Fundamentals Point Toward Oil-Market Balance: IEA Too Pessimistic

Posted in The Petroleum Truth Report on January 21, 2016

Fundamentals point toward market balance but pessimism is dragging oil prices down. IEA has apparently succumbed to this negativity but their data suggests that things are getting better, not worse.

In a business-as-usual world in which nothing unusual happens, the world will be close to market balance some time in 2016. If anything unusual happens, all bets are off and oil prices could rebound much faster than anyone imagines.

Just to be clear, I continue to believe that oil prices must fall further in order to modify producer and capital-provider behavior and thus prepare the way for some kind of meaningful market balance to occur and I don’t see that happening any time soon.

Fundamentals are moving slowly in the right direction toward market balance.  Imbalance will persist for some time and a meaningful price rally—that is not taken away when reality forces its way back upon the markets—cannot occur unless/until supply and demand are approaching balance.

A Year of Extreme Price Cycles

NYMEX WTI futures prices have fallen 34% since October 2015, and are below $30.00 per barrel for the first time since 2003. Prices have gone through four cycles of 30-40% increases and decreases over the past year (Figure 1).

Chart_2015 NYMEX Price Cycles
Figure 1. NYMEX WTI futures prices and price cycles in 2015. Source:  EIA, Bloomberg & Labyrinth Consulting Services, Inc.
(Click image to enlarge)

The two price rallies from March-to-June and from August-to-October were based largely on hope and the price decline from June-to-August represented a return to the reality of supply and demand fundamentals.

The most recent price decline that began in October is a bit different. Here, confirmation bias has replaced critical thinking about the oil market. The ruling paradigm is that prices are likely to stay low for years or even for decades and evidence is easily found that favors and confirms this bias. I believe that this paradigm is incorrect.

Despite troubling signals of structural weakness in the global economy, data suggests that the oil market is stumbling toward balance. Although I have said that prices must go lower in order to flush out the zombie producers,  IEA’s statement in the January Oil Market Report that the world could drown in over-supply is based more on sentiment and pessimism than on data.

Stumbling Toward Market Balance

The best way to show this is by using both IEA (International Energy Agency) and EIA (U.S. Energy Information Administration) data. Each has its advantages and disadvantages. IEA data estimates demand—oil use (consumption) plus stock increases—whereas EIA only estimates consumption, a proxy for demand. EIA presents monthly global liquids data while IEA only presents quarterly data. EIA forecasts both supply and consumption a year forward whereas IEA only forecasts demand. Together, the two provide a reasonably full view given the difficulties and uncertainties involved.

IEA data shows that global over-supply (supply minus demand) of liquids was 1.83 mmbpd (million barrels per day) in the 4th quarter of 2015 (Figure 2). Although that is an increase of 250,000 bpd over the 3rd quarter, it represents a 530,000 bpd decrease compared with the second quarter, the highest level of over-supply since the price collapse began in mid-2014.  Furthermore, the 6-month moving average (1H MA in Figure 2) of market balance shows that the production surplus is decreasing.

Chart_Market Balance-Brent

Figure 2. IEA World liquids market balance (supply minus demand) and Brent crude oil price. Source: IEA & Labyrinth Consulting Services, Inc.
(Click image to enlarge)

Total supply actually decreased somewhat in the 4th quarter, and it was the seasonal decline in demand that increased market balance. I am not trying to make a case that things are great but simply that the data indicates that things are moving slowly in the right direction.

EIA’s monthly data shows that market balance is clearly improving with a decline of almost 1 mmbpd in supply surplus from August (2.51 mmbpd) to December (1.55 mmbpd) (Figure 3). The 4-month moving average (4 MMA in Figure 3) reinforces the observation that the over-supply is decreasing.

