Art Berman Newsletter: July 2021 (2021-6)
This market is on fire. The only way is up. The market is hungry for oil. There’s quite a chance of reaching $100 a barrel.
Those are real headlines. That is the consensus view.
The bull case for oil is perhaps best articulated by Goldman Sachs’ Jeff Currie in a recent interview with Bloomberg. There is a 2.8 mmb/d supply-demand deficit with no supply increase in sight except by core GCC OPEC countries. They will not increase output and squander the opportunity to make huge profits from higher oil prices. There has been no investment in shale and, therefore, no hope for better than maintaining current levels. Most non-OPEC production is in decline. The global economy is robust and able to absorb higher prices. This oil market is in the strongest position in decades.
If Currie is right, buckle up. Although his forecast is for $80 Brent this summer, his story suggests that oil prices may go well above $100. Price reached almost $150 per barrel in 2008 but this market, he says, is better than that or anything “in decades.”
The obvious question for Currie is to explain the -2.8 mmb/d supply-demand deficit that he cites for June? That would be the largest deficit “in decades.” No supply-demand data that I have seen indicates anything close to that level. If that supply deficit cannot be supported, then the rest of his story, while true, loses its urgency.
OPEC data indicates a +0.6 mmb/d supply-demand surplus for the second quarter of 2021 that moves to a -0.5 mmb/d deficit in the third quarter (Figure 1). Those both round to a balanced market.
In Figure 1, I have annotated a demand level of 100.53 mmb/d at the time of the Saudi refinery attack in September 2019 and 100.70 mmb/d when the Iranian general Soleimani was assassinated in January 2020. OPEC estimates that demand at the end of 2021 will be 99.82 mmb/d. That’s about 1 mmb/d less than in late 2019 and early 2020. That sounds more like a recovering oil market rather than the best “in decades.”
Figure 1. OPEC estimates +0.6 mmb/d oil supply-demand surplus in Q2 and a deficit of -0.5 mmb/d in Q3 and -1.8 mmb/d deficit in Q4. Q4 demand expected to be -1 mmb/d less than in Q4 2019. Source: OPEC, EIA & Labyrinth Consulting Services, Inc.
For better resolution, I turned to the EIA June STEO report that provides monthly production and consumption data. I converted that to supply and demand using a algorithm that compares EIA historical data with OPEC and IEA supply and demand data.
Figure 2 shows that June supply and demand was in approximate balance at -0.08 mmb/d. The -2.65 deficit in February was close to Currie’s number but it has improved +2.5 mmb/d since then.
The message from Currie and other bullish analysts is that 2021 world demand will surpass pre-Covid levels. Demand in 2020 was the lowest in modern history so a year-over-year comparison would not be very useful. Instead, I compared 2021 demand with 2019 data.
It shows that June demand lagged 2019 by -2.82 mmb/d (Figure 3). That was a huge improvement from January and February levels of -6 mmb/d less than 2019 but still relatively weak. EIA’s forecast suggests that demand will probably improve in the second half of 2021 and end the year at about -0.73 mmb/d less than in December 2019. That hardly supports the view that 2021 demand growth is or will be exceptional.
Both EIA and OPEC will publish new data soon but I would be surprised to see anything new that supports Currie’s claim that this is the strongest oil market in decades.
Let me emphasize that my criticism is not meant to minimize the significance of what is going on in oil markets. I think that Jeff Currie is a brilliant analyst and I pay close attention to anything he says. He is also pitching Goldman Sachs’ book—that’s his job and he does it extremely well. My intent is to separate the signal from the confusing noise generated by analysts and journalists.
On July 1, WTI reached $75.23 which was the highest price since October 3, 2018 (Figure 4). Price averaged $71.35 in June and $62.42 so far in 2021. The 2021 average price is higher than in any all of the last six years except 2018 and it is only 4% below 2018. That doesn’t happen because of market sentiment or speculators. This price rally is based on fundamentals.
Figure 4. July 1 $75.23 WTI futures price highest since October 3, 2018. Price averaged $71.35 in June and $62.42 so far in 2021. Source: Quandl & Labyrinth Consulting Services, Inc.
How long this rally can be sustained and how high oil prices will get? Comparative inventory is the best way to evaluate those concerns.
Comparative inventory (C.I.) is based on comparing working supply for a particular period with the same period during the last five 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.
C.I. has fallen to -50 mmb less than the 5-year average—the lowest level since September 2008 (Figure 5). Superficially, that seems like a green light for $100 oil prices. After all, between 2010 and 2014, WTI spot price was $80 more more 88% of the time. It was $90 or more 60% of the time, and $100 or more 29% of the time.
The problem with that kind of approach is that oil markets periodically change oil-price valuation based on supply urgency. For example, WTI price averaged $98 per barrel for much of 2014 when C.I. averaged -20 mmb. During the third quarter of 2018, however, C.I. averaged -21 mmb but WTI averaged only $70 per barrel.
