In early 2004, U.S. crude stocks were at alarmingly low levels. They fell under 270 million barrels at the beginning of the year, below “minimum operating levels” and forward cover—a ratio that shows how long inventories will last given expected demand at refineries—tumbled to just 17.5 days. There was not necessarily a crisis, but the market was labeled as “tight” and prices surged and soon hit new records. The crude futures curve was in backwardation—with prompt prices higher than deferred contracts—taking away the financial incentive to store. Demand was surging in the U.S. and Asia, and OPEC, at its meeting in February that year, misread the market and cut its members’ quotas. The Energy Information Administration (EIA) forecast that U.S. inventories would remain under 300 million bbl for the next couple of years.
Crude inventories defied expectations and actually reached 331 million bbl mid-year 2005, but oil prices kept rising amid low spare production capacity, geopolitical unrest, and high demand growth. Moreover, even though stocks were building which created a perception of abundance, inventories were not that flush—forward cover in the U.S. rebounded to only 20 days, not much higher than critical levels, since demand was so robust.
Inventories are getting just as much scrutiny in today’s current market, but they are at the opposite end of the spectrum, thanks mostly to the domestic production gains from fracking. In order for the oil market to break out of the current price range, supply must be balanced with demand or fundamentals move into a deficit. Unplanned supply outages and capital expenditure cuts are already bringing about a rebalancing. Still, the large stock overhang has to be trimmed for any significant price increase to occur.
The large stock overhang has to be trimmed for any significant price increase to occur. Except it’s not really happening.
Except it’s not really happening. In early April, ahead of the summer driving season, the EIA forecast crude stocks to fall by some 40 million bbl, or 7.5 percent, from the end of the first quarter to the end of the third. The government agency expected crude inventories to decline to 490 million bbl by the end of September, but current EIA data puts them at 526 million bbl, down only a fraction from end-March. With demand expected to fall and refinery maintenance set to begin after Labor Day, it’s safe to say that inventories will head into the fourth quarter well above what the EIA originally expected.
At the end of April, U.S. crude stocks soared to 543.6 million bbl, putting forward cover at a massive 34 days. To put that data into context, both were double the levels seen in early 2004. Although stocks fell, on average, throughout the summer, they did so only modestly and even saw some surprise weekly builds along the way. This year, from their peak in late April to the end of August, crude stocks drew by 17.7 million bbl, or just 3.2 percent. By contrast, during the same period a year ago, the decline totaled roughly 35 million bbl, or 7.1 percent. In 2014, the stock draw was even bigger, totaling 40 million bbl, or 10 percent. Simply put, stocks were higher than ever entering summer, but the pace of the decline was weaker than usual.
Underestimating production, overestimating demand
It’s too soon to fully evaluate why the EIA missed the mark on this year’s stock draw given that we don’t have final data for the third quarter yet—weekly data is typically substantially revised and can’t provide a comprehensive fundamental analysis at this point (the EIA, however, is attempting to improve its preliminary demand numbers by using real-time export data). Second-quarter data, however, can provide some clues. It appears that the EIA overestimated demand and underestimated crude production and imports. For the second quarter, based upon the latest revised figures, U.S. crude output averaged 8.85 million barrels per day (mbd), roughly 60,000 b/d higher than expected in April. At that time, the EIA predicted production to average even lower at 8.29 mbd for the third quarter, but has subsequently revised that upward to 8.45 mbd. On the demand side, the EIA said demand would average 19.5 mbd for the second quarter, but it came in 60,000 b/d lower. How much is imported is another piece of the inventory puzzle. The EIA also underestimated the amount of net crude imports that the U.S. brought in during the April-June period by 50,000 b/d. The agency was also likely off the mark for third-quarter net imports, now that weekly data has them above 8 mbd, the highest level in three years.
Weaker-than-expected demand, coupled with the refiner flexibility from having high stockpiles and robust imports, has kept refined product inventories at high levels.
The weaker-than-expected demand, coupled with the refiner flexibility from having high stockpiles and robust imports, also kept refined product inventories at high levels. Total petroleum stocks in the U.S. ended the summer at a record 1.4 billion barrels, up 116 million bbl, or 9 percent year-on-year. Looking at the entire global market, commercial stocks for crude and products are some 400 million bbl above the historical norm. Given all the crude sloshing around storage tanks, it’s no surprise that oil price have remained stuck in the current range of $40-$50.
Can inventories remain so high?
Where do inventories go from here and what will they tell us about price? Inventories, according to the EIA, are set to end 2016 with a draw, rise at the beginning of 2017, and then decline throughout the rest of next year to 470 million bbl, helping lift prices to the $60 per barrel level. Given that the EIA’s forecast was off for this summer, it’s important to take its predictions with a healthy dose of skepticism. Moreover, with the crude futures curve remaining in contango—with prompt prices lower than contracts further out on the curve—there’s a financial incentive to store, another factor that has allowed inventories in the U.S. and elsewhere to perform better than expected. However, if the EIA is correct in its forecast that U.S. crude production will slip under 8.2 mbd during the third quarter of next year, the slow grind downward in output will eventually take its toll on stockpiles.
If the EIA is correct in its forecast that U.S. crude production will slip under 8.2 mbd during the third quarter of next year, the slow grind downward in output will eventually take its toll on stockpiles.
Even with next year’s expected draws, stocks will remain ample and above historical averages, particularly when put in context of what the market saw in 2004, when they fell below minimum operating levels. Beyond 2017, the stock situation could continue to worsen, however. Consultancy Wood Mackenzie said this week that last year crude oil discoveries in 2015 were the lowest they’d been since just after World War II.
Explorers will likely find even less this year. Last year, they found some 2.7 billion bbl, the lowest level since 1947. The massive declines in exploration and capital expenditures as a result of an extended period of low prices are setting the stage for demand growth to outstrip the rises in supply. A price spike is not inevitable, but is looking more likely as long as demand remains on its projected path and supply gets choked. The high levels of inventories will be the main buffer to help cushion against any shock should the bullish scenario take place.