$60 – $65 Emerging Mid-Cycle Price For WTI

This is a guest post by J. M. Bodell modified from a comment he wrote on my recent Oil Price Crossroad post. He has extensive experience in petroleum market analysis, natural resource cost structure, scenario planning and strategic planning for Strategic Energy Research & Capital, Cambridge Energy Research and Associates, and Unocal.

Comparative inventory (CI) is a term that falls out of systems dynamics. System dynamics considers all the feedback loops by which the market prices a commodity based on relative “extant” supply including 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 for a hypothetical relative benchmark volume compared to what the “market expects.” The market is typically either short or long, passing through a null point or fulcrum at zero on the y-axis (Figure 1).

Figure 1. Disequilibrium supply-demand dynamics. Source: Aperio Energy Research.

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 Economics 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, 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 phenomenon 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 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, and 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. 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. Producers responded developing and attempting to make 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 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 witnessed beginning in late 2004 and early 2005 what happens to per-capita driving miles as WTI prices skyrocketed. They dropped and have only recently begun to rise toward late 2008 levels (Figure 2).

Figure 2. Per Capita Vehicle Miles Traveled (VMT) Slowed 2005-2013 But Increased With Lower Gasoline Costs 2014-2017. Source: U.S. DOT, U.S. Dept of Labor Statistics, EIA and Labyrinth Consulting Services, Inc.

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 be). 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 rig count over the last 18 or so months has increased by 153%, all with 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.



28 Comments

  • Rick

    What happened to oil sky rocket?

    • Arthur Berman

      Rick,

      As my friend and colleague Mike Bodell wrote below,

      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?

      All the best,

      Art

  • Curt zimmerman

    I change my mind? What’s the point of you being
    A supposed expert. A lot of people make decisions
    Based on your expertise? And you say oops.

    • Arthur Berman

      Curt,

      You are commenting on a guest post by J.M. Bodell–not by me.

      That said, when “I change my mind,” it is more data that changes it, not a spontaneous mood swing. That is the fundamental premise of science.

      I am not a financial advisor and the interpretations of data that I present on my website are not meant as financial advice. I am a consultant and have clients who make use of my proprietary, unpublished data and interpretations as calibration for their financial decisions.

      Until this week, I had not posted anything since November 6, 2017. In that post, I stated,

      “if C.I. continues to fall at the 9-month average of 4 mmb/week, oil prices may be approximately $67 per barrel by the end of December.”

      C.I. did not fall at 4 mmb/week but WTI futures reached $66.14 on January 26, 2018 anyway. If you can find a better forecast, then please stop reading my posts and go with another “expert.”

      All the best,

      Art

  • As M. King Hubbert (1956) shows, peak oil is about discovering less oil, and eventually producing less oil due to lack of discovery.
    https://imgur.com/a/6dEDt

    IEA Chief warns of world oil shortages by 2020 as discoveries fall to record lows
    https://www.wsj.com/articles/iea-says-global-oil-discoveries-at-record-low-in-2016-1493244000

    Saudi Aramco CEO sees oil shortage coming as investments, oil discoveries drop
    https://www.reuters.com/article/us-aramco-oil/aramco-ceo-sees-oil-supply-shortage-as-investments-discoveries-drop-idUSKBN19V0KR

    Peak Oil Vindicated by the IEA and Saudi Arabia

  • Joe Schreiber

    It sounds like JM Bodell’s article is a long winded way of saying that the frackers will keep the oil price capped below $70 with a ready supply of unconventional crude. But what about the notion that a lot of that tight oil supply is actually too light for use by refineries. How much of our inventory is not really crude oil, but more like condensate? Is the actual inventory (absolute and comparative) of usable crude oil not really much lower than what is reported?

  • Jeff

    Schreiber,

    I interpret it rather differently. The market believes $60-65 is sufficient (right or wrong) and the price will follow the new YC until the market is proven wrong/believes otherwise. Issues that can affect this is e.g. if the lack of new conventional projects start to affect the global balance, oil investors requiring higher profit and earnings, lower demand than expected, changed OPEC behavior.