Chart_Market Balance-Brent

Figure 3. EIA Market balance  vs. Brent crude oil price. Source: EIA & Labyrinth Consulting Services, Inc.
(Click image to enlarge)

Much of IEA’s negativity is because of lower forecasted demand growth of 1.2 mmbpd in 2016 (Figure 4). This is based largely on pessimism about China’s unstable economy and declining oil demand, discouraging economic expectations in the developing world, and renewed Iranian production.

Chart_Annual Demand Growth

Figure 4. IEA annual liquids demand growth and 2016 forecast. Source: IEA & Labyrinth Consulting Services, Inc.
(Click image to enlarge)

Let’s put this in context. 1.2 mmbpd is disappointing only compared with 1.7 mmpbd in 2015 but that was the highest demand growth in 5 years. 2016 demand growth is more than the average for 2011 through 2013 when oil prices were more than $100 per barrel, and is one-third higher than in 2014 when the oil-price collapse began.

Annual consumption growth data from EIA (Figure 5) offers a somewhat different perspective suggesting a progressive increase since 2013.

Chart_ANNUAL YOY CONS

Figure 5. Annual demand growth and 2016 forecast, and Brent crude oil price. Source:  EIA & Labyrinth Consulting Services, Inc.
(Click image to enlarge)

What conclusions might we reach from this? If we assume that supply remains flat and IEA’s forecast of a 1.2 mmbpd increase in demand is reasonable, the supply surplus should fall to approximately 350,000 bpd. That does not include the wild card of Iranian production.

That is where EIA’s forward estimate of both production and consumption is helpful because Iranian production is included (correctly or incorrectly). Figure 6 shows improving market balance using a 6-month moving average of supply minus consumption to smooth through the month-to-month variations that have characterized market balance since the oil-price collapse began.

Chart_6MMA MARKET BALANCE-BRENT

Figure 6. EIA market balance (6-month moving average) and Brent crude oil price.  Source: EIA & Labyrinth Consulting Services, Inc.
(Click image to enlarge)

Using this approach, the world liquids supply surplus should decline to approximately 730,000 bpd by the end of 2016 (Figure 7). That would be a decrease in supply surplus of about 1 mmbpd from year-end 2015. This suggests that Iran may add an average of 400,000 bpd in 2016 which seems reasonable although it exceeds EIA’s recent reference case estimate of approximately 300,000 bpd.

Chart_MARKET BALANCE-BRENT_Annual
Figure 7. EIA market balance (supply minus consumption) vs. Brent crude oil price. Source: EIA & Labyrinth Consulting Services, Inc.
(Click image to enlarge)

Finally, the Oil and Gas Journal has provided an analysis and forecast of world liquids production that is more optimistic than either EIA or IEA (Figure 8).

OGJ Chart_Supply-Demand
Figure 8. Oil and Gas Journal world liquids supply and demand and 2016 forecast. Source: Oil and Gas Journal & Labyrinth Consulting Services, Inc.
(Click image to enlarge)

Their forecast calls for world liquids market balance by mid-year 2016.

The World Is Not Drowning In Oil

The analysis that I have presented assumes the improbable namely, that nothing unusual happens in 2016. In a business-as-usual world, the oil market will be close to balance this year.  The liquids surplus will be about a million barrels per day less than it is today. The world will not be drowning in oil a year from now.

What might happen to complicate this outcome? A supply interruption in the Middle East is likely based on current events in that region. The failure of some large producing nation or a group of smaller nations to maintain production at current prices or because of lack of capital investment is possible. Greater decline in U.S. production than assumed is probable especially after the disastrous full-year financial data is released beginning next month. OPEC and Russia will probably cut production in 2016.

Any of these scenarios or combination of scenarios would affect the oil-market and would probably accelerate movement toward market balance and higher oil prices.

Opinion suggests that little progress has been made in reducing the over-supply of oil in the world and the momentum of pessimism points toward low prices for years to come. Data points toward a different outcome in the relatively near-term.


Comment on this article

Required fields marked with *

21 comments on this entry


  1. Art,

    Thanks for another fantastic post! I always love your charts and graphs.

