Oil Prices Plunge: Over-Reaction or Turning Point?

Posted in The Petroleum Truth Report on March 9, 2017

Oil prices plunged yesterday. Is this an over-reaction or a turning point?

WTI futures fell $2.86 from $53.14 to $50.28 per barrel, and Brent futures dropped $3.81 from $55.92 to $52.11 per barrel. WTI is trading below $49 and Brent, below $52 per barrel at this writing.

The official narrative was that a larger-than-expected 8.2 million barrel (mmb) addition to U.S. crude oil inventories pushed prices lower. That explanation is not consistent with larger recent additions to storage that had little effect on oil prices. The timing of the price slump also seems to be at odds with positive developments in the global market balance and demand growth.

Something more fundamental is happening. In part, the price slump reflects a growing realization that the OPEC production cut is unlikely to quickly resolve the problem of outsized global oil inventories. Perhaps more importantly, a major downward shift in the term structure of oil futures contracts suggests that headwinds in the global economy are driving the end of the present oil-price rally.

Over-Reaction

The drop in prices was an over-reaction to recent storage data based on history since the OPEC production cut was finalized in late November 2016. WTI has fallen below the $50 to $55 per barrel range in which oil futures have traded for the last 3 months (Figure 1).

Figure 1. Oil prices have not exceeded $55 per barrel since early 2015. Source: EIA, CBOE and Labyrinth Consulting Services, Inc.

An 8.2  mmb addition to crude oil storage is actually fairly normal during the annual re-stocking season that we are in now (Figure 2). Inventories increased more–10.4 mmb–during this week in 2016 and the 5-year average for this date is 5.3 mmb.

An 8.2 million barrel addition is fairly normal for re-stocking season. Source: EIA and Labyrinth Consulting Services, Inc.

The fact that inventories have been in record territory since the beginning of 2015 has not kept oil futures from going through several rallies or from trading near $55 per barrel since November. The 13.8 mmb addition to storage a month ago was larger than yesterday’s amount yet prices barely responded.

Comparative inventory–the crucial price indicator–only moved up 2.4 mmb (Figure 3). That is because we are in the re-stocking season and compared with previous years, this addition to storage is not that big. Other key measures of gasoline and diesel volumes fell by more than 1 mmb each.

Figure 3. Comparative crude oil plus refined products inventory increased only +2.4 mmb. Source: EIA and Labyrinth Consulting Services, Inc.

And there was some good news this week that the markets ignored. EIA’s Short-Term Energy Outlook (STEO) showed that the global market balance (production minus consumption) moved to a deficit last month. The world consumed almost a million barrels more than it produced in February (Figure 4).

Figure 4. The world liquids market balance (production minus consumption) was -1 mmb/d in February 2017. Source: EIA March 2017 STEO and Labyrinth Consulting Services, Inc.

This is a one-month data point and should not be seen as a trend. Still, it is a positive sign that seems to have been overwhelmed by an otherwise normal addition to U.S. storage.

The March STEO also had good news about world demand. Average liquids consumption growth for 2016 was 1.5 mmb/d and 1.6 mmb/d for the first two months of 2017 (Figure 5).

Figure 5. 2016 global liquids consumption growth: +1.5 mmb/d, early 2017: +1.6 mmb/d. Source: EIA March 2015 STEO and Labyrinth Consulting Services, Inc.

In mid-2016, there were indications that consumption was only growing at only about 1.2 mmb/d but particularly strong year-over-year performance from August through January have brightened that outlook.

Turning Point

Although yesterday’s price plunge may have been an over-reaction, it may also represent a turning point for prices to adjust downward.

I have written for months that global oil inventories must fall before prices can make a sustainable recovery yet they remain near record levels. OECD inventories fell 15 mmb in February but are nearly 550 million barrels above December 2013 levels (Figure 6).

Figure 6. OECD incremental liquids inventories are near record high levels. Source: EIA and Labyrinth Consulting Services, Inc.

Brent was probably $10 over-valued at $55 and WTI was at least $6 over-valued at $54 per barrel as Figure 1 shows.

The other negative weighing on oil prices is the increase in U.S. crude oil production. Output has increased 420,000 b/d since September and EIA forecasts that it will exceed 10 mmb/d by December 2018 (Figure 7). That is higher than 1970 peak production and 1.1 mmb/d more than current levels. In short, this would more than cancel the U.S. decline since oil prices collapsed in late 2014.