    Best

  • Heinrich Leopold

    Mr Bodell,
    As with any model happens over time, events influence the outcome when some parameters change. In the case of crude oil, most statistics included condensate into crude oil production. Until 2008, this did not matter as crude oil and condensate – although somewhat different in their chemical composition – fetched the same price. However, since about 2009 crude oil as defined by the WTI specifications decoupled in price from condensates or light distillates. At the beginning, the difference has been small, yet it swelled considerably during the last months and light distillates (>50 API) are selling now at considerable discount to WTI.
    In my view this is the outcome of Shale production, which increase ever more towards lighter products. As of 2008 worldwide condensate production increased from 10 mill bbl per day to over 20 mill bbl per day mostly due to Shale production, yet also due to more gas production from Qatar, Iran, Australia…. which carry significant amounts of condensates as coproduct.
    In contrast, production of classic crude oil defined as WTI or Brent stagnated. This is specifically true for the US where only a small part of current production can be specified as WTI (API 37-42). As a consequence, the condensate market cannot be anymore considered as a minor part of crude oil production, yet has developed into an own segment at its decoupled price from crude oil.
    As many statistics still regard condensate included into crude oil production, it is in my view the reason for the change of the yield curve.

  • J. Michael Bodell

    Allow me to respond to comments by Joe and Heinrich.

    On the change in WTI price projection, I am somewhat surprised also that WTI has not risen higher faster. In my client missive, I have noted for a good year that EIA believes US production of crude oil will rise and rise steadily. Therefore, my view has been that comparative inventory would fall for reasons noted herein but likely rebound during 2H2018 on increased domestic production. As a result, I’ve offered that prices would top out near $75-$80 per barrel in this cycle. While I note that, I opined also that prices between $45 and $55 per barrel have better than doubled the rig count over the last 18 months. And we know that service costs eased in the meantime. I add that such behavior is telling on the marginal cost of supply, while I have not wanted to believe that the market would repriced WTI at a mid-cycle even as low as $65.

    One note about forecasts, we all do the best we can with all available data. We cannot see what has yet to appear and none of us have a crystal ball. In my career, I am often reminded that forecasts are almost always wrong the moment they are let fly. A few times, I’ll add, when I planted a flag in the ground, the continent moved.

    Having invented this manner of viewing price formation, and having followed it closely for 17 years for several commodities, I have witnessed many inflection points. In almost every case, they are astoundingly rapid. The first one I noted occurred in December 2001 for natural gas. The change was completed literally over a three week period, during a surplus not less. At that time, productive capacity had moved below 93 percent (don’t hold me to the numbers) and earlier in the year higher prices and greater drilling failed to alter that.

    Productive-Capacity-on-Price

    Another view I promote is that all price cycling, from surplus to deficit back to surplus, is on actions by producers. The time lag to investment and the timing to taper investment are the main culprits. Consider that as prices rise, producers begin to target resources for exploration and/or exploitation. When the price is right for them, they contract rigs, typically for a period. These boardroom actions are somewhat slow to come to pass, but once they mobilize capital, they are committed. If we examine the yield curve, it is clear that deficit peaks occur with extremely high demand-yielding, but drilling-inducing price levels. But once CI begins to fall, the gambit is nearly over, yet producers are still seeing rich peddle-to-the-metal prices, so they bang on. They oversupply the market and that quickly rebuilds CI, in the last cycle to massive record-breaking levels.

    As far as the quality of crude oil, I’ve put together three charts. The first is just crude oil.

    Oil-Only-YC

    The second is crude oil and traditional products (no NGLs).

    Commerical-YC

    The third is the entire complex.

    Select-Crude-Product-YC

    I used monthly data, which is less noisy. The views are different slightly, but all tell a similar story. One could argue that the crude oil only chart shows that the change in YC behavior and lower mid-cycle price occurred six or more months ago.

    Now on to crude slates for refineries. The US refineries have been among the few in the world able to handle poorer quality crude. They did this to lower the “refinery acquisition costs” or RAC. On the East Coast, that allowed some marketers to improve margins considerably. The refiners did this because the price of poorer quality crude was low. US refiners are adept at making the changes necessary to process whatever discounted crude is available to them. This is unlike what occurs in Europe for example, where refineries are limited in crude slates.

    So given the system’s dynamics view of the world, with powerful feedback loops that impact behavior, what do you believe will occur within 18 to 24 months, if the US remains awash with light crude and NGLs at most favorable discounted prices? I have an idea.

