Oil Demand Exceeds Supply: Oil Inventory Analysis and Implications (Commodity: CL1: COM)

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Oil’s narrative has changed as fundamentals improve

Over the past year, the discourse on the oil and gas sector has shifted from almost universally negative following the fall in oil prices in 2020 to more optimistic in mid-2021. the forecasts of the major investment banks have also been increasingly optimistic, with Goldman Sachs increasing their 3Q oil price projections to $80.00, and Bank of America stating that expectations of a “strong recovery in demand would outpace supply in the coming months and could lead oil prices to briefly hit $100 a barrel in 2022.”

One of the main reasons the crude oil narrative has become more bullish is that the latest crude inventory reports show a rapidly tightening market, well beyond earlier expectations. Oil production has grown much more slowly than oil demand, which has almost returned to pre-pandemic levels, leading to a significant decline in crude oil inventories in recent months. Below, we discuss recent changes in the physical crude oil market and share our thoughts on the relevant implications.

Source: JP Morgan

Oil inventories help illustrate the supply side of crude oil fundamentals. Weekly crude oil inventory reports show current storage levels and the difference between production and consumption over a given period. Inventories increase (or increase) when there is more production than consumption in the previous period, and decrease (or decrease) when consumption exceeds production in the previous period. When oil inventories are well below historical averages or declining rapidly, we are more likely to see sharp increases in oil prices.

US crude inventory figures are released weekly by the US Energy Information Administration (EIA) and the American Petroleum Institute (API), both of which have shown that crude inventories have fallen sharply over the past 6 last weeks. Reported API that U.S. crude inventories fell 8 million barrels for the week ended July 1, after a drawdown of 8.2 million barrels reported the previous week. Additionally, the July 8 version of EIA Weekly Petroleum Report, showed a U.S. commercial crude oil inventory draw of 6.9 million barrels for the week ending July 2, compared to a draw of 6.7 million barrels for the previous week. Both agencies reported drawdowns that beat analysts’ expectations of a 4 million barrel decline in crude oil inventories for the week.

The pace of recent inventory drawdowns has also been remarkable. The EIA reported that over the past 4 weeks, total crude inventories (including the Strategic Petroleum Reserve) have fallen at a rate of nearly 1.2 million barrels per day, the largest inventory over 4 weeks drawn from rolling data going back nearly 40 years. At 445.5 million barrels, crude oil inventories in the United States are about 7% below the five-year average for this time of year. Excess crude oil inventories, which built up in 2020 during the COVID-19 economic pause, have been depleted at an exceptional rate, signaling a tighter physical market.

Source: EIA, July 2021

WTI Futures Curve Chart and Spot Price

Another indication of a tight market is the increasingly steep shift in the crude oil futures curve. Futures contracts illustrate what people are willing to pay today for barrels at some future date. In the event of a backwardation, spot prices hold a premium over future prices and stocks are usually depleted for immediate use. At contango, spot prices are at a discount and it is more economical to store barrels to resell later.

Source: corner stone Global Products

In the graph of the WTI 2022-2026 calendar futures curve above, we can see that the futures curve is in steep decline and has been falling for the past few weeks (between 23/06/2021 and 07/ 07/2021). This tightening in the physical market, along with the recent positive sentiment, has contributed to a sustained appreciation in crude oil prices over the past few months. WTI prices have remained above the $70 mark continuously since June 10, 2021 and above $65 since May 24, 2021. This week, WTI briefly rose above $75 per barrel on Tuesday, July 6, 2021, reaching unprecedented heights since November 2014before returning to $72 on Thursday, July 8.

WTI Crude Oil Spot Price Chart (08/07/2021), source: Ycharts.com

Conclusion and reflections

Crude oil inventory data tells us two things: current demand is exceeding new supply, and crude oil inventories are falling rapidly. With oil prices rising significantly as a result, the main current risk to sustained oil prices is that OPEC and US shale producers could flood the market with new production from their idle production capacity. Historical evidence suggests that an oil price in the $65-$75 range would prompt producers to bring additional barrels online, however, today’s oil and gas landscape is different from that of the past.

It’s true that many recent potential oil price increases have been thwarted by the “drill baby, drill” mentality of US shale producers, but so far in 2021 we’ve seen North American exploration companies and publicly traded production companies be much more disciplined with respect to capital. This is likely a response to shareholder concerns after years of capital destruction, and we’ll see how much longer North American E&Ps can remain calm in this high price environment. Additionally, it may be more difficult to significantly increase production for both OPEC and non-OPEC producers next year.

Sources: EIA, Baker Hughes

“But OPEC+…? »

The shortage of capital in the oil and gas sector since the 2014 downturn has led to a lack of investment in oil production and infrastructure over the past decade, which has significantly reduced probable global reserves and production capacity. . Additionally, OPEC+ spare capacity may be lower than announced and may not be sufficient to meet growing demand.

Bