- February 26, 2018
- Posted by: Art Berman
- Category: The Petroleum Truth Report
The oil-price rally that began a year ago is at a crossroad. In February, WTI futures fell from a 3-year high of more than $66 to less than $60 per barrel but have since recovered almost 70% of that value.
Was this a temporary adjustment on the long march to $70 oil or have prices reached a ceiling at around $65 per barrel?
Oil Price Recovery 2017-2018
WTI averaged about $42 per barrel in the 12 months before OPEC+ production cuts began in November 2016. Prices increased immediately to more than $50 based on false expectations that oil markets would balance quickly (Figure 1). By March 2017, concerns developed that the cuts would not work and prices fell back to pre-cut levels by June.
At about the same time, global oil inventories began falling and prospects for economic growth improved. WTI increased fairly consistently to more than $66 by late January 2018. That represented a 57% increase and led to price levels that had not been seen since December 2014.
The recent drop in oil prices was probably more because of the broader market sell-off than because of oil market factors specifically. Some analysts dismiss the sell-off as a correction to over-valued equity markets along with concerns about inflation and higher interest rates. There is also a darker perspective that slow productivity growth, increased debt and higher commodity prices in addition to those factors are already limiting economic expansion.
How Oil Traders See Things
Managed money and hedge fund long bets on oil price have fallen 125 mmb from a record high in late January (Figure 2). Long positions still outnumber short positions by 11-to-1 but the shift marks an important change in sentiment by major capital providers and that affects the way that oil traders think about the market.
Some traders view the 200-month moving average of futures prices as an important upper limit at least for the short to medium term (Figure 3). The convergence of the 200-month average and other trends suggest $55 to $65 range boundaries going forward. Many believe that oil prices are more likely to fall than to rise.
Comparative Inventory and The Direction of Oil Prices
Comparative inventory (C.I.) is the difference between current storage levels of crude oil plus a select group of refined products, and their 5-year average for the same weekly time period. Because it is a year-over-year calculation, it normalizes seasonal variations in production, consumption and refinery utilization.
It is an indicator of oil over-supply and under-supply. It shows that the U.S. over-supply of oil has ended (Figure 4). C.I. has fallen 236 mmb since April 2015 and 209 mmb since February 2017. It is now only 3 mmb above the 5-year average. The last time C.I. was at the 5-year average in late November 2014, WTI price was $72.36 per barrel.
Why is oil trading now in the low $60 range?
Figure 5 shows the same C.I. vs. price data as a cross-plot. The resulting “yield curve” (Bodell, 2009) offers a structure for organizing seemingly random variations in oil prices. The long-term yield curve (in black) has provided a useful solution for the complex market forces that relate inventory and price over the last 3 years.
Figure 5 also shows the possibility for a new 2018 yield curve (in blue) that may offer a better inventory-price solution going forward since current price is less than the long-term curve predicts. This new yield curve suggests that the mid-cycle WTI price may be $65 or lower instead of the higher price associated with the long-term curve.
This does not mean that prices will not exceed $65 per barrel. It means that $65 is the approximately correct price at the 5-year average. If C.I. becomes increasingly negative, prices should rise.
This is hypothetical and may represent a temporary phenomenon resulting from speculative pressure and bearish market sentiment. It may also indicate the market has re-priced WTI because of new market forces.
The IEA and EIA have promoted widespread belief that U.S. tight oil production will surge in 2018 and 2019. Producers and analysts claim that efficiency and technology have lowered break-even prices substantially below current benchmark levels. The market may have decided to believe those narratives.
If higher oil prices are what producers want and need, they should be careful about what they ask investors to believe. The market is rarely generous.
Thanks Art,
Is there a risk the current 5yr CI data may be skewed by the fact that we have been in an oversupplied oil market with high inventories for 3-4yrs now? Your data show that inventories are no longer high relative to the past 5yrs, but what about relative to history, and say the 2010-14 period preceding the recent downturn?
Thanks!