Figure 7. EIA U.S. crude oil forecast is 10.1 mmb/d and $59 WTI by December 2018. Source: EIA March 2017 STEO and Labyrinth Consulting Services, Inc.

There has been a change in the term structure of futures contracts since the OPEC production cut was finalized. In the last week, the maximum WTI near-term price has fallen $2.81 to $51.36 per barrel and prices do not reach $52 until mid-2021 (Figure 8).

Figure 8. The term structure of WTI futures contracts has changed. The maximum near-term forward price has fallen $2.81 per barrel in the last week. Source: CME and Labyrinth Consulting Services, Inc.

The term structure of Brent futures has changed also. Near-term forward prices have fallen $3.39 from a week ago to $53.15 per barrel then, fall and do not reach $53 again until late in the third quarter of 2020 (Figure 9).

Figure 9. Figure 8. The term structure of Brent futures contracts has changed. The maximum near-term forward price has fallen $3.39 per barrel in the last week. Source: CME and Labyrinth Consulting Services, Inc.

Although the forward curve of futures contracts is hardly a predictor of oil prices, it appears that a major downward shift in oil prices is occurring. This reflects something far more consequential than a higher-than-expected U.S. crude oil storage report.

Over-Reaction or Turning Point?

In part, this week’s price downturn reflects waning confidence that OPEC production cuts will result in higher prices. Much of the discussion until now has centered on whether OPEC will deliver on the announced cuts or if output increases by Libya and Nigeria will offset those cuts.

There seems to be a growing awareness that global oil markets are incredibly complex, and that there are so many moving parts that a single, simple solution is unlikely.

The problem may be about expectations. Many believe that the OPEC cuts will increase prices but the cuts may be more about establishing a floor under those prices.

There is no good reason why a normal addition to U.S. inventory should affect prices so much. The timing of this price adjustment may be an over-reaction but the direction may also represent a turning point.

A larger issue is the inexorable relationship between stocks and prices. It’s not so much about this week’s change in inventory. It’s about how much inventory needs to be reduced and how long that will take in the most hopeful scenario.

If OECD stocks must fall by approximately 550 million barrels to support $70 prices, it will take more than a year to get there if production is cut by 1 mmb/d. If the production-consumption balance fluctuates, it will take even longer.

The change in the term structure of oil futures contracts suggests that causes for the recent price slump transcend oil market supply-demand fundamentals. Larger forces in the global economy are operating here. These may include reduced levels of credit creation that signal a slow-down in economic growth. If true, lower oil and other commodity prices are likely along with lower oil-demand growth.

For more than two years, the industry has believed that higher prices are possible without extreme reductions in inventories. Great expectations were placed in an OPEC production cut to rescue the industry from a weak oil market.The fallacy lies in thinking that the problem stems from a simple imbalance between production and consumption and is unrelated to a fragile and debt-dependent global economy.

That hope was a dream. It appears that oil markets have woken up from that dream.

 


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23 comments on this entry


  1. Great chart on 5 year inventories! If sentiment was really washed out, wouldn’t it be lower than 2016? If someone showed me that chart I would be under the impression that nobody in the industry was concerned about over supply. IF that can happen with the crash in stocks last year, what happens if oil goes to $65? Again I’m not an expert here, just asking because it doesn’t look like the industry tightened up supply during a time where there was a collapse. Thanks for the great analysis Art!


  2. Vince,

    When oil prices are lower in the future than they are today, there is incentive to store the oil. That has been the case since prices collapsed in late 2014 hence the increase in inventory.

    I don’t see oil prices getting anywhere close to $65 for some time based on fundamentals and on the change in the structure of futures contracts over the last few weeks.

    All the best,

    Art


  3. Art, I have a question unrelated to your email. Is it possible to build new or modify our existing refineries so they are able to process only the shale light oil, thus eliminating having to mix in the heavier crude? I’m wondering if the cost to build/modify is prohibitive, or if the physics (if that’s the right word) make it impossible, no matter how much you are wiling to spend? Or is it that the refiners figure we’ll run out of domestic light oil at some point? Thanks.


  4. Doug,

    Sure, it’s possible to expand light oil refining capacity. It just costs lots of money and takes time. The industry spent tens of $billions a few decades ago shifting from more light to heavier refining capacity. To now go the other way might cause a lot of questions about how long this tight oil production is going to last. The life of a refinery is decades.

