Oil inventories are approaching the five-year average level in OECD countries, the all-important threshold for “re-balancing” the oil market.
A year and a half on from OPEC’s original deal to limit output, the surplus oil stashed in storage tanks around the world are nearly back to average levels. However, by all indications, OPEC is not ready to ease up on the production caps, with top officials signaling a desire to keep the cuts in place into 2019.
But that might require changing of the definition of a “balanced” oil market. OPEC has consistently held up OECD inventories as the metric upon which it was basing its calculations. The goal was to drain inventories back down to the five-year average. With OECD inventories about 44 million barrels above that threshold in February – down from a roughly 300-million-barrel surplus at the start of 2017 – the goal will likely be achieved at some point this year, perhaps in the second or third quarter.
For a variety of reasons, reaching this milestone is not satisfactory for OPEC. For one, the measurement is clouded by the fact that it’s a running calculation, meaning that the past five-years is now made up of more than three years of bloated inventories. In other words, the current five-year average is significantly higher than the five-year average in early 2014 when inventories were not suffering from a supply glut.
The flip side of that argument is that the oil market is way bigger than it was in 2014. Both supply and demand are higher, meaning that the global market probably needs a much higher level of oil sitting in storage. As such, it isn’t necessarily a bad thing that inventories are above the five-year average.
Another reason why OPEC is suddenly not satisfied with OECD inventories as the sole metric around which it bases its decisions is that OECD inventories do not capture the entire global oil market. What is happening in the non-OECD, where at this point, much of global demand growth is occurring? A more comprehensive measurement that included non-OECD inventory data would paint a more accurate picture of the global oil market. However, the problem with this is that non-OECD data is notoriously opaque, which is exactly why OECD inventories is a widely-cited data point.
Still, OPEC is scrambling to come up with another metric to justify keeping the cuts in place. One idea reportedly floating around would be using the five-year average, but somehow discounting the surplus years. Or, the group could use a seven-year average, which would make today’s surplus relative to the average look bigger, necessitating keeping the cuts in place for much longer. OPEC is also mulling an even longer range.
OPEC is set to discuss a range of possibilities in April. “Consumers’ opinion of how much inventories they need to hold may have changed,” Saudi energy minister Khalid al-Falih said in February. “We need to make sure that we look at non-OECD inventories, floating storage, investor behavior and numbers from respectable agencies.”
Saudi Arabia is especially keen on keeping the cuts in place as it is preparing the IPO of Saudi Aramco in 2019. For that, higher oil prices are vital. Abandoning the current production cuts could result in another downturn in prices, an unacceptable risk.
That means that whatever OPEC comes up with, the new metric it wants to use will need to justify keeping the production cuts in place.
Ultimately, that may mean that a longer period for inventories could be in the cards. For instance, “with OPEC’s initial five year OECD inventory target, they were 11 mn bbl away from reaching those levels based on the latest OECD inventory data from Jan’ 18,” JP Morgan Chase said in a note. “However with a 7 year average, they will be 69mn bbl away.” Switching to a 7-year average would require keeping the production limits in place for longer.