell as investors lost confidence that the cuts were working. Forward curves moved into weak backwardation (prices are lower in the near-future). Now, prices have increased with outages in Canada and Libya, and the forward curve has moved into stronger backwardation. That favors selling rather than storing crude oil and contributes to decreasing inventory levels.

Market Balance, Supply and Demand

The latest IEA Oil Market Report stated, “It can be argued confidently that the market is already very close to balance.” What does that mean?

Market balance means that production and consumption are approximately equal. That is an important first step for a market in which production has exceeded consumption for most of the last 3 years but it hardly means that $70 oil prices are around the corner.

Market balance must be expanded to be useful: production is not the same as supply, and consumption is not the same as demand. Supply is production plus inventory. Demand is the quantity of oil the market is willing to buy at a certain price–it may be either more or less than production. Related: Reeling From Low Oil Prices, Saudis Look To Freeze Megaprojects

Oil prices collapsed in 2014 because demand wasn’t great enough at $100 per barrel to absorb the output from the 2010-2014 production bubble. Prices collapsed to $30 per barrel before a transformed market began a weak and uneven recovery, and production surpluses began to decrease slowly (Figure 6).

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Figure 6. Critical Supply & Demand Are In Approximate Balance. Source: EIA April 2017 STEO, IEA OMR, OPEC MOMR and Labyrinth Consulting Services, Inc.

Demand did not increase enough until July 2016 to require critical supply withdrawals from inventory–a small subset of total supply. U.S. inventories did not begin to decline until after the OPEC cuts took effect in February 2017.

In the real world, the 5-year average inventory level represents a dynamic proxy for market balance. Comparative inventory is the measure of how far the present market must rise or fall to reach that level. IEA data indicates that inventories are 330 mmb above the 5-year average although revised EIA data suggests that levels are closer to 260 mmb higher than that important benchmark. In either case, it will take 6 months to a year to approach the 5-year average.

Demand Growth

Weakening demand growth is the potential barrier to continued inventory reduction and price recovery assuming that OPEC production cuts hold and are extended. Annual demand growth has declined to 1.25 mmb/d from the comparatively robust 2 mmb/d growth in 2015 and 1.62 mmb/d in 2016 (Figure 7). IEA forecasts continued weak demand growth for 2017. Related: Iran Ready To Join OPEC’s Production Cut Extension

Figure 7. 2017 Demand Growth Has Fallen To 1.25 mmb/d. Source: EIA April 2017 STEO, IEA OMR, OPEC MOMR and Labyrinth Consulting Services, Inc.

The problem, of course, is that demand is highly price-sensitive in a global economy that is burdened by unmanageable debt. Demand lags price and demand growth reflects the full spectrum of economic headwinds. In early 2016, oil prices reached the lowest level in a decade-and-a-half. After that, year-over-year demand and oil prices increased through November 2016 and yet, demand growth in 2016 was lower than in 2015. Since then, $45 to $55 per barrel prices appear to have depressed demand growth to annual levels of about 1.25 mmb/d.

The OPEC cuts are accelerating the reduction of global inventories but continued progress toward the 5-year average will push oil prices higher. Higher prices may collide with weak demand growth in a stagnant economy that simply needs less oil. The long road to market balance may be slower and bumpier than bullish analysts predict.

By Art Berman

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  • TightAggressive on April 19 2017 said:
    Great article. Couple of things.

    1) OPEC inventories would have made the picture more complete. Opec especially Saudis increased inventories in 2014. They had been selling that down slowly and used the price rise after the Nov deal announcement to unload massive inventories. Saudis and Iran combined have 100MMbl lower inventories since Dec 15. Every OPEC country has lower inventories than last year. Now they cannot increase production to 3Q16 or 4Q16 levels even if they wanted to.The winding down of the inventories was part of their production increase.

    2) Price of oil in 1Q16 vs 1Q17 as almost 60% or $20 higher. $54 vs $34. That crushed the demand growth comp at the same time OPEC cleared out inventory and Permian shale hedged big. But now that Crude is only $7-8 higher going into driving season we should see more robust demand growth, while only inventory left to clear is the US. Longer crude stays in the low 50, higher the chance it'll see $60 in 3Q.
  • Kr55 on April 19 2017 said:
    Prices will go up long before 5-yr average is hit. It's actually unlikely stocks get within 50M barrels of the 5-yr average. There is ~100M barrels of new commercial stocks now permanently inside of new pipelines and hubs needed to keep new infrastructure filled. This is a by-product of the production boom in the USA. New infrastructure and line filling is needed to ensure refineries are supplied as ~3M barrels/day that used to be ensured with a steady line of tankers at sea are replaced by oil at home.

    If we went back to 2013 and pretended that all the oil inside those tankers were included in the EIA report just as they left port to come to the USA, the baseline of stocks would be tens of millions of barrels higher.
  • Jhm on April 19 2017 said:
    It's so nice to read an article that correctly understands that demand is about consumption at a given price. Too often the price element is ignored as if it were irrelevant. But demand is becoming increasingly elastic. Consumption aside, demand is weak. There is no certainly that consumers are willing to pay $70/b so that production can keep growing. Price matters.
  • George Mathew on April 19 2017 said:
    I really enjoyed the article. Is there any way to analyze the oil purchases by the main consumer countries and their suppliers, because there is a share of oil in the market sold at very cheap prices by the rebels/terrorists in countries like Syria, Iraq etc which are also contributing to the increasing inventories and low oil prices.
  • Silk route on April 20 2017 said:
    Arthur, Your articles always contains fundamentals and more practicle data which gives real life inside out unlike few typical trade driven articles. I request you to throw few lights on US shale oil, I mean how much % of US shale oil can be consider as real crude oil. As per my knowledge 50% of them are condensate but they are still accounted as crude oil upon which hedge fund/stock market are betting.
  • Dave on April 29 2017 said:
    Art, California just announced INCREASES to the tax burden on each gallon of consumed Fuel (gas, a bit lower). WILL this affect the demand side? Will people drive less?

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