Lyall
Lyall,
I appreciate your comment but do not think the issues you mention skew the data. The comparative inventory method goes back as far as 5-year inventory is available namely, 1995. The method has proven to be durable through more than 2 decades of inventory supply ebbs and flows.
Your point about the 5-year average progressively increasing is astute and something that Mike Bodell and I have discussed many times. The effect is that being at the 5 YA in 2018 is not quite the same as being at the same point 3 years ago. Although there are philosophically interesting implications of this observation, I do not believe that it makes a substantial difference nor can it or should it be corrected. It is what it is.
All the best,
Art
PS another way & perhaps better way of saying the same thing would be to say, as the oil oversupply has dragged on over several years, average 5yr inventory levels will have risen, and hence there could, in theory, be a decline in 5yr C.I. not on account of current inventories declining, but the 5yr average steadily rising.
Art,
The Long-Term Yield Curve in figure 5. How many years of data does that represent? Is it 5 years of data, 10 years of data, or 50 years of data?
I would say, as I am sure you would, the greater the number of data points supporting the CI LTYC the less likely that the 2018 yield curve is real. On the other hand if the CI data only goes back for say 5 years then it probably isn’t a large enough sample to dismiss 2018 as a fluke.
I don’t recall you having mentioned the years that the yield curve represents, which is why I ask.
Taylor,
Thanks for your comments. There is a legend on the chart that shows the data is from 2014-2018.
All the best,
Art
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Hi Art
Another excellent article
For your information from Oil Price article
First, what constitutes the five-year average for inventories has changed significantly, with that period of time increasingly encompassing surplus years. The level of inventories that was “average” for the period of 2011-2015 is substantially lower than the “average” for 2013-2017 — the latter period includes more than three years in which the market suffered from a glut.
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In other words, the five-year average inventory level is a moving target, and because it has been rising quite a bit, bringing global inventories down to that threshold is not as impressive as it would be if using an older five-year period.
As a result, Saudi oil minister Khalid al-Falih suggested that OPEC would meet to discuss using a different metric. One option would be to use the “forward demand cover,” Bloomberg reports, or the number of days that the current stock of inventories could supply the global market. This would arguably be a more accurate measurement because it would incorporate the fact that demand has climbed significantly in recent years.
Art, Great data and figures as usual. Figure 4 typo? “C.I. has fallen 236 mmb since April 2015” …. Shouldn’t that read ‘ C.I. has fallen 236 mmb since April 2016’?
Regards, and thanks for your work.
Comparative inventory (CI) is a term that falls out of systems dynamics. In system dynamics, considering all the feedback loops, the market prices the commodity based on relative “extant” supply, which includes an expectation for domestic production, net imports and critically, absolute storage. The CI value–based on how it is calculated–is automatically adjusted for seasonal variation by month or week. In that way, CI is normalized. The moving 5-year average therefore becomes a proxy in system dynamics thinking to a hypothetical relative benchmark volume compared to what the “market expects”. As we see in the charts, the market is typically either short or long, passing through a null point or fulcrum (at 0 on the y-axis). I will get into the meaning of this null point in a moment.
This temporal trend I termed a yield curve (YC) in 2001 based on my work for an oil company on pricing fundamentals for natural gas, crude oil and coal. This so-called YC trend is a collection of price-quality (price-CI) positions over a period of time or a cycle. I used the term “yield curve” because I believe the curve shows when in deficit, under certain circumstances, the need for demand to yield to price lower consumption and producing a powerful signal to producers to invest in new supply, and conversely, when in surplus, low prices stimulate consumption while causing producers to yield their investments.
To regress for a moment, classical Econ 101 deals with fundamental supply and demand and shows also a price-quantity relationship. Along that P-Q relationship all parties in theory absolutely make an equilibrium transaction. Economists call this process to equilibrium tatonnement (Fr.), an iterative Walrasian auction process by which an exchange equilibrium is imagined to be achieved. Furthermore, in classic economics storage is NOT considered. Unfortunately, that is not how the real market works.
