It is more likely that oil prices will fall below $50 per barrel than that they will continue to rise toward $70. Prices have increased beyond supply and demand fundamentals because of premature expectations about the effects of an OPEC production cut on oil inventories.
Last week’s 13.8 million barrel addition to U.S. storage was the second largest in history. It moved U.S. crude oil inventories to new record high levels.
Meanwhile, 130 horizontal rigs have been added to tight oil drilling since the OPEC cut was first announced in September. That means that U.S. output will surge and will continue to be a drag on higher prices.
Comparative inventory analysis suggests that the current ~$53 per barrel WTI oil price is at least $6 per barrel too high. Don’t hold your breath for $70 oil prices.
Inventory Is The Key
Most analysts believe prices will increase steadily now that OPEC has decided to cut production. Their logic is that over-production caused lower oil prices and lower output should bring markets into production-consumption balance.
The problem is that production is not the same as supply and consumption is not the same as demand. Inventories lie in-between and modulate the flows from both sides of the production-consumption equation.
Inventory is clearly part of supply but is also a component of demand. Excess production goes into inventory when demand is less than supply. When consumption exceeds production, oil is withdrawn from inventory reflecting increased demand.
The International Energy Agency (IEA) reported last week that global liquids markets would move to a supply deficit by the first quarter of 2017 if OPEC production cuts take place as announced (Figure 1).
Figure 1. IEA Demand/Supply Balance until 2Q17. Source: IEA February 2017 Oil Market Report.
Yet the OECD inventories on which IEA’s forecast is based have increased and are now more than 400 million barrels above the 5-year average (Figure 2). In order for a supply deficit to develop in the first quarter of 2017, those stocks would have to be drastically reduced over the next 6 weeks. Comparative inventory analysis provides some context for the necessary magnitude of that reduction.
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Figure 2. OECD Incremental Inventories Are At Record High Levels Although Absolute Inventories Have Flattened in Recent Months. Source: EIA and Labyrinth Consulting Services, Inc.
Comparative inventories index current storage levels against a moving average of values for the same calendar date over the previous 5 years. This provides the most reliable way of understanding oil-price trends by normalizing stock changes for seasonal variations and comparing them with 5-year average values.
Figure 3 shows that current OECD comparative inventories (C.I.) are at an all-time high level of more than 300 million barrels (absolute inventories are 3.1 billion barrels).
C.I. values around zero (+/- about 50 mmb) correspond to periods of high oil prices (>$80 per barrel) over the past decade. That suggests that comparative inventories need to fall approximately 200 to 300 million barrels to support $70 to $80 per barrel oil prices.
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Figure 3. OECD Comparative Inventories Are At An All-Time High & Need to Fall 200-300 mmb To Support $70-$80 Per Barrel Oil Prices. Source: EIA STEO and Labyrinth Consulting Services, Inc.
What the IEA is apparently showing in Figure 1 as a “demand/supply balance” is really a demand/production balance. If OPEC cuts move forward as announced, consumption will exceed production in the first two quarters of 2017 and withdrawals from storage will occur. That is a legitimate demand increase.
The billions of barrels of working capacity remaining in inventory are not considered supply in this calculation of balance. That distorts the supply-demand relationship.* At the very least, it does not treat the ~550 million barrels of incremental inventory that has accumulated since December 2013 in Figure 2 as supply.
Inventory is like a savings account for oil. It may be in a separate account from checking but it is part of total available supply. This sort of confusion over definitions of supply and demand is easily avoided by considering comparative inventories. Related: Is $60 Oil Within Reach?
Figure 4 is a cross-plot of OECD comparative inventories and Brent prices. It shows that current prices of ~$55 per barrel are approximately $10 per barrel over-valued compared to the trend line. It further shows that comparative inventory levels must fall ~200 million barrels to support ~$70 per barrel oil prices.
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Figure 4. OECD Comparative Inventories At Record Highs–Comparative Inventory Suggests That Current Prices Are ~$10/Barrel Over-Valued. Source: EIA and Labyrinth Consulting Services, Inc.
Movement toward market balance cannot help but accelerate as a result of OPEC production cuts. Still, the massive stock reductions necessary to support higher oil prices will only occur over a much longer period.
It will take at least a year to reduce OECD inventories 400 mmb down to the 5-year average. This assumes that all OPEC cuts take place as announced and continue beyond the 6-month term of those agreements. It also assumes that non-OPEC production declines or at least remains static.
U.S. Production Will Not Remain Static
It is worth recalling that over-production by the U.S. and Canada was the trigger for the global oil-price collapse in 2014 (Figure 5). These two countries accounted for almost half (44 percent) of the incremental increase in crude oil and lease condensate production in the world as of March 2015 peak production levels.
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Figure 5. U.S. + Canada Incremental Ouput: The Major Contributor to Low Oil Prices. Source: EIA and Labyrinth Consulting Services, Inc.
U.S. production fell more than 1 million barrels per day (mmb/d) from April 2015 through September 2016 but is now recovering because of higher oil prices (Figure 6). EIA forecasts that field production will increase to 9.28 mmb/d by the end of 2017 and will reach almost 10 mmb/d by December 2018.
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Figure 6. U.S. Crude Oil Production Has Increased 290 kb/d in The Last 4 Months After Falling 1.06 mmb/d From Apr 2015 to Sept 2016. Source: EIA February 2017 STEO and Labyrinth Consulting Services, Inc. Related: Energy Storage Set To Boom In 2017
EIA does not predict that WTI oil prices will exceed $60 per barrel throughout this 2-year period. It is interesting to note that EIA shows prices falling below $50 per barrel in February 2017 and remaining at that level through mid-year.
After OPEC announced that a production cut agreement was evolving in September 2016, the U.S. horizontal tight oil rig count accelerated. Since then, 130 rigs have been added and 67 percent have been in the Permian basin tight oil play (Figure 7). In recent weeks, the Eagle Ford play rig count has made impressive gains and the Bakken rig count has steadily increased also.
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Figure 7. 130 Tight Oil Rigs Added Since Mid-Sept 2016: 67 percent Are In The Permian Basin. Source: Baker Hughes, EIA, Bloomberg and Labyrinth Consulting Services, Inc.
This reflects a massive flow of capital into these plays that will certainly result in production increases. Approximately $10 billion was spent in 2016 on Permian basin drilling and completion costs for horizontal tight oil wells. An additional $28 billion was spent on Permian land acquisitions.
Don't Hold Your Breath for $70 Oil Prices
Traders, analysts and the press have consistently looked for every possible reason to anticipate higher prices since the collapse in 2014. Expectation of an OPEC production cut or freeze has provided an artificial lift to oil prices for at least a year and now, probably accounts for at least $6 per barrel of current $53 per barrel NYMEX futures prices.
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A recent Wall Street Journal article noted a new record in long crude oil futures positions during the last week in January. It went on to speculate that this meant a possible end to the over-supply of oil and that prices should increase.
That observation is not supported by history. In fact, record long positions are commonly followed by a drop in oil prices. Notable examples shown in Figure 8 include price declines around the 2008 Financial Collapse, the 2014 world oil-price collapse, and the brief rally to $60 prices in the Spring of 2015.
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Figure 8. Record Long Positions on Crude Oil Futures Suggests That Prices Will Fall. Source: CFTC, EIA and Labyrinth Consulting Services, Inc.
Inventory data provides compelling evidence that present oil prices are over-valued. Last week, 13.8 million barrels (mmb) were added to U.S. crude oil storage. That's the second highest weekly addition ever--the highest was 14.2 mmb on October 28, 2016 when WTI prices were about $5 per barrel lower.
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Figure 9. Crude Oil Inventories Are At Record Levels 140 mmb Above the 5-Year Average. Source: EIA and Labyrinth Consulting Services, Inc.
Comparative inventories are also near record highs (Figure 10). When C.I. was at this level in March 2016, WTI prices were around $39 per barrel. When C.I. was slightly lower in August 2016, prices were about $47 per barrel. The trend line in Figure 10 shows that oil prices are probably about $6 or $7 per barrel over-valued.
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Figure 10. Comparative Inventories Near Record High Levels--Comparative Inventories Suggest Current Prices Are ~$7 Per Barrel Over-Valued. Source: EIA and Labyrinth Consulting Services, Inc.
Oil prices do not always reflect underlying fundamentals but markets eventually adjust because of them. Comparative inventory analysis suggests that current oil prices are over-valued. It is possible that markets have already priced in anticipated uplift from OPEC production cuts. If so, prices may not increase much beyond present levels and expectations of $70 prices any time soon are improbable.
OPEC cuts have almost certainly put a floor under oil prices but volatility will continue to characterize markets as it has for the past 2 years. U.S. production is a wild card that will almost certainly be a drag on upward price movement. My guess is that WTI prices are likely to move below $50 per barrel until effects of OPEC production cuts are reflected in falling global inventories.
*To its credit, IEA shows 2016 inventory declines reaching the maximum levels of the 2011-2015 average. That doesn't change the fact that current stock levels are 400 mmb above the 2012-2016 5-year average. That's why comparative inventories are essential.
By Art Berman for Oilprice.com
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