What Goes Up Must Come Down, and in the Case of Crude Inventories It’s Happening

Authors: John Mayes and John Auers

Since the end of March, U.S. crude oil inventories have fallen by over 90 million barrels, equivalent to an average drawdown of almost 370 MBPD.  This has happened despite a continuing rebound in U.S. domestic production, which has increased by about 700 MBPD over that same timeframe, reaching a weekly record of almost 9.8 million BPD in last week’s EIA supply estimates.  The market is certainly paying attention, as crude prices have reached their highest levels since early summer 2015. The decrease in inventories is seen as welcome relief for a global market that has been plagued with high crude stocks for four years.  Those stubbornly high inventory levels (in excess of one billion barrels globally at their peak) have been a dominant roadblock to increases in oil prices since their collapse in 2014.  As inventory levels recede, the potential that the recent bullish moves in prices can be sustained becomes more promising.  But while these price increases are being met with growing optimism by the upstream sector of the petroleum industry, they offer a mixed blessing for refiners.  In today’s blog, we discuss some of the recent developments and trends and what they might mean for industry participants.

This current market cycle began in the second half of 2014 when it became apparent that global crude production was outpacing consumer petroleum demand.  The surplus crude market forced crude oil prices lower, but only slowly at first.  After peaking for the year in mid-June at slightly over $115 per barrel, Brent prices fell steadily, crossing $100 per barrel by mid-August.  In the fourth quarter of 2014, however, the decline turned into a rout.  Attempts to structure OPEC production agreements with Russia collapsed when Saudi Arabia announced it would focus on protecting its market share and all hope of a resurgence in prices evaporated.  Brent prices fell to slightly over $45 per barrel in January of 2015 before there was a temporary rebound.

Figure 1
Dated Brent Prices

In the early stages of the price collapse, most of the market assumed the decline would be short lived.  As a result, the futures market shifted from backwardization (future prices are lower than current prices) to a contango market (future prices are higher than current prices).  Figure 2 displays the WTI fourth month out less the spot month (first month).  When crude prices exceeded $100 per barrel in the first half of 2014, the market expected lower prices in the near future.  When prices collapsed in the second half of the year, however, sentiment shifted to the expectation of higher future prices.  The further actual prices declined, the stronger the view that prices would rebound in the immediate future.  The 4th month less front month spread peaked in March of 2015 and again in February of 2016 at between $5 and $6 per barrel.

Figure 2
WTI ICE Futures Prices
4th Month less Front Month

While reflecting the market sentiment of an expected imminent price rebound, the contango market also had the effect of incentivizing the storage of crude oil.  In the early stages of the contango environment, when there were numerous unused tanks still available, oil could be stored for as little as $0.50 per barrel per month.  On this basis for instance, a three-month roll (Figure 2) would require a spread of $1.50 per barrel to break even.  WTI futures prices passed this mark in late December of 2014.  With the $5 per barrel spread seen in March of 2015, a three-month storage of oil could yield a profit of $3.50 per barrel.

Traders and speculators rapidly seized on this opportunity for quick guaranteed profits.  When crude inventories rose, however, surplus tankage was quickly utilized and storage costs also escalated.  As the downturn in oil prices persisted, optimism for the future began to wane and by 2016 the “lower for longer” sentiment took hold.  This resulted in the steady decline of the 4th month less the spot month spread in 2016 and 2017.

From 2010 through 2014, U.S. crude stocks generally ranged between 300 and 360 million barrels (Figure 3).  Because of the sharp increase in the contango spread, oil inventories began to escalate rapidly in January of 2015.  After several upward oscillations, crude stocks peaked in late March of 2017 in excess of 535 million barrels, a build of around 185 million barrels.

All good things must end, however, and the storage bonanza ended in early 2017 as the declining contango spread fell to below storage costs.  The 93 million barrel decline already experienced since the March peak likely represents about half of the contango induced inventory build.  The three- month futures pricing spread slipped into backwardization in late November.  Assuming similar future pricing sentiment in the near term, further inventory declines would be expected.

Figure 3
U.S. Crude Stocks (excl. SPR)

The primary effect of the U.S. inventory drawdown has been a reduction in crude imports.  It is likely this trend is also being seen on other regions, resulting in a reduced level of global crude production requirements from what they otherwise would have been.  This would offer some restraint on crude price increases, at least during the drawdown period.  Coincidentally, crude exports from the U.S. have also risen recently.  This increase is driven more by the optimization of crude qualities for U.S. refiners and is not the cause of the stock draw.  Increases in crude exports will simply increase imports to balance and do not substantively impact inventory levels.

Ironically, the prevailing bearish future pricing sentiment (as seen in the current backwardization) is likely to be the harbinger of higher prices.  The decline in global crude stocks means recent production levels are below demand requirements.  When the surplus crude inventories are dissipated, production must rise or prices will increase.  A combination of the two is probably the likely scenario.  One can see the early impacts of this shift in oil markets with the recent rise in Brent prices since June (Figure 1).

The specter of rising oil prices presents both opportunities and challenges for refiners.  During the period of price increases, refining margins are likely to be squeezed.  Product prices generally lag crude oil increases and can create temporary dips in processing margins.  Higher prices also retard product demand growth.  Lower demand growth contributes to lower refinery utilization rates which foster a longer term impediment to refining margins.

On the positive side, however, rising oil prices are also likely to stimulate increased oil production in the U.S.  Because of quality differences, incremental production is likely to be exported.  This trend will keep U.S. crude prices below world prices and improve the competiveness of domestic refineries.  Rising production also increases the potential of sporadic “stranded” production areas where production has outpaced exit pipeline capacity.  These situations can produce crude prices with significant discounts.  The challenge for refiners will be to capitalize on the opportunities of higher oil prices while managing the challenges.

Turner, Mason & Company follows and analyzes all the critical factors impacting global and regional oil markets.  Changes in crude oil supply and demand are obviously the key drivers of these markets and many dramatic developments on both sides of the equation have taken place over the past few years.  We can expect the environment to remain very dynamic in both the U.S. and globally, creating uncertainties for all segments of the supply chain, from producers down to refiners.  Our analysis of the factors that will influence supply and demand, along with trade flows on both the crude and product side, has become an important part of our overall consulting practice and our industry studies.  We are currently in the process of preparing our next editions of the Crude and Refined Products Outlook (C&RPO) and the Worldwide Refinery Construction Outlook (WRCO), both of which are scheduled to be released in late January or early February 2018.  In each of these reports, we provide significant and detailed forecasts of petroleum markets, including both crude and product prices, crude and product supply/demand and analyses of all the factors influencing those items. More information on these publications and our other work involving oil industry developments and dynamics can be obtained by contacting either one of us, visiting our website at turnermason.com or calling Cindy Parker at 214-754-0898.