    This is a rare case where I disagree with you, at least in the very short term. I contend that CUSHING INVENTORY has been the biggest short-term driver of oil prices. In fact I’m convinced that the primary reason that crude is bouncing so vibrantly last two days is that the CUSHING inventory build was tiny, even though the total build was double expectations.

    When you stop and think about it, that makes perfect sense. What is it, really, that stops the front-month price from falling to $5 just before expiration if there aren’t enough buyers? The answer of course is that spreaders step in, take delivery of the front month, and sell it forward the next month, pocketing the contango for their trouble. If those guys can’t use Cushing for storage, their trade is hosed. Yeah, sure, they could truck or rail the oil out of Cushing and find a tank elsewhere. But adding all that logistic complexity and cost usurps the whole point of the trade unless the contango goes crazy-wide.

    In short, downside “washout risk” in a panic is a function of available CUSHING storage preventing a panic-selloff of front-month futures just before expiry. THe closer we get to Cushing tanks being full, the higher the risk and the more the downside pressure.

    Check out the last several weeks of DOE reports if you don’t believe me. Most people assume that price movements should be most strongly correlated with TOTAL inventory and domestic production. But in reality the correlation has been to CUSHING’s inventory build/draw numbers more than any other factor.

    I do agree that this should end soon – I’ll be very surprised if the bottom is not in before the first half of 2016 is out. But for the next 4-8 weeks, I think we’re headed for new lows, especially if Cushing builds resume in earnest as I expect they will.

    Best,
    Erik


  2. Erik,

    Thanks for the interesting comments and analysis. I think, however, that you misunderstand my point.

    My point that the title of the post reflects is that IEA is being too pessimistic when they declare that the world oil market could drown in oil.

    I am not arguing that oil prices are going to rally but am pointing out that fundamentals are moving in the right direction slowly. I am saying that the market imbalance will persist for another year at least based on the best forecasts available to me (although Oil and Gas Journal suggests that market balance will be reached by mid-2016). A meaningful price rally, that is not taken away when reality forces its way back upon the markets, cannot occur unless/until supply and demand are approaching balance.

    I say that there are factors that might cause oil prices to increase sooner and more quickly than simply allowing market forces to adjust the imbalance. These include an OPEC production cut, a supply interruption in the Middle East, or a faster-than-expected decline in U.S. tight oil production.

    Barring those possibilities–and I think any of them are quite likely, by the way–prices should continue to do what they have done since October namely, fall further and bounce around based on news that only peripherally affects supply and demand like EIA weekly oil storage reports, perception of Chinese economic weakening, Euro debt crises, Federal Reserve pronouncements, etc.

    Just to be clear, I continue to believe that oil prices must fall further in order to modify producer and capital provider behavior and thus prepare the way for some kind of meaningful market balance to occur and I don’t see that happening any time soon.

    I understand your focus on Cushing inventory but last week’s build was even smaller than this week’s. That doesn’t really fit your model very well. I’m not disputing your observation, just saying that it’s not exactly the perfect fit that you claim.

    All the best,

    Art


  3. Art, I will echo what Erik says. We know that markets look ahead, but how far ahead? The situation now has no equal in your excellent charts. A price rally now would only serve to push back the day equilibrium is reached. And I don’t believe there is enough blood on the ground yet.

    However, I can declare self interest here. I’d be hoping to pile into the market sub $20 and so why would I buy at $30 when I would have fear of $20 ahead? If the market doesn’t go sub $20 that will be opportunity lost which I will be philosophical about.

    And by email I sent you this:

    “Looking forward we can say with absolute certainty that without any spare capacity the oil price volatility will be massive.”

    Which I’d tend to agree with. Once the surplus is gone and once the storage tanks are being emptied scarcity will return and the price will spike. Don’t know how high. The days of OPEC simply turning taps seem to be over. Their ±2.5 mbpd will be difficult for OECD suppliers to emulate.


