Oil prices will be lower for longer—that is the conventional wisdom. Data suggests, however, that oil supplies are tightening and that higher prices are likely in the relatively near-future.
Refined Product Demand and Crude Oil Exports
U.S. crude oil plus products comparative inventories have fallen 120 mmb (million barrels) in 26 of the last 32 weeks (Figure 1). Strong domestic demand for refined products and increased crude oil exports are the main reasons. That translates into lower net imports of both crude oil and petroleum products to the United States. The year-to-date average of U.S. product net imports is down 0.5 mmb/day from 2016. That’s 3.5 mmb/week which is about the average weekly storage withdrawal since mid-February.
Figure 1. Approximately 3.3 mmb/week (470 kb/d) Decrease in Net Petroleum Product Imports Account for Most Inventory Reductions in 2017. Comparative Inventories Have Fallen 126 mmb Since Mid-February. Source: EIA and Labyrinth Consulting Services, Inc.
U.S. crude oil exports have increased, reaching a record 1.9 mmb/d during the week ending September 29 (Figure 2).
Figure 2. Record Crude Exports of 1.9 mmb/d Week Ending Sept. 29 2017. Source: EIA and Labyrinth Consulting Services, Inc.
Increased exports have been part of how producers cope with limited U.S. refining capacity for the ultra-light oil from tight oil plays. Recent increases in exports levels, however, are because of higher international oil prices compared with domestic prices.
Brent has traded at a premium to WTI since U.S. tight oil became a factor in global supply in late 2010. That was largely because of limited take-away and refining capacity for the new U.S. supply in the early days of tight oil production. The Brent-WTI “spread” reached $28 per barrel in September 2011 but decreased when infrastructure caught up with supply. It averaged about $1.68 in the first half of 2017.
In June, the spread began increasing and is currently almost $7 per barrel (Figure 3). Some of this is a “fear premium” because of tensions in the Middle East—the GCC boycott of Qatar and the Iraqi Kurdish independence referendum. Some of it is also a buildup of inventories at the Cushing, Oklahoma storage facility and WTI pricing point.
Figure 3. Brent Premium to WTI Has Increased More Than $5/barrel From 1H Average. Middle East Fear Premium plus Cushing Inventory Levels are the Cause. Source: EIA and Labyrinth Consulting Services, Inc.
Inventory increases at Cushing may be partly explained by refinery and pipeline outages following recent hurricanes but the build ups actually began in July a month before Hurricane Harvey. The causes are not entirely clear but rising inventories at Cushing especially when its storage exceeds 80 percent is generally a negative factor for WTI prices.
In addition to crude oil, exports of distillate, liquefied petroleum gases, and liquefied refinery gases have also increased in 2017.
Comparative Inventories and The Yield Curve
Falling U.S. comparative inventories (C.I.) in 2017 is a trend and not an anomaly. Figure 4 shows the 120 mmb decrease in C.I. since mid-February and the associated “yield curve” (Bodell, 2009) that correlates inventory with WTI price.
Figure 4. U.S. Crude + Product Comparative Inventory Has Fallen 120 mmb Since Mid-February–Yield Curve Suggests Higher Oil Prices Sooner Than Later. Source: EIA and Labyrinth Consulting Services, Inc.
The magnitude of the inventory drawdown cannot be over-stated. The fact that it is driven by increasing demand suggests that that U.S. supply is moving steadily toward balance.
OECD comparative inventory (less the U.S.) has fallen 72 mmb since July 2016 (Figure 5). Although the data frequency is lower (monthly vs. weekly) and less systematic than U.S. inventory data, the reduction in C.I. is the main point.
Figure 5. OECD (minus U.S.) Comparative Inventory Has Fallen 72 mmb Since July 2016. Source: EIA, IEA and Labyrinth Consulting Services, Inc.
The relative lack of price increase with falling C.I. for both the U.S. and OECD is because the yield curve was flat for much of the reduction because of the magnitude of storage volume. Now, enough inventory has been drawn down that the curvature of the trend is increasing. Greater price response with incremental reduction in C.I. is likely as volumes approach the 5-year average.
Misplaced Concern About Shale Supply
Fears about burgeoning U.S. supply from shale reservoirs has been a consistent drag on market sentiment about price for at least a year. This has been based more on rig count than real evidence. Continental Resources chairman Harold Hamm has loudly blamed overly optimistic EIA supply forecasts for low U.S. oil prices. This is misplaced and typical of the hyperbole regularly heard from shale company executives.
The fact is that U.S. output has been flat since early 2017 and the EIA has adjusted its forecasts as data replaces sampling algorithms in their accounting (Figure 6).
Figure 6. U.S. Output Has Been Flat in 2017. Source: EIA and Labyrinth Consulting Services, Inc.
The reason is that despite increased drilling, frack crews and equipment are not sufficient to meet demand for well completions. Pressure pumping equipment was not maintained and parts were cannibalized after the oil price collapse, and crews were laid off. It may take another year of strong demand to rebuild this capacity.
The result is that far more tight oil wells are being drilled than completed and I expect that this pattern will continue (Figure 7).
Figure 7. More Permian Wells Have Been Drilled Than Completed in 2016 and 2017. The Number of DUCs (Drilled Uncompleted Wells) is Increasing. Source: EIA and Labyrinth Consulting Services, Inc.
Fears that DUCs (drilled uncompleted wells) will flood the market with supply are unrealistic. When these wells are completed, it will be gradual and the natural ~30 percent annual decline in legacy shale production will be difficult to overcome. Moreover, production from the Eagle Ford and Bakken plays is declining. Only Permian production is increasing and on balance, it is unlikely that net shale production will increase much unless production trends outside the Permian basin somehow reverse.
The Tyranny of Preconception and Conventional Wisdom
In a recent interview about the documentary film The Vietnam War, co-director Ken Burns discussed the “tyranny of preconception and conventional wisdom” on public perception. Similarly, the lower-for-longer mentality has distorted perceptions of global oil markets.
That mantra made sense in 2015 and in the first half of 2016 as global inventories soared and supply outstripped demand. But data clearly shows that things have changed. The OPEC-NOPEC production cuts and increased demand for oil and refined products have resulted in a profound reduction of inventories. If those patterns continue, higher oil prices are likely in the first half of 2018.