- December 1, 2020
- Posted by: Art Berman
- Category: The Petroleum Truth Report
WTI futures have rallied +$9.74 (+27%) since the end of October (Figure 1). Current prices are the highest since early March when OPEC+ failed to agree to extend production cuts and oil prices collapsed.
Is this based on sentiment and hope or does it reflect something more immediate and basic?
It is probably not a transient phenomenon. The market knows something.
Figure 1. WTI price closed at the highest level since the March 7 OPEC+ debacle. Price increased +$9.74 (+27%) since the end of October but supply-demand fundamentals have not changed. Source: Quandl and Labyrinth Consulting Services, Inc.
Price excursions are common when there are perceived changes in oil supply-demand fundamentals or events that affect broader markets. Comparative inventory is a useful way to understand whether these excursions represent a substantial change in oil pricing or just a transient shift in sentiment.
Comparative inventory (C.I.) is based on comparing working supply for a particular period with the same period in previous years. Markets seem to have a kind of collective memory and an expectation for what the components of supply—domestic production, net imports and storage—should be.
Storage or inventory is like supply’s saving account. When inventory/savings is increasing, there’s nothing to worry about. When it’s decreasing to pay expenses that cannot be otherwise met, there may be a problem with liquidity.
The C.I. value is automatically adjusted or normalized for seasonal variation by month or week. The moving 5-year average, therefore, becomes a proxy for market expectation. The market is usually long when C.I. is less than the 5-year average and short when it is more than the 5-year average. The y-axis in Figure 2 represents the dividing line.
The trend line that fits C.I. vs spot price for a particular time period is called the yield curve. When C.I. is in deficit and demand exceeds supply, markets typically increase price— or yield—forcing consumption to decrease. Higher price sends a signal to producers to drill more wells. Conversely, when C.I. is in surplus, lower prices stimulate consumption while causing producers to drill fewer wells.
The mid-cycle price is where a yield curve intersects the 5-year average or y-axis. That represents the market-clearing price of the marginal barrel at the 5-year average needed to maintain supply.
The most important characteristic of the yield curve for 2020 oil prices is its slope. Yield Curve 1 in Figure 2 has a steeper slope than Yield Curve 2. That means that the market had a greater sense of supply urgency during the period described by Yield Curve 1 than for the period of Yield Curve 2.
The comparative inventory yield curve is similar to a bond yield curve. Instead of plotting interest rate versus borrowing period, it consists of plotting oil price versus comparative inventory volume.
Figure 3 shows the price-volume relationship between WTI spot price and U.S. crude + refined product inventory volume from 2013 to the present. Three yield curves describe different periods of price formation. The red curve fit 2013 through mid-2015 data based on market sense of supply urgency. Oil prices collapsed in 2014 but the price-volume data tracked down the red yield curve just as it had when earlier when prices were rising and C.I. was falling. The blue yield curve fit mid-2015 through 2019 price-volume data. It was similar to the red curve but reflected a lower supply urgency once price-volume data approached the 5-year axis. The green yield curve is somewhat speculative because of the extreme price-volume changes in 2020 but data since June supports its probable trajectory. It reflects a very low sense of supply urgency.
There have been four major price-volume excursions from their respective yield curves: one from March through June 2015; another from late 2015 through early 2016; a third from September 2016 through April 2017; and a fourth during the second half of 2018 during the period of Iran sanctions
The yield curve is not a regression but rather, a trend line. The factors that go into price and inventory involve human behavior and its interaction with the complex global energy systems that underlies our economy. It is empirical and not mathematical.
Excursions from the yield curve represent periods of price discovery because of a shift in market perception. The excursions are at least as important as the price-volume data that more closely fit the yield curve. For those who prefer mathematical equations to the complexities of human behavior, I recommend staying away from oil market investing. It’s messy.
There are some who believe that comparative inventory is a backward-looking method that is not useful for describing the near-term trajectory of oil prices. I believe that is an example of contempt prior to investigation. In other words, I believe that those skeptics are armchair critics who have never attempted to work with C.I.
Oil price formation is perilous. All approaches have pluses and minuses but I invite anyone to look at the predictive price calls that I have made over the past few years and decide for yourself if the method has merit.
Let’s review the major price excursions over the last several years to see what insight these provide for oil pricing in late 2020 and early 2021.
March – June 2015 Excursion
A price excursion took place from March through June of 2015 (Figure 3). In March, many investors believed that the price collapse that began late in the previous year was over and that things were going back to normal. Prices moved off the yield curve from $48 in February to $60 in March and April. The rally proved to be based on false hope and by June price fell back to $51. By July, WTI moved down to $43—$5 lower than when the rally began.
Late 2015 – Early 2016 Excursion
Another price excursion took place in late 2015 and early 2016 in which prices moved below the yield curve.
In November 2015, WTI was $42 and price-volume data was on the blue yield curve (Figure 3). A weak world economy, increasing global inventories and weak oil demand from China created a shroud of pessimism over oil markets. In December, price moved below the yield curve to $37. By February 2016, inventories reached a record maximum and the monthly average WTI price fell to $30 per barrel.
WTI was about $10 under-priced based on the yield curve. As inventories began to slowly draw down in March, price moved up to $38 per barrel. By April, price-volume data was back on the blue yield curve.