  4. Euan,

    Thanks for your comments and for the email interchanges over the past day. You make many excellent points along with Erik that I do not dispute.

    What I dispute is IEA’s statement and the general pessimistic view that the world oil market could drown in oil over-supply. That is a vast over-statement of reality based on any reasonable data including IEA’s own data.

    As I wrote to Erik, “I continue to believe that oil prices must fall further in order to modify producer and capital provider behavior and thus prepare the way for some kind of meaningful market balance to occur and I don’t see that happening any time soon.”

    I do not foresee a true price rally until this happens and balance is closer even than the 750 kbpd liquids surplus that I suggest may be the case by year-end 2016.

    All the best,

    Art


  5. @Art

    Now that you’ve clarified your intended meaning, we are in violent agreement. This thing is in the 9th inning, but it ain’t over. You are absolutely correct that a reversal of OPEC (read: KSA) policy would change everything overnight, instantly. No argument there. But so long as KSA maintains course and speed on their strategy, the price has to come down more to force the needed supply destruction.

    @Euan

    I too plan to “pile in”, both in my personal accounts and in the fund I manage, starting in the low $20s and very aggressively if we see teens.

    But just a word of caution in case you haven’t stopped to really ponder this… What precisely do you mean by “pile in”? FWIW, I already have north of 500 hrs of analysis time into designing my “pile in strategy”, and frankly it still feels rough around the edges. This is neither obvious nor easy. If we really do see front-month futures in the teens (I think we have a 50/50 chance of that), I can practically guarantee you that the only way it will happen is with a very steep contango in the prompt time spread.

    So buying that front-month futures contract when you perceive it to have bottomed is probably a really bad idea. You’d likely be giving up several dollars per month to contango roll premia. Better to choose one of the longer-dated contracts that should be immune to extreme contango at the very front of the curve. But which one? I’ve spent months pondering the contract selection issue and now have a plan, but I’m also the first to admit it’s subject to change in an instant becuse the market dynamics change so fast.

    But then even if you liked (for example) the 2017, 2018, or 2019 futures to avoid the contango problem, you have to also remember that eventually prices are going up and we’ll move back to a backwardation term structure. As that starts to happen you don’t want to be in those long-dated futures. You want to ride the front-month as it ascends out of deep contango into backwardation. Rolling the front-month could easily produce double the return of holding the long-dated futures, but only after the upside momentum starts. So one of the pillars of my pile-in strategy is that when I perceive the market to be bottoming, that means time to buy LONG-DATED futures. When a clear up-trend is in place, it’s time to reverse-roll those long-dated positions back into rolling front-month exposure.

    Meanwhile, calls on the long-dated futures will also be very attractive, but not when the market bottoms. That will happen in an environment of extreme vol, and will be concentrated at the front of the curve. If you want long-dated futures, you need to wait for the back of the curve to collapse and for what should be record contango to start to abate. So back months should bottom after front-months. But it all happens in a record vol environment, which is the worst imaginable time to be buying calls. So now you have to think about an overweight entry to the outright futures (to catch the price bottom), but then wait for implied vol in the options to settle down before converting some of those outrights to long calls, perhaps with more leverage. This is a very complex puzzle with a lot of moving pieces.

    Maybe you meant pile into oil-related equities? I think that would be a mistake too. The bottoming of the oil price should CAUSE a wave of bankruptcies and distressed acquisitions in the shale patch. The bloodbath in equities should come with the bankruptcy wave, and that won’t happen until a few months after prices bottom. The decision of what to buy in the equity space is also very complex. Shale companies will be hit hardest, so from a value investor’s perspective, that’s the place to play. But frankly I don’t think it’s the smartest focus. Shale will recover some day. When is really hard to say – depends on too many factors. But I think the service companies (i.e. OIH) are going to be busy doing something for someone, so they seem attractive. There should be more upside in the RIGHT oil companies themselves, but knowing which are the right ones will be very hard.

