« 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.
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).
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.
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.
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).
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).
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.
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).
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.
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).
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).
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.