The first crude stock declines will have a significant psychological impact on the market, but it will be tricky to determine if the draw is a standard seasonal pull, or if the market is beginning to rebalance.
U.S. oil inventories are one of the most critical components of the market, and the current unusual dynamics have kept the attention of traders and market analysts. That’s with good reason: Stock levels are at all-time highs and continue to rise, keeping prices in check. According to the latest data, just last week, U.S. oil stocks grew by another 2.3 million bbl, slightly lower than expectations, but it really doesn’t matter: Tanks are still at record levels. At 535 million barrels, U.S. crude inventories are some 200 million bbl, or 60 percent, higher than at the beginning of 2011, when shale oil production started taking off. When refined product stocks and other oils are included, total petroleum commercial inventories are at 1.35 billion bbl, up 12.5 percent year-on-year.
Trends from the last few years offer guidance on what we can expect from this summer’s anticipated inventory draw. The massive increase in shale production from 2011-15 caused inventories to balloon, and even with production having declined from its peak last April, volumes haven’t begun drawing down. Following more than three months of consecutive inventory builds, the first declines will have a significant psychological impact on the market, but it will be tricky to determine if the draw is a standard seasonal pull, or if the market is beginning to finally rebalance. Big price effects will occur if there are any surprises—say, for instance, if stocks draw quicker than usual as a result of declining shale production, weaker imports, and stronger-than-expected demand, the market would find this bullish. Or, the opposite could occur—shale output could continue to demonstrate unprecedented resilience, crude imports could rise, and demand may underperform. Such a scenario would slow the pace of the stock draw and hold down prices.
Along with shale output, inventories have defied expectations
According to the latest Short-Term Energy Outlook (STEO) from the EIA, crude inventories should draw by 40 million bbl throughout the second and third quarters, and it sees more stock declines in the fourth quarter too. This means the EIA expects a draw similar to last year, from the end of April to the middle of September, when stocks fell by 37 million bbl. In the March 2015 STEO, the EIA had expected an increase in the second quarter and a draw of only 21 million barrels through the third quarter: The actual decline was more than what was expected, but inventories still remained exceptionally high. The EIA’s miscalculation was due to a dramatic underestimation of refinery runs, which were some 500,000 barrels per day higher than expected in 2015. This miscalculation in large part stemmed from the agency low-balling gasoline demand, missing the mark by .32 million barrels per day (mbd) for the summer months.
Stocks recovered quickly, and built sharply during the rest of the year—contributing to the leg down in prices at the beginning of 2016. In the same March 2015 STEO that dramatically underestimated the spring-summer inventory draw, the EIA had originally forecast inventories drawing by some 18 million bbl in the fourth quarter. Instead, they rose by almost 21 million bbl during that time period. The EIA significantly underestimated crude oil imports by a whopping .78 mbd for the fourth quarter, making the inventory projections significantly off-target. That was followed by a build of 53 million bbl so far this year, over double what was expected. As recently as January, the EIA had predicted the first-quarter build to be only a modest 21 million bbl.
Even though it wasn’t enough to bring stocks the into normal range, last year’s summer draw was still relatively sharp and near levels seen the previous couple of years. In 2014, from April to September, the crude draw totaled 41.4 million bbl, while the prior year, stocks started dropping in May and fell by 42 million bbl through September. This year’s draw should begin in April or May and total around 40 million bbl. If that occurs, stock levels will likely be in the 490 million-500 million bbl range at the end of the summer driving season—still at historically high levels.
Through the rest of 2016, it will take more than just a normal seasonal drawdown to push prices significantly higher, and the pace of the draw will be a key indicator.
Through the rest of 2016, it will take more than just a normal seasonal drawdown to push prices significantly higher, and the pace of the draw will be a key indicator. Inventories will just be one piece of the puzzle next to summer demand growth, shale’s performance with prices around $40 per barrel, import levels, and the shape of the forward curve. Gasoline demand is already running 3.6 percent higher than year-ago levels, a bullish signal if it holds up. But on the flip side, shale output has remained above 9 mbd, and has been given a lifeline, at least in the short term, by the recent push above $40. That will slow down any rebalancing, even with the possibility of some OPEC and non-OPEC producers “freezing” production. And, of course, the futures curve remains in contango, with prompt prices lower than deferred contracts. This structure provides financial incentive to keep storing. Against this backdrop, even though stocks should draw, they will remain high. Market bulls have a rough ride ahead.