  • […] süredir Art Berman’ın CI (Comparative Inventory) kıyaslanabilir stok açıklamalarına bakıyorum .Metodoloji […]

  • Joe Schreiber

    Michael, thanks for your response. Yes, clearly the price and shape of the yield curve is based on market perception, not actual reality. With my previous comment, I was trying to explore the possibility that the reality is different from market perception. Specifically, I am wondering if the market perception has not taken into consideration that a significant and growing percent of the reported storage numbers is really liquids that are too light for refinery use. If this is so, then reality will assert itself and perception will change when the demand for WTI can’t be met because what’s in storage is mostly condensate, and the WTI price will rise above what the yield curve for all combined liquids would predict. I guess what I’m saying is that a yield curve that is trying to predict the price of WTI will give an erroneous prediction if it includes inventories of other liquids especially if the proportion of those liquids changes over time. Perhaps we need a yield curve for WTI only (leaving out the inventories of other liquids) since it is the WTI price we are trying to predict.

  • Heinrich Leopold

    Fully agree with Joe. Condensate production will be going to over 25% of total global liquids production within a few years if Shale producers realize their production goals. In addition, Australia, Qatar, Iran production will increase significantly as condensate is exempt from OPEC cuts. The condensate market has significantly decoupled in volume and price and cannot be automatically linked anymore to WTI prices which represent an ever more narrow segment of global liquids production.

  • J. Michael Bodell

    Joe and Heinrich: First off, thank you both for your insights, feedback and suggestions. The issues you two have brought up caused me to pull out some older materials to post here, thanks to Art. You will see how capacity utilization impacts mid-cycle price for NG back in the late 1990s and early 2000s. Yes, in a system dynamic approach, all feedback loops must be considered and evaluated. I believe those relatively cheap liquid BTUs will be employed by US refiners, once those refineries have modified their processes to use it. Furthermore, liquids may find their way into chemical business.

    See above Art has inserted three of my YC charts. These charts employ monthly data. The first is crude oil only. The second includes NGLs; the entire crude-petroleum complex. The third removes NGLs. I’ve tried to look at this with the issues you point out in mind.

    However, I agree with you that if changes do not come to use the BTUs offered in NGLs, something has to give. Right now, producers are bringing in more liquid (crude-NGLs) at prices lower than $65 per barrel. We see that all over the place and I think it is why prices have not risen at this time. Will it change, yes; when, I don’t know.

  • Joe Schreiber

    I have wondered for some time now, why refineries have not retooled to use the lighter grades since they seem to be abundant and cheaper. Is it that hard and expensive to do? Or do the refiners think light tight oil will not last long enough into the future to make it worthwhile?

    • Arthur Berman

      Joe,

      It’s a good question. Before oil prices collapsed in 2014, many refiners planned to make that adjustment or at least said they would. Little of that happened and I expect it was not only b/c of lower oil prices.

      There are a few important things to consider. First is that ultra-light oil makes poor-quality gasoline that has to be put through an additional process (and cost) called catalytic reforming that boosts octane to sales specifications. Second and most crucial is that this light oil lacks the middle distillates needed to produce diesel. Those are the two biggest refined product markets so ultra-light oil has a lot going against it.

      The costs for refinery re-design and engineering are huge and require confidence that long-term ultra-light oil supply will be available at reasonable cost.

      Right now, the main approach is to blend the ultra-light with heavier grades of oil to create a mixture that can be put into refineries. This has created high demand for heavier oil (20-30 API gravity). The main sources for the U.S. are deep-water Gulf of Mexico, Mexico, Venezuela and Canada. Much of this heavy oil has problems of its own for refiners especially the syn-crude from Canada and Venezuela that contains large volumes of bitumen that requires a special kind of refinery (“cokers”) that can deal with the carbon and sell it as petroleum coke. Most of these refineries are in the Midwest (Chicago area mostly). The deep water GOM crude contains considerable sulphur that must be removed before refining further.

      As you can see, it is a complex problem. It reflects the fundamental premise of Peak Oil—namely, that we are not running out of oil but have run out of cheap oil.

      All the best,

      Art

  • The knowledge of the exhibitor and that of the commentators surpasses me.
    My questions are:
    Can a complex society, like ours, sustain itself with prices of US $ 60 or more?
    According to Gail Tverberg, the historical price of oil after the war was maintained at a price that today would be 20 or 25 USD, is far from 60 U $, with these prices society, as we know it has very high risks of collapse . Is she right?

    Best regards for all of you

    • Arthur Berman

      Carlos,

      Thank you for your thoughtful question. Post-war prices were a bit higher in 2017 dollars–about $24–but the point is valid.