In the real world, oil producers are pure price takers. They own many, many wells, in different parts of a field (to keep it simple) and of different ages, depths, and cost structures, and actually have little real time knowledge of their unit costs. Over time, they know when they make or lose money, but they see that their stock price is relative to production growth. Producers are also loathe to shut in production, for many reasons, but one is need for cash flow. Also, very few have tank storage or are willing to hold the physical commodity for any length of time. As a consequence, the tatonnement process or “price searching” to equilibrium never happens, producers are at the mercy of bid-ask spreads. Period. Also, producers employ traders whose job is to place their physical production in the monthly cash market and the daily spot market. They want to get that right, not have to buy the physical to fulfill a contract. They may or may not use NYMEX futures to create a notion of price stability.
Given the seasonal nature of demand for crude oil and supply, in this convention, storage then is critical in balancing the overall market. Any surplus in production to consumption is stored and that grows storage, with a recent safety valve in exports. Any deficit in production to consumption, typically, draws storage down, depletes it, and that always leads to a decline in the CI surplus and movement into a deficit.
Since a particular phenomena was mentioned above, I would like to address a special case since I need to make a point or two. Let’s say that production is maintained for a long time at a level higher than consumption. That then increases the amount in absolute storage. We know this has occurred in the recent past. Let’s assume also that this high level of storage lasts for five years. And let’s also say, to make it simple, that relative weekly or monthly production, net imports and consumption remain the same for each equivalent period (January to January on a monthly basis or the first week of January to the first week of January on a weekly basis) for five years. Since above I mentioned that CI is normalized, in this special circumstance, given static storage volumes, CI will decline by definition. Think about it, if we have exactly the same total supply each week and the same total consumption, storage will be exactly the same for each period. On a normalized basis, each year that this unusual condition persists, CI moves closer and closer to the null point, completely normalized. At some point, the market is neither long or short, it is at equilibrium.
That brings us to the null point, zero on the y-axis, that I call the mid-cycle price. What is the meaning of this mid-cycle price on the yield curve? In system dynamics theory, that price is the value of the marginal unit of production, the cost of the last barrel to clear the market. More on this concept in a moment. If we knew the actual unit costs of production from the entire system, we could construct–in an Econ 101 sense–the supply curve. The price of the commodity at any point, in an equilibrium market, is the intersection of all supply (including delivered imports) and exact demand. In Econ 101, too costly supply might not even exist, but all pricing follows a demand curve intersecting along the supply cost curve. Producers would have a say, they would no longer maintain ‘out of market’ supply. And that is where and why storage is critical to a functioning market.
Beginning in 2004, the U.S. market began to raise the crude price at WTI. It did this because it sensed that future domestic production was in some peril; conventional resources were reaching a peak. At that point, the market raised the price to induce producers to invest and ultimately to find new resources. That producers did, developing and making economic unconventional resources known earlier but considered too costly to be produced. That process continued until approximately 2014. As a consequence, the market raised the YC mid-cycle price to a higher and higher price levels, peaking in 2008, where finally, the mid-cycle price was about $100± per barrel.
This price is not the “cost of the last barrel to clear the market.” We will never know that value. The market simply raised the price to get producers to do what producers do when they are so incentivized. And consumption did what consumption does when it encounters too high prices. We witness beginning in late 2004 and early 2005 what happens to per capital driving miles as WTI prices skyrocketed. They dropped and have only returned to late 2008 levels.
At the moment, two forces are lowering CI along the YC. They are the fact that storage has been high for a handful of years, as discussed directly above, and because storage levels are actually being drawn down. Both contribute to a massive, historic depletion in the CI surplus over the last 14 months. Also, now the convention, unconventional crude production is growing. The market is no longer concerned about the production side of fundamentals (even if it should). The U.S. some claim is moving to energy independence and the amount of crude production approaches the peak in the early 1970s. Furthermore, the U.S, is so awash in crude that it can export it as crude and product, and a change in legislation makes that possible. Moreover, the right count over the last 18 or so months has increased by 153%, all with a spot prices below $65 per barrel, and most of that when prices at WTI were between $45 and $55.