September 2016 – April 2017 OPEC+ Production Cut Excursion
In August, WTI was $45 per barrel and OPEC started discussing a production freeze (Figure 3). Price increased to $50 the next month but uncertainty about whether or not Russia would join the proposed agreement caused prices to move lower. In November, the new OPEC+ group announced a production cut that would take effect in the beginning of 2017. Prices increased to $53 by February. There was widespread expectation that inventories would fall more quickly than they did and by June, the average monthly price was $45. The excursion was over and price-volume data had reverted to the yield curve where it remained until May 2018.
2018 Iran Sanction Excursion
In April 2018, the U.S. announced that it was leaving the Iran nuclear accord and planned a full embargo on Iran’s oil exports. At the time, Iran was producing more than 4.5 mmb/d of crude and condensate. World inventories were already at the lowest levels since early 2014 and WTI reached $70 in May 2018 (Figure 3).
As Saudi Arabia and its Persian Gulf allies went into full production mode, C.I. began increasing but markets were nervous about supply and continued to send a high-price signal to producers. By October 2018, U.S. C.I. was more than the 5-year average but price was $71 per barrel, its highest level since November 2014.
In early November, the U.S. unexpectedly announced sanction waivers for eight countries. Oil prices collapsed to $57 in December and to $50 by January 2019. In another month, price-volume data had returned to the yield curve where it remained until February 2020.
The 2018 Iran Sanction excursion—unlike the previous excursions described here—was based on a real perceived threat of global oil under-supply. Ironically, Iran’s exports had fallen by more than 1 mmb/d by early 2019 when oil prices reached their lowest point despite sanction waivers. The message here is that higher prices were only needed for a few months to avert a supply crisis. An added insight is that prices sometimes rise despite increasing C.I. if markets are concerned about supply.
Covid Price Discovery Excursion
2020 began with price-volume data directly on the blue yield curve but moved substantially lower by February to $50 (Figure 3). This was before the Covid economic closure.
OPEC+ infamously failed to reach an agreement in early March to extend production constraints. Then, Saudi Arabia and Russia entered a foolish market-share competition that some called a price war. This happened just as the world was going into quarantine to try to stop the spread of a global pandemic.
In March average WTI price fell to $29 and reached $17 in April. By summer, price-volume data was tracking the green yield curve but has fallen below in recent months as Covid infections have surged again. I am showing an estimated December price of $47 per barrel and C.I. at the 5-year average in Figure 3. That would be on the yield curve again.
This price and C.I. transit cycle is the greatest price discovery excursion since inventory data has been available.
What Does the Market Know?
Price-volume excursions have occurred at least once per year since 2014. They usually last 3 to 4 months and may involve price changes of 30% compared to the yield curve.
The latest excursion in 2020 has been extraordinary. It has lasted 9 months so far and prices have varied up to 60% from the yield curve.
Price formation in oil markets is all about supply. Demand is of course important but markets cannot control demand. They can, however, use price as a lever to encourage drilling when there are concerns about under-supply and to discourage drilling when over-supply dominates.
In 2020, markets sent the strongest possible message to producers with a negative daily price in April to stop drilling. It worked and thousands of wells were shut in.
Prices have been relatively stable since June with WTI averaging a little more than $40 per barrel. The announcement of promising Covid vaccines in November led markets to consider supply security for 2021 and it doesn’t look good. Certainly OPEC+ has ample spare capacity for much of the coming year but U.S. production looks bleak.
U.S. output has accounted for nearly all supply growth over the last 10 years. Production is down from almost 13 mmb/d in early 2020 to less than 11 mmb/d in September. EIA forecasts an average rate of 11 mmb/d for 2021 but that is optimistic. Current rig counts are approximately 1/3 of what is needed to maintain that level and I am skeptical that drilled uncompleted wells will make up the difference.
The recent increase in WTI futures price to about $45 suggests that markets agree with me. What has happened so far is that the ~10% Covid discount has been removed. Price and projected volume data is back on the green yield curve in Figure 3.
I believe that markets will continue to send a strong price signal to producers to drill more wells. It will take time before more drilling translates into enough oil production to offset legacy declines. Markets know this.
I do not anticipate substantial decline in U.S. production until April of 2021 based on the long lag between drilling and output. Production will not increase until next summer if rig count continues to increase from its apparent bottom in July.
Previous price-volume excursions suggest that WTI could go as high as $60 per barrel if markets continue to feel supply urgency. At the same time, that history does not suggest that prices will be permanently higher.
The real question is whether or not investors will get the price signal and provide capital for oil companies to drill.
The response so far is not encouraging. Figure 4 shows 2020 normalized share prices for key E&P companies and normalized WTI prices (“Permian” is the average share price of Concho, Diamondback, Pioneer and EOG). Despite the recent increase in share prices, all sampled companies are under-performing WTI price.
The economy runs on oil. Perhaps a major energy transition has begun in which the role of oil will be progressively diminished in coming decades. Markets do not think in decades.
I am surprised that this opportunity for profit is apparently missed or ignored by investors.
The market knows that investment is needed immediately. The consequences of ignoring what the market knows may be economically disastrous for a struggling world economy.