    Euan, I know you’re a super smart guy (I follow your blog), and I certainly don’t mean to speak down to you; please don’t take it that way. My point is simply that I too started with the simple idea of “Pile in at $20”, then realized that translating that emotion into an actual trading strategy is a BIG job. My point is only to encourage you and others to start thinking carefully and in detail about how, precisely, you plan to ‘pile in’.

    All the best,
    Erik


  6. Erik and Euan,

    I have taken your comments to heart and have updated the beginning of the post to clarify that I am not calling for a price rally and that prices must fall lower in order to modify producer and capital-provider behavior before market balance can be restored.

    Best,

    Art


  7. I have just read an article in the Daily Telegraph (Saudis ‘will not destroy the US shale industry’), which says that there is $60 billion of investment money just waiting for the frackers to all go bankrupt. They will buy up the assets cheaply, wait for a rise in oil prices before they restart oil production and then make a fortune.

    Seems highly unlikely to me. And no mention of the investment companies that are currently losing money as the frackers go bankrupt.


  8. Trevor,

    There is considerable concern about credit exposure to the shale companies. I had 15 top analysts from the New York banks in my office a few weeks ago and they are worried. This recent article in Zero Hedge over-states the danger somewhat in my view but, nevertheless, conveys a reasonable sense that this is not a trivial matter.

    Beyond those already in bankruptcy, many shale companies will go bankrupt and still more will be acquired or merged into existing E&P companies. That will not end tight oil production.

    I don’t doubt that there is plenty of money from geniuses that think that buying low and selling high is a great idea that only they have figured out! It would never occur to them that Exxon and other majors have been thinking about that kind of thing since before they were born.

    My advice to them–good luck owning an oil company and trying to make money!

    I guess the advantage going forward would be if there was no debt but how many of these guys are going to buy a failing shale company out of their own cash? They will owe someone money. How, then, are they better positioned to make money than the present owners except that they have no experience running an oil company? Brilliant!

    All the best,

    Art


  9. Shouldn’t the decline of “excess supply” from U S shale mimic the decline we see from the decline curve on those type production curves?


  10. Tim,

    Only if no new wells are completed.

    Art


  11. Very useful article and good comments.Thank you all.
    I’m far from as skillful as you boys are but I’ll throw in my non-professional opinion anyway.

    @Eric
    I doubt the lesser than expected increase in Cushing oil inventory was the main reason for the surge in the oil price. The increase was global.
    But I noticed that the negative spread ($Brent/$WTIC) was erased. As the opening of the export market for US crude was already discounted in the price, your argumentation could be the reason. Anyway should we not be able to check this, the moment the cushing inventory for this week is published?
    My bet goes to plain short covering, just like natural gas recently.

    Even a non-professional needs a strategy, but a far more simple one than Eric’s.

    Briefly
    I cannot time the bottom and therefore will accumulate shares of oil companies during the decline. A first small initial position was taken last week (serves more as a reference). Now I have to wait for the losses on my initial position to appear. The bigger they are the more I’ll buy (if the fundamentals of the C° remain the same). Ideal would be to see a divergence where the prices of oil companies rise while the oil price still falls (have you noticed how tight both move).

    Oil companies with sustainable debt, good reserves, low operating costs, … (I like investments in the NCS … geopolitical motives included). The upward potential for these companies looks as good as for shale companies with distressed prices but the risk and complexity of selection is lower (and I will only to have a look at my investments once every quarter).

    I also doubt oil prices will fall below $20. There are a lot thirsty oil animals running around and as Art points out even more drought (lower prices) would kill them and balance the market. Another possibiity is time. In the end an oil price between $ 25-35 will annihilate the weak too. I bet on lower prices around $25 with more time to sanitize the market. I would neither be surprised that OPEC unofficially targets this price (worries about sovereign credit) and investors will anticipate the sanitasation. Is this the wall of worry or will China change it all. Who knows?