    My guess is that as long as refiners think they can buy imported oil cheaply, they will choose not to spend too much on new capacity. If domestic oil becomes discounted relative to international oil and it looks like it could last, they might decide it’s worth the change.

    All the best,

    Art


  5. Art, another great post – keep them coming.
    I would be really curious to see how much of the oil production increase (and forecast increase) comes from long-investment cycle GOM production, and how much from short-cycle LTO ?

    My guess is that some of the decline in LTO since prices crashed has been masked by ‘conventional’ coming on-stream from investment decisions made years earlier…


  6. Richard,

    Gulf of Mexico oil production has increased from ~ 1 mmb/d near the end of 2012 to 1.7 mmb/d as of December 2016 and the trend is upward. There is no doubt that many of the U.S. crude oil increases during 2015-2016 were because of field development in the deep water part of the Gulf and that is ongoing.

    I think that your instincts are correct but do not know how to address EIA’s forward modeling.

    All the best,

    Art


  7. I think the remarks of exasperation by SA were more what moved the market than the inventory build.


  8. Who said anything about an inventory build? Not me.

    That was one of the main points of this post–the inventory build was largely irrelevant. I also don’t think Saudi comments had anything to do with it. Look at the evolving term structure of the future curve in Figure 8.

    Change in term structure of futures contracts

    That indicates a downward, structural shift in oil prices that has been developing for weeks, not after KSA comments at CERA.

    All the best,

    Art


  9. Discrepancy between output and global economic growth/fuel efficiency/renewables.

    The race to the bottom, for now.


  10. Change from contango to backwardation has been short term bullish for oil prices over the past few years. Disincentives producers to store oil. This move down was pretty easy to predict. Record length by speculators and tight range was always going to cause an over reaction one way or another. Classic capitulation love setting up a clear path to challenge the $55 top. Agree that oil prices can’t breach $60 until inventories show signs of normalization. Cheers Art, thanks for the always informative and data driven content!


  11. Ryan,

    You may be right.

    However, I think that the expectation premium is being withdrawn from oil prices.

    Downward-Shift-in-Oil-Prices-Toward-47-With-OPEC-Expectation-Removed

    I imagine that prices may settle somewhere below $50. Volatility appears to be falling today.

    All the best,

    Art


  12. Hi Art,
    If I right remember, In one of your previous article you said the huge amount of cuts in new E&P investments of 2015, 2016 and 2017 will have their effect on the word wide oil procution rate in the future. When you think can we have evidence of this substantial reduction of production rate at global level?
    Thanks Marco


  13. Marco,

    I honestly don’t know but IEA thinks it will happen around the end of this decade. Here is a graph from their recent Medium Term Oil Market Report.

    IEA-Global-Supply-Capacity-Growth

    All the best,

    Art


  14. Fantastic article as usual. It is estimated to take 45-60 days for an oil tanker from the Persian gulf to reach the U.S, with OPEC’s cuts being implemented in early January, do you see the effects of these cuts showing up in U.S. inventories shortly? It seems that this combined with usual seasonality could lead to material drawdowns in U.S. inventories over the coming months…


  15. Adam,

    Thanks for your comments and question.

    EIA STEO indicates that OPEC crude oil production fell only 190 kbpd in February with the largest cut from Iraq (120 kbpd). Who knows if that is an accurate count but it is what I have to work with until IEA’s OMR next week. Not too impressive if correct.

    Most of the oil that the U.S. imports from the Persian Gulf is heavier oil for blending with lighter domestic oil so for now, I don’t see the OPEC cuts having much immediate effect on U.S. inventories. That may change but I imagine that OECD stocks outside of North America will be more immediately affected by the production cuts since most of those countries rely almost exclusively on imported oil for supply. The difference in term structure between WTI and Brent futures seems to reflect that.

    In answer to your second question, I doubt that the global market balance will be consistently in deficit. I’m not even sure that it is now–one month hardly establishes a trend. The main driver for over-production–cash flow to service debt and to maintain marginal popular satisfaction with governments and economies–is unchanged.

    Demand and demand growth are highly price sensitive and lag price by several months so I do not believe that demand yet reflects $55 oil prices. My guess is that those prices will temper demand.

    There has been a marked slowdown in debt creation or “credit impulse” in many parts of the economy most notably in China but also in the U.S. I believe that this has important consequences on the global economy and should be expressed in weaker demand at the very least.

    I hate to seem pessimistic but these are the reality factors that must be considered. Empirical experience during the 3 years of oil price collapse tells me that the worst for oil prices may be over but we are a long way from recovery. Energy is the economy. Oil markets remain weak and uncertain.