The difference is that supply urgency decreased dramatically because of tight oil after 2014. When C.I. went into deficit in 2018, the market was willing to increase price but not to nearly 2014 levels because there was 4 mmb/d of tight oil production in 2014 that didn’t exist in 2008. Markets are like people—only willing to pay the minimum necessary to meet its needs.
We can use comparative inventory to fairly precisely identify what markets have been and currently are willing to pay for oil by cross-plotting. In much the same way that analysts establish variable bond yield curves by plotting interest rates versus term, yield curves are identified by plotting price versus C.I. (Figure 6).
The trend line that fits C.I. vs spot price for a particular time period is called the C.I. 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 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.
Figure 7 is the same comparative inventory vs WTI found in Figure 2 for 2014 through the present but cross plotted instead of shown on a time scale. The blue yield curve describes this volume-price relationship from 2017 through 2019. The green circles represent the market response in 2020 to the economic disruption and demand destruction from the Covid-19 pandemic. The gold circles represent 2021 data with the latest week in yellow and the previous week in light blue.
The chart indicates that markets were under-pricing WTI until June. All of the gold circles represent 2021 price-volume data that plotted below the yield curve. Markets were discounting price because of many factors but chiefly the likelihood that Iranian oil would soon re-enter the market. Because that now seems unlikely until later in the year, the discount has been removed. There are many other downside factors to consider but for now, markets are pricing oil correctly based on the C.I. yield curve.
The important point is that only happened a few weeks ago. Markets are far more cautious than many analysts.
The beautiful thing about comparative inventory is that it is allows reasonable scenario testing. If you tell me that oil will reach $80 per barrel, I will tell you what C.I. is needed to meet that price expectation. Conversely, if you ask what might happen to price if inventories decreased by 50 mmb, I can tell you what the price ought to be.
The magenta circle in Figure 7 by the caption “$90, -100” is a hypothetical price-volume point based on the following scenario: if comparative inventory fell another -50 mmb from today to -100 mmb, what price would correspond to that volume change?
The blue yield curve predicts that WTI would reach $90 per barrel. That price is higher than price forecasts by most credible analysts today but less than some market observers who believe that price could reach $100 per barrel in 2021.
I didn’t choose -100 mmb arbtrarily for this scenario example. The EIA first published inventory data in 1990 so the earliest comparative inventory history we have is from 1995. Figure 8 shows the eleven price-volume trends over that 26-year period. Each trend represented a change in supply urgency that caused markets to re-price WTI and each had a different yield curve.
The lowest C.I. in history was -108 mmb in March 1996, shown by the large orange circle in Figure 8 and hence my choice of -100 mmb for the magenta circle in Figure 7. It is possible for C.I. to go lower than around -100 mmb. It just hasn’t happened yet.
It is crucial to keep in mind that the current C.I. deficit is entirely artificial. It is because OPEC+ has withheld 8 to 10 mmb/d from the market for the last 15 months. If we want to talk about something that hasn’t happened “in decades, ” let’s talk about that because it has never happened before.
I believe that the OPEC+ accord is unraveling. The present impasse at the OPEC+ meeting is broadcasting that message at high volume. Abdulaziz bin Salman has done an extraordinary job of holding that coalition together but it has achieved its goal and its end approaches. The UAE has a much lower break-even price than Saudi Arabia and doesn’t need prices to go any higher. It is worried about inflation and the many negative factors that high oil prices always cause producers. It doesn’t want Saudi Arabia to squander the opportunity for profit that it has sacrificed so much to achieve.
There’s another thing that never happened before that’s at play here: the effects of Covid-19 on oil markets and the broader economy. It’s true that the world economy is recovering but it is happening unevenly.
Covid is losing ground in the vaccinated countries of western Europe and North America but not in the rest of the world. Even in America, there are tens of millions of people who remain unvaccinated and that could potentially reverse some of the progress made so far with the more powerful Delta variant making the rounds. We have not reached “mission accomplished” yet.
There are two economies and classes of people that inhabit the wealthy countries of the world. Ten million Americans remain unemployed. The travel industry may never recover for the millions of mom and pop businesses that provide food, lodging and services. The oil industry in the United States is a shadow of itself 15 months ago. The 40% of Americans who didn’t have $400 of spare cash for emergencies in 2018 has undoubtedly grown and the threshold may be only $200 by now.
When Jeff Currie says that $4 or $5 gasoline is not a problem because the economy is strong, I’m sure he’s right for Goldman Sachs’ clients. I doubt he talks to the second economy in the UK where he works.
I expect oil prices to increase. $80 or $90 WTI would not surprise me between now and the end of summer. But this rally will end because they all do.
The exuberant headlines and analyst quotes that I read every day in Bloomberg and Reuters have some basis in fact or they wouldn’t sell. As investors, we must recognize that they are more noise than signal. We must search for the more complex issues that define our risks and rewards going forward. When analysts like Jeff Currie talks every week about $80 prices and the strongest oil market in decades, I wonder if his company isn’t already shorting oil.
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