    A last item that bothers me. What about tar sands? More than 2 Mbpd, huge upfront costs, a high operating cost (Suncor published $27) and WCS at $15 per barrel.
    http://www.cmegroup.com/trading/energy/crude-oil/western-canadian-select-wcs-crude-oil-futures.html
    I don’t get it.


  12. GV,

    Thanks for your comments. I would be careful if oil sands operating costs are reported in U.S. vs. Canadian dollars considering the 30% difference today. $15 per barrel sounds too low to me.

    All the best,

    Art


  13. My comment on the decline right shale production presupposes that very few wells will be drilled at these prices because they are not economical. I guess I am assuming it takes a minimum of $65 a barrel for Shale drilling to continue. Unless the completions you are talking about is the Frac log or backlog of wells drilled but not completed?


  14. Tim,

    The number of producing wells in the 3 big tight oil plays continued to increase until October because the companies still had other-people’s-money to spend. The number of new wells drilled should start to decline more sharply at current prices but there will be a lag before this affects production.

    We get better reporting on the Bakken than the other tight oil plays because the North Dakota Dept. of Mineral Resources has less to do than the Texas Railroad Commission. There are still almost 1000 Bakken wells waiting on completion, about 7% of the producing well population, and production has only declined 51,000 bopd since December 2014.I assume that a similar proportion of WOC wells exist in the other plays as well.

    All the best,

    Art


  15. @ Art
    Yes CAD or USD.
    I only noticed that quite late during my analysis and as I went for a search I bumped into this table (page 12) http://www.suncor.com/pdf/2015-Q3_Suncor_QuarterlyReport_English.pdf
    The price difference between WTI and WCS seems to fluctuate between 13 and 20 USD bbl. Therefore $15 for a barrel seems possible.


  16. Great analysis Art.

    I am not convinced that we are going to see a meaningful number of bankruptcies unless current prices persist for several years, which I consider unlikely for all the reasons enumerated by Art. There are simply too many companies, on both sides of the border that have relied on HY bonds rather than conventional bank debt to fund their drilling programs. Typically the bondholders have no recourse other than in the event that interest goes unpaid so consequently, the producers will do whatever it takes to make sure that does not happen. If they have to sell midstream assets to generate cash, that’s what they will do.

    When you have a debt/cash flow ratio in the 8-12 range as many do, you are essentially insolvent. On the other hand, if the debt maturities are stretched out until 2019/20 (as is frequently the case), you can survive as long as you can service the debt. The motivation is to keep pumping as much as possible to generate whatever cash you can until a price recovery takes hold. I dont expect to see many defaults.


  17. DDH,

    I have cautioned for some time that expectations of widespread bankruptcies and panic in the E&P business are over-stated. It is all in accordance with the old adage about who really has the problem when debt is great, the creditor or the debtor.

    Thanks for your comments,

    Art


  18. Art, I’m trying to understand the technical side of oversupply. The approximately 1.5 mb/day that has no buyer ends up sitting in storage and the producers have to pay storage until it eventually sells which could be a long time. I understand that shutting down a well is problematic, but is it not possible to just dial down the output? Why are the only choices either full on, or full off? A small reduction in oil flow would save the storage costs.


  19. Art,

    I am trying to figure out US numbers and I think you are the one that can tell me what I’m doing wrong. If we take the latest EIA report and take refinery inputs of 15.6 MMBO x 7 days = 109.2 MMBO for the week. Add in a build of 7.8 MMBO and you get 117 MMBO/week oil supply. Then you back out imports of 8.3 MMBO/day (58.1 MMBO/week) and you’re left with 58.9 MMBO/week that presumably came domestically. That number translates to 8.4 MMBO/day which is far less than the 9.2 the EIA is reporting. What am I doing wrong?

    Thanks,
    Todd


  20. […] to be skeptical about these new revelations but reports by both groups have been pointing toward improving market balance for some […]


  21. […] be skeptical about these new revelations but reports by both groups have been pointing toward improving market balance for some […]