    Despite economic optimism by some that is seemingly reflected in U.S. Fed statements, I see more weakness and uncertainty. World growth since the 1970s has been artificially created by debt. In 2008, we bumped up against the limits of growth-through-debt. The Financial Collapse was remedied with more debt and the years that followed were characterized by the highest sustained energy prices in history. Those fundamental issues have not changed and will remain unchanged by recent policies.

    All the best,

    Art


  16. One more question! You mentioned that it could take over a year for the market do be able to support $70 oil given a 1 million bpd deficit. Do you ever see us getting there and being able to maintain that kind of deficit for the time it will take? It seems to me that if demand holds up such an outcome would be likely given that the U.S. seems to be one of the only material sources of supply growth especially at sub-$60 oil.

    Thanks again for your objective outlook on the oil market.


  17. I was just expressing my perspective on events. At some points it may be similar to yours (inventory). Others different: Saudi remarks.

    The change from NOV to 02MAR that you show is interesting. And of course Saudi remarks could not have caused them as they were made after 02MAR (unless you believe in tachyons). But I don’t think you can say that a change from NOV to 02MAR explains a change from 02MAR to 09MAR. In the prompt. (“Momentum” in finance charts is an economic fallacy.)

    Obviously the markets have to consider a lot of factors (going both directions) in guessing the prompt and strip pricing.

    I just think if you look at even a longer sweep of time (maybe from when we were in at $26 to now) that you can see the impact of OPEC. It is, as Adelman well explained with thorough coverage of the history in 70s and 80s, an imperfectly functioning cartel. It does not have zero impact. But it is also not all powerful. However the high elasticity of demand and supply in short/medium terms means it can have an impact on pricing beyond true free market competition. Those who believed in “hundred here to stay” (Hamilton 2014) or even higher (Hall, Simmons, etc.) were wrong.

    But also those who said shale killed OPEC were wrong as well. After all we are not at $26 now (or whatever the current prompt was predicted to be when we were at $26).


  18. Obviously if WTI prices are significantly below EIA expectations, than we shouldn’t expect their US production volumes to unfold. How much lower they would be with $5 lower strip, I don’t know. Obviously there is some elasticity of supply and then there is uncertainty even with the price invariant case. I have read reports that expected both less and more growth than what EIA said (a little more to the high side though.) Those were before our little dip though. Be interesting to see how both EIA and other analyst projections change if we stay in the high 40s.


  19. Art- great article! I listened to your interview on Macro Voices and appreciate the additional explanation of how comparative inventories are calculated. Given your analysis is largely centered around this concept (and with very good correlation), the explanation was very helpful.


  20. […] http://www.artberman.com/oil-prices-plunge-over-reaction-or-turning-point/ […]


  21. “If OECD stocks must fall by approximately 550 million barrels to support $70 prices.”

    Isn’t the first part a false premise, given that OECD inventories were only ~300 mb above 5-year average?

    If OECD stocks fall by 550 mb, they would be at the lowest point in recent years (see Figure 6), not at five-year average. In fact, OECD stocks today are only ~270 mb higher than where the five-year average will be in 3Q17.

    I look forward to reading your answer.


  22. The oil producers need higher oil prices to cover their production costs according to breakeven prices and fiscal breakeven prices… and on the other side of the equation is the economy over indebted and slowing down which causes a deflationary down pressure on the oil price.

    The increase in supply and fall in demand has led to an inventory build up that is now forcing the producers to cut production.

    The futures indicate a fall in oil prises. A cut in production/sales combined with a fall in prices would hurt the producers revenue.

    The supply has now fallen below demand but it will take a year to bring the inventories down if supply remains below demand at this level.

    And if the oil price would rise in the future… how would the economy react to a rise in fuel prices ?

    Well… I guess we will just have to wait and see what happens.

    Thx for an interesting article.


  23. Recently during an extensive stay in Corpus Christi Tx I noted numerous tankers in and out of the port. My brother-in-law said that that activity has been consistent with Valero and Citigroup refineries for couple of years. Those companies are bring in huge amounts of crude and refining and noted that their business in South America drives a large refined product market.

    From what I note and I do believe that imports are driving the large inventories numbers and not necessarily domestic production blowing up inventory. Cushing and others stock points are choked off by the river of crude coming in at $7 to $10 cheaper than US crude.