Bottom line, from my seat, the market believes it can get what it needs by way of production at a mid-cycle price $40 lower than during the earlier crisis. That is how I see it. $60 per barrel, maybe $65 is the emerging fulcrum price of the latest dynamic YC.
Mike,
I greatly appreciate these important comments that clarify some points made in my post and expand well beyond what I wrote.
All the best,
Art
If demand for oil is up materially the last five years, so the current demand is well above the 5 year average. Does it make sense to look at days of inventory vs inventory compared to 5 year average?
Thanks,
George
George: I track days cover, just as you suggest, in a weekly missive I produce for select clients. To be sure, comparative inventory is a backward looking metric. Days cover, on the other hand, is a forward looking metric. Routinely, I have employed the EIA estimated monthly consumption data to make this calculation, and I use a five-year moving metric. As it turns out, the days cover are right now saying the same thing CI is telling us. The market is on normal, or very, very close.
Art,
IN my opinion the current US inventory reduction do not reflect a shift in rising demand nor a trend in lower supply, yet it is just an accounting gimmick, when oil is transferred out of the US into the worldwide supply chain. Therefore, the impact on the oil price and the yield curve is limited.
However, this can change very quickly when the US have reduced inventories to the point where no reduction are anymore possible. In my estimate the US inventories – including oil products and SPR withdraws – have been reduced between 1 to 2 mill bbl per day over the last half year. If the US has to cease inventory reduction, worldwide over 1mill bbl per day will come off the market, which could work like a massive supply cut and the yield curve will readjust to the previous pattern in a very short time.
[…] reading: “Oil Price Crossroad” The Petroleum Truth Report, […]
Heinrich brings up an interesting point that should be explored. The reason why is because the U.S. has not exported crude and petroleum products is such volumes for many decades, certainly not within the purview of the YC (mid-1990s).
A review of the driving miles per capita will clearly show that from mid-2014 to late 2017, this metric was rising quickly. So yes, domestic demand has rebounded nicely over this period, in part to restore to prior higher levels of driving. Further, the U.S. economy has been recovering from the 2007-2009 Great Recession, so transportation and industrial uses of petroleum has increased. At the same time, volumes in storage have risen on much higher domestic production, while domestic production did dip slightly in the early 2015-late 2016 time period.
Late last year, U.S. driving miles on a per capita basis, began to flatten, possibly due to higher pump prices, or saturation, and minor impacts from CAFE standards on fleet fuel economy.
If we evaluate absolute storage volumes in the crude-product complex back to 2014, we note a rapid rise in volumes beginning in 3Q2014. That trend continues with mostly weekly record volumes until week 27 in 2017. At that point a turnover occurs that is unmistakable and it continues now driving absolute stored volumes in the complex to very near the 5-year average. Given that production is rising, consumption is somewhat flat, why is this occurring.
Net U.S. petroleum product imports-exports moved to net exports in mid-2011, grew rapidly in 2012 but held somewhat steady until 2016 at about 1.8 to 2.1 MBPD. Beginning in 2017, net product exports rose again by another 1.0 MBPD. These volumes are seasonal, so I am talking in general, and not just peak volumes.
Without question, exports of crude oil and product behaves like demand. The export of crude began in early 2016, after a 40-year ban. Those exported volumes meant that the prior massive storage balloon was likely to decline. And it has and along with it, WTI prices have risen, just as the YC would predict.
The fact that the U.S. has sufficient crude and product to export means the system is awash in crude, at least for now. We see this also in net crude imports, which have been falling like a rock since 2008 (with a large seasonal bump up in 2016 to import a certain type of crude). For some months in 2017, imports dropped to ~2 MBPD compared to 12 MBPD in 2008! Those exports absolutely impacted CI and helped it decline from record levels to near the five year average.