      CPI-Adj-Oil-Prices

      I honestly don’t know what oil price is sustainable for the world economy. The higher it is, however, the less growth is likely. Energy costs are certainly one of the main factors in low post-2008 economic growth. Also, reaction to higher or lower prices is a long-term process that is difficult to measure except with the perspective of history.

      Bottom line: Gail is right but I don’t know how imminent a collapse is from oil price alone. Debt is a larger problem but it may be argued that debt is the logical corollary to higher energy costs.

      All the best,

      Art

  • Juan Rubio

    Hi Art, thanks for your posts. One question, if most of the shale oil is not suitable for diesel, could this lead to an scenario with deficit in diesel, pushing prices up of diesel with oil prices not going up? Could this cause 2 oil markets, one 42+ and 42-? Thanks for your work

  • Martyn

    Hi Mike, Art

    1/ How do you define “cycle” in the context above ?
    e.g.: “…I’ve offered that prices would top out near $75-$80 per barrel in this cycle. “
    “…while I have not wanted to believe that the market would repriced WTI at a mid-cycle even as low as $65.”

    2/ Have you inferred any relationship between WTI price precipitation in the second half of 2014 and the end of QE3 in October 2014 (I’m not sure when the end of QE3 was signaled) ?

    It isn’t rational, but I couldn’t help feel the market “decided” it could not pay so much for oil due to the ceasefire on new fiat dollars.

    3/ Just to clarify:

    a/ If very light crude oil is processed and used in making gasoline, what might be the highest proportion of such oil in the final product? (maybe you could qualify that with a particular API)

    b/ Above a certain API, is crude oil not at all a suitable component in making diesel?

    Thanks to all for this piece and discussion.
    Martyn.

    • Arthur Berman

      Martyn,

      Perhaps you should hire me as a consultant to help you understand all of these complex questions! LOL.

      The simple answer is that there have been many empirically defined price cycles based on changing market response to the dynamic price-comparative inventory relationship. It is, in the end, a market clearing price expectation based on market perception of the need to drill more or less to maintain supply.

      Evolution-of-Yield-Curve

      I don’t know the specific proportion of definable tight oil b/c I’m not a chemical engineer and no one knows the necessary details of global per-refinery specifications. What I know is that ultra-light oil and condensate makes poor quality gasoline and lower volumes of distillate. Those are bigger problems than most analysts understand.

      All the best,

      Art

  • MASTERMIND

    The End of the Oil Age is Imminent!

    Recently, the HSBC oil report stated that 80% of conventional oil fields were declining at a rate of 5-7% per year. This means that there will be an oil shortage of ~30 million barrels per day by 2030 and ~40 million barrels per day by 2040.
    http://www.scribd.com/document/367688629/HSBC-Peak-Oil-Report-2017

    What is mentioned far less often is that annual oil discoveries have lagged annual production since the 1980s.
    https://imgur.com/a/6dEDt

    Now, this problem has nothing to do with the recent decline in the oil price, which started in 2014. This has been an on-going problem for the past 30 years. Now, the IEA is predicting oil shortages by ~2020 due to declining exploration.
    https://www.wsj.com/articles/iea-says-global-oil-discoveries-at-record-low-in-2016-1493244000

    Here, the IEA blames this problem on the low oil price. But, this problem started in the 1980s. The problem is geological: we are running out of conventional cheap oil. Shale and tar sands are not the answer, either. Those resources are far too expensive, compared to conventional oil, because the global economy is based on cheap conventional oil. Expensive oil is not a replacement for cheap oil.

    Based upon the HSBC report and the IEA, the End of Oil Age will start around ~2020: there will be a dramatic economic depression due to exhaustion of cheap oil. This will cause a global economic collapse.

  • […] Comparative inventory (C.I.) provides a reliable correlation between secular trends in oil-price, and stocks of crude oil and refined products. Rising stock levels correspond to falling prices and vice versa. […]

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  • […] Comparative inventory (C.I.) is the key to understanding price formation. It is the best way to identify price trends and to anticipate future price movements. […]

  • […] since the maximum negative C.I. more than a year ago. For more on comparative inventory, please see this and other posts on my […]

  • […] between WTI spot price and total U.S. petroleum inventory from 2014 to the present. Two yield curves describe different periods of price formation. The red curve fit 2014 through 2016 data based on […]

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