Global oil inventories are falling because of OPEC and non-OPEC production cuts, but the road to market balance will be long.
Production cuts have removed approximately 1.8 million barrels per day (mmb/d) of liquids from the world market since November 2016 .
Saudi Arabia has cut 619 kb/d (35 percent of total) and the Gulf States Cooperation Council—including Saudi Arabia—has cut 1,159 kb/d (65 percent of the total). Other significant contributors outside the GCC include Iraq (12 percent), Russia (12 percent) and Mexico (9 percent) .Nigeria’s cuts are probably involuntary since it was exempted from the OPEC agreement. Iran and Libya–also exempted–and both increased production.
Inventories and The Forward Curve
OECD inventories began falling in July 2016, four months before the OPEC production cuts were finalized. Stock levels have declined approximately 107 mmb according to recently revised EIA STEO data . That includes the January 2017 increase recently noted in the April IEA Oil Market Report.
Although this represents progress toward market balance, stocks must fall at least another 260 mmb to reach the 5-year average level to support oil prices in the $70 per barrel range.
Almost three-quarters (73 percent) of OECD decline was from non-U.S. inventories. Perhaps the intent of OPEC’s November cuts was to stimulate a decrease in U.S. inventories (about 45 percent of the OECD total). U.S. stocks and comparative inventories were increasing at the time of the cuts and did not start to fall until February 2017 . Since mid-February, U.S. stocks and comparative inventory have each declined 20 percent.
The immediate results of the OPEC cuts were an increase in oil prices and an important change in the term structure of crude oil futures contracts. Before the cuts were announced, the term structure of the WTI oil futures curve was in contango (prices are higher in the near-future). That favored storing rather than selling oil and contributed to growing inventory levels .
In early March 2017, however, oil prices fell as investors lost confidence that the cuts were working. Forward curves moved into weak backwardation (prices are lower in the near-future). Now, prices have increased with outages in Canada and Libya, and the forward curve has moved into stronger backwardation. That favors selling rather than storing crude oil and contributes to decreasing inventory levels.
Market Balance, Supply and Demand
The latest IEA Oil Market Report stated, “It can be argued confidently that the market is already very close to balance.” What does that mean?
Market balance means that production and consumption are approximately equal. That is an important first step for a market in which production has exceeded consumption for most of the last 3 years but it hardly means that $70 oil prices are around the corner.
Market balance must be expanded to be useful: production is not the same as supply, and consumption is not the same as demand. Supply is production plus inventory. Demand is the quantity of oil the market is willing to buy at a certain price–it may be either more or less than production.
Oil prices collapsed in 2014 because demand wasn’t great enough at $100 per barrel to absorb the output from the 2010-2014 production bubble. Prices collapsed to $30 per barrel before a transformed market began a weak and uneven recovery, and production surpluses began to decrease slowly
Demand did not increase enough until July 2016 to require critical supply withdrawals from inventory–a small subset of total supply. U.S. inventories did not begin to decline until after the OPEC cuts took effect in February 2017.
In the real world, the 5-year average inventory level represents a dynamic proxy for market balance. Comparative inventory is the measure of how far the present market must rise or fall to reach that level. IEA data indicates that inventories are 330 mmb above the 5-year average although revised EIA data suggests that levels are closer to 260 mmb higher than that important benchmark. In either case, it will take 6 months to a year to approach the 5-year average.
Weakening demand growth is the potential barrier to continued inventory reduction and price recovery assuming that OPEC production cuts hold and are extended. Annual demand growth has declined to 1.25 mmb/d from the comparatively robust 2 mmb/d growth in 2015 and 1.62 mmb/d in 2016 IEA forecasts continued weak demand growth for 2017.
The problem, of course, is that demand is highly price-sensitive in a global economy that is burdened by unmanageable debt. Demand lags price and demand growth reflects the full spectrum of economic headwinds. In early 2016, oil prices reached the lowest level in a decade-and-a-half. After that, year-over-year demand and oil prices increased through November 2016 and yet, demand growth in 2016 was lower than in 2015. Since then, $45 to $55 per barrel prices appear to have depressed demand growth to annual levels of about 1.25 mmb/d.
The OPEC cuts are accelerating the reduction of global inventories but continued progress toward the 5-year average will push oil prices higher. Higher prices may collide with weak demand growth in a stagnant economy that simply needs less oil. The long road to market balance may be slower and bumpier than bullish analysts predict.
By Art Berman