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Oil Fundamentals, Market Sentiment, Data Lag, and Constructive View of Oil Market

Open Square Capital 1Q17 Letter, March 31, 2017

Oil

  • OPEC and Non-OPEC agreed to reduce oil production by approximately 1.7M bpd in a series of agreements last year
  • Initial six month cut should have rebalanced the market and lowered inventories to its five-year average, and this potential outcome led oil prices to end 2016 on a high note; 3 factors, however, forestalled the rebalancing and temporarily sidetracked oil prices in Q1
    • OPEC overproduction
    • Refinery maintenance
    • Offshore inventory destocking
  • OPEC overproduction:
    • OPEC and Non-OPEC participants separately increased production leading up to and immediately after the Vienna Agreement as part of their negotiating strategies to “cut” from a higher level of oil production and to front-run impending oil quotas
    • Production spiked in 4Q16 – eventually, these extra barrels would show up as higher imports and inventories at the beginning of the year
    • Physical oil takes time to travel from the source to the market – oil consumed today was largely produced a few months ago
      • Normally, this time lag isn’t much of an issue, but with hyper-scrutiny on inventory levels after the Vienna Agreement, market fixed its attention on US inventory data
    • Refinery maintenance:
      • Planned refinery outages in the US were much higher than normal in 1Q thus tempering crude demand
      • Refinery outages will progressively decline in Q2 and when brought back online, oil draws will accelerate the destocking
    • Offshore inventory destocking:
      • As the market rebalances, oil kept in offshore floating storage will work its way back onshore and show up in inventory data
      • In Q1, offshore stocks worldwide halved and some of this came onshore in the US
      • Morgan Stanley recently stated that floating inventory has decreased by 72M barrels in the past few months
      • Quick background: when supplies exceed demand, the spot price for oil becomes cheaper than future prices (contango) – traders capture this spread by buying oil today and simultaneously selling a futures contract; trader then rents space to store oil until delivery; when supplies tighten, price curve enters backwardation and traders abandon the trade and oil stored offshore destocks and onshore inventory rises
    • Regardless of the reasons, nuances were lost on the market – when met with higher inventory figures in March, oil market sold off
    • For all the drama, believe the price action makes little sense, and much of it is sentiment driven
    • Oil market and supply chain is exceedingly complicated, and while rebalancing will take time, it will occur
      • Fundamentals drive sentiment, not the other way around
      • Recent air pocket only helps the oil market rebalance faster as it discourages needed investment

Oil Fundamentals

  • Oil data is a mess: it’s opaque and incomplete because countries clutch their data tightly for competitive and national security reasons
    • No matter the source, frequent “true-ups” are made to the data when new information is available or when things need to balance properly
  • US represents only a tenth of global supply and demand, so a singular focus on US data can distort your perspective on the underlying trends
  • Those who suffer together, stay together:
    • General consensus is that there are 285M barrels of excess oil in storage and the Vienna Agreement was designed to whittle down the excess in 2017
    • Market pundits originally predicted OPEC’s compliance would hover around 60-70% – however, it has been exceedingly high
    • High compliance rates are not surprising with the severity and length of today’s oil price declines – many countries can’t fulfill their political promises at $40-50/bbl
  • Inventories:
    • Even without the Vienna Agreement, it’s becoming clearer that oil inventories are drawing down
    • IEA and EIA data have been reporting a glut of oil because supplies have exceeded demand in 2016, yet if supply/demand figures were correct, inventories should have increased substantially
      • Opposite is occurring which likely means IEA and other agencies may have underestimated demand
    • According to IEA report, OECD inventories have been decreasing by ~700k bpd since August 2016
    • If supplies actually exceeded demand, where’s the extra 250M barrels (e.g. equivalent to 125 large supertankers)? It’s likely these “missing barrels” don’t exist and will be cleared when IEA adjusts its demand figures
    • We believe that oil market was already balanced by mid-2016 and since then, demand has eclipsed supply
    • OECD crude inventory only increased in January and February by 61.5M barrels – this is despite US inventories increasing, OPEC’s overproduction, floating storage destocking of over 70M barrels and higher refinery outages: this likely means that underlying inventory draw has carried over from 2016 and should accelerate in 2017 when Vienna Agreement impact is felt and temporary factors masking the decline fades away
  • International production:
    • Oil producers can keep pumping at high volumes, but that increases depletion rates, or pump at lower volumes to stem depletion and preserve the reservoir, but that increases decline rates
    • Low oil prices means many producers have elected to keep pumping at high volumes (need the cash), but that sacrifices longevity of their reserves
    • As we enter 3rd year of low prices, there’s just not enough capital to even stem decline rates let alone depletion
    • While rig counts recovered dramatically in the US, rig counts worldwide have remained at all-time lows
    • US production accounts for about 10% of worldwide production – with international rig counts hovering near all-time lows, many of these countries will be subject to faster declines simply because new wells are not being drilled
    • US production will increase – but the 400k bpd of US production increase has already inflated service costs which will cap US production growth; also, global demand is expected to rise 1.4M bpd
      • It’s ill advised to think that 10% production base (US) alone can make up for falling international production in the next few years
    • Third year of low oil prices:
      • There simply isn’t any profit at $45-55/bbl to reinvest and stem both decline and depletion rates
      • As temporary factors impacting US inventories wear off, market should begin to turn and focus on the bigger picture
      • Anticipate inventory draws will approach 1M bpd for the entire year and inventories will be slightly below the 5-year average by year-end – draws will, however, accelerate thereafter in 2018-2019
      • Data lag effect will work both ways – it took time before oversupplies showed up in the data and it’s taking time before the undersupply will as well
Image Source: QuIntIQ, Open Square
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