Absolutely, combining slowing demand, rocketing production, and sufficient excess to export, means the system is comfortable now. The P-Q relationship as seen in the YC shows that. The market is not concerned.
Now with prolific North American shale oil development, particularly the re-emergence of the Permian in West Texas, the market is ready to return to this prior YC behavior when in deficit, or something close. See that in the chart Art posted in a response, 1995-2018. If the market feels secure in future production, as would appear to be the case (real or not), then we may no longer witness extreme prices in deficit (from 2006 to 20116). That is to say, the current YC when in deficit will not rise as quickly as drawn for the 2014, for example. We already see that behavior since mid-2017, while a handful points do not constitute a trend. Yet, for now, the market-deemed mid-cycle price appears to be only $60 per barrel. Remember, we witnessed over the last 20 months how $45 to $55 per barrel WTI prices facilitated a better than 100 percent rise in oil-directed drilling. Drilling is now ~150% higher since May 2016, a rise based on prices below $65 per barrel.
I’ve learned over the years that the market is loathe to overpay for anything. Unless a shortage or potential shortage exists, in commodities (not taking securities) downward pressure will persist. Even for the 2006-2016 period, the market was adjusting downward what I call the mid-cycle price. Over that period of high prices, relatively speaking, those high prices did their work to develop new supplies. The same thing happened actually in the 1870s, when whale oil became increasingly harder to source, the first “oil” men in Titusville, PA developed a substitute beginning in 1859. Right now, the market is not particularly concerned over the future of production. The future is so bright, we’re gonna all wear shades.
Will the market return to 2006-2016 price behavior if supply is stressed? Absolutely. Until then, I expect we will enjoy lower prices.
This is all contradictory to Art’s December article(s) saying higher oil prices were inevitable in Q1 18. I don’t know how the party keeps going when most (all?) of these so called producers are cash flow negative especially in a rising interest rate environment.
I’m surprised we are not already encountering a price shock but there’s obviously something I am, and have been, missing.
Economist Paul Samuelson said one of these, maybe all of them. He even attributed the third quote to John Maynard Keynes.
When events change, I change my mind. What do you do?
When the facts change, I change my mind. What do you do, sir?
When my information changes, I alter my conclusions. What do you do, sir?
When someone persuades me that I am wrong, I change my mind. What do you do?
I ascribe to these slices of wisdom. In late 2017, I was convinced also that WTI was headed above $75 per barrel. While I considered that $80± would be a top end. Since then, I’ve done a lot more thinking, a lot more charting, and engaged in a lot more discussions on the topic. I’ve changed my mind.
The WTI spot market is elegant, complex, with numerous feedback loops. In the last two years, the role of exports has a much bigger impact on price formation, using the method discussed in this missive. Exports are like demand since the crude in one form or another is effectively removed from the market and not allowed to maintain or grow storage volumes. We know that imports are in steep decline, another feedback loop, that in this case removes supply. We know new domestic resources are contributing increasing amounts of production to a market surging with shale oil supply. We know that lower overall prices—$45 to $55 per barrel—stimulate drilling, whether that drilling is profitable or not. We believe the market is less concerned about the future of supply, only looking for a price signal to develop more from known resources. That is a huge change from a decade ago. We also see high and record levels of storage in the last five years. Finally, we see that demand is growing, but slowly.
After careful consideration, I believe the YC trend will follow for a period the 1999 to 2003 behavior, particularly when CI is in deficit. That earlier period featured little concern for where the next barrel was coming from, only whether the price was adequate to incentive producers to bring on the desired barrels from their marginal resources. Therefore, the crisis of short-term extant supply in very high prices in deficit may not occur this time. Instead, demand will yield, exports will be limited, imports will rise and modestly higher prices will get producers drilling more wells.
On the other hand, WTI could be $75 by May.
Art, how much of our inventory is really so light that it really should be called condensate, not crude oil. Isn’t it a much larger amount than in previous cycles, and shouldn’t today’s yield curve be steeper and call for a higher oil price because there is less actual crude oil (API less than 40) in storage than what the total inventory numbers suggest?
