Markets Have Devalued Oil Prices: How Long Will it Last?


Comparative inventory: The most important approach to oil & gas price formation

  • Comparative Inventory (CI) is the difference between current stock levels of crude oil and select refined products, and their 5-year average
  • CI has accurately predicted most of the changes in oil pricing since the 1990s when inventory data first became public
  • This is the context for understanding the near- to medium term direction for supply, demand and prices

Markets devalued WTI and Brent ~35% during the last year

  • Mid-cycle price for 2014 to mid-2017 was ~$75-85 but a new yield curve has developed with mid-cycle price of $60-70 but more significantly, with a much flatter trajectory than the previous yield curve
  • August OECD CI of -56 mmb corresponds to a Brent price of $72.53
  • A similar CI for June 2014 of -58 mmb corresponds to a Brent price of $111.80
  • That represents a 35% price devaluation
  • 1995-2004 price cycle had a flat yield curve trajectory
  • Despite very negative CI levels, prices remained correspondingly flat
  • This was based on market sense of supply security
  • Market devalued price of WTI partly because US oil rig count tripled (2.9x) from 193 to 568 rigs at prices less than $60/bbl from May 2016 to April 2018
  • Producers have been claiming profits at successively lower breakeven prices since the 2014 price collapse
  • Markets hate to overpay
  • Tight oil production returned to pre-oil price-collapse peak level (4.1mmb/d) at WTI prices of $47-53/bbl by July 2017
  • Markets take that as confirmation that adequate supply will be available at relatively lower oil prices than before the 2014 collapse
  • Output has continued to increase at prices less than the lowest levels from 2011-2014

Managed money has been unwinding net long positions

  • From mid-June 2017 to Jan 2018, net long positions increased +615 mmb for WTI crude and products, and +776 for WTI and Brent
  • Brent & WTI net long positions have fallen -335 mmb since January 2018
  • WTI crude + refined product net long positions have fallen -225 mmb since January 2018 and -104mmb since the week ending July 10
  • Despite high frequency price fluctuation, the overall trend is down

The US export party seems to be losing momentum

  • Distillate exports have been the cash cow driving US refined product exports
  • Distillates comprise ~17% of product exports
  • Distillate exports remain strong and above the 5-year average but have declined compared with record levels in 2017
  • Big drop off in exports to Mexico and Brazil where refinery expansions have occurred
  • Exports may increase again when Latin American refineries begin maintenance toward the end of the year

Distillate and gasoline inventories have been building

  • Distillate CI is -4.3mmb below the 5-year average but at the highest level since the week ending 3/30/18
  • Stocks and CI have increased dramatically since June
  • Gasoline CI is +17.6mmb above the 5-year average and at the highest level since mid-June 2017
  • Gasoline stocks have been flat-to-rising during the normal destocking period

Crude exports are lower but the Brent-WTI differential sends another message

  • Crude exports remain strong but have fallen sharply from 2-3mmb/d level from April through July
  • At the same time, Brent-WTI premium vs. 5-year average is up from $0.13 to $3.43 since week ending August 2017
  • Premium increased +4.46 from $3.67 to $8.13
  • These changes reflect increased market concerns about supply security
  • This could mean increased US exports on the horizon
  • Yet foreign refiners have begun to understand the limitations of high gravity US crude

WTI and Brent spreads are moving in opposite directions

  • WTI 6-month calendar spreads and front-month prices are falling
  • Brent spreads and price are generally increasing
  • WTI spreads have fallen -$6.78 since July 8, from $7.77 to $0.99
  • Brent spreads went into contango in July but have increased from -$0.81 to $1.95 in August and early September
  • Increasing Brent backwardation and positive pricing relative to WTI reflects supply security concerns

Markets have been sensitive to supply concerns in recent weeks

  • Price rally that began in mid-August reflected renewed market concerns about tighter world supply
  • This is an artificial problem created by US sanctions on Iran but real nonetheless
  • Iran, Nigeria, Libya & Venezuela production has fallen 1 mmb/d since January and 0.5 mmb/d since May 2018
  • Saudi Arabia, Kuwait & UAE have increased production 542 kb/d since April but there is considerable doubt about true spare capacity
  • Maximum output was 16.84 mmb/d just before the 2016 production cuts
  • If that represents spare capacity then, there is little left to overcome tighter supplies in the future

Closing thoughts and observations

  • Oil fundamentals are only part of the story – the global economy is the main factor going forward
  • US interest rates are of 1.9% are 15x higher than the average 0.12% from 2009 through 2015
  • Emerging markets are taking the blows for now & Oxford Institute for Energy Studies places global economic growth risks above geopolitical risk or shale growth risks for oil price
  • Oil supply threat from Iran probably over-stated: sanction relief likely and Iran will find ways to export crude through Iraq & black market
  • OPEC spare capacity may be greater than assumed
  • It is critical to recognize that oil markets remain in a period of secular deflation that began in 2014

Art Berman – Labyrinth Consulting Services, September 20, 2018

Image Source: Quandl & Labyrinth Consulting Services