Art,
As I have seen the yield curve from 1992 to 2004,which has been very flat, it came to my mind that there is a second parameter other than US inventories, which influences oil prices. This is in my opinion spare capacity,being the main parameter why the yield curve became much steeper after 2004. Spare capacity can actually work like inventory. It is basically inventory in the ground, which is not yet pumped up. The reason for the sharp price rises over the last decade has been in my view low spare capacity. As Shale has increased steadily production, the market assumes that capacity will be added at a rapid clip, mitigating low OPEC spare capacity. However, given the high depletion rate of Shale wells this can change very quickly.
Heinrich: Please excuse me for butting in and addressing your question to Art.
You mention the role of spare productive capacity as a parameter in the pricing of WTI. You are absolutely correct. Just as you surmise, the existence of abundant, historically speaking, spare capacity, tells the market that near-term supply from production is secure. I’ll add that it used to be easier to secure EIA data on productive spare productive capacity. During the early 2000s when EIA stopped providing that data due to cost, I was in a position to share with them why knowing that estimated volume was important to understanding price formation. At that time, I was working on National Petroleum Council updates, and was invited twice to address the DOE.
To further support your premise, in my presentations “in the day” I argued that the rise in the WTI mid-cycle price beginning in 2004 was predicated on emerging evidence of lower spare capacity and attendant concern over future production as conventional resources peaked. Few of us then could see the impact of higher prices in the development of unconventional resources.
For that reason, I now argue the opposite trend on the emergence of shale resources. Above I note that future supply is of less concern for the market, at the moment. We have reason to believe that productive spare capacity is much, much higher now, while that is temporal, as you note. The market sees that (and I believe Art shows that in some of his analyses), and also it is an issue on the natural gas side. Some of the backlog in drilled unconnected wells (DUCs) is related to the timing of commissioning takeaway capacity. Producers do work some on just-in-time inventory.
As I wrote recently: At the moment, the market believes crude oil production is rising and supply is abundant, easily accessible, ready to produce, exportable in yet higher volumes, and cheap, whether that is true or not. I believe we are witnessing a seachange in market perception, a substantial evolution in perspective just as in 2004, meaning something just shy of a paradigm shift. I know its only a handful of data points, I know it comes on the heels of a correction in the securities markets, I know this cycle has not yet reached the turnaround to begin a rebuild. I know demand is still growing, while showing signs of a slowing. I know that even commodity traders don’t understand this pricing except they do what they do and it just happens. I know the market is in the long-run relatively efficient and moreover is unwilling to pay more than it has to for anything. And I know Shell thinks the future of oil price is important enough to jettison expensive Canadian tar sands. This market, if I may editorialize further, is where only the quick and strong survive.”
Again, excuse me for thread capping.
While I do not deal with DUCs here, last year I wrote: The underlying decline in the production has been less than expected in part because a rig is capable of doing more work now than a few years ago, availability of drilled yet unconnected wells, and now a rebound in drilling. Underlying production is in some state of decline, particularly in the Bakken, while clearly the overall recent strength in prices has put rigs in the field.”
My view now is that instead of demonstrating “high demand yield” behavior as seen from the 2005 to 2014, the YC curve will rise more slowly into deficit. The pre-2004 did not see gross surpluses noted over the last several years, a product of extremely high WTI prices. My view is this earlier behavior reflected little concern about deficit CI positions because supply was not considered tight, only that price-induced drilling had yet to deliver new production to rebalance the market. The extreme pricing behavior we noted in 2007 and particularly 2008 was a consequence of a peak in conventional oil in the U.S. Now with North American shale oil development, particularly the re-emergence of the Permian in West Texas, the market may be ready to return to this prior YC behavior when in deficit. If the market is secure in future production, supported also by higher productive spare capacity, as would appear to be the case (real or not), then we may not witness this time extreme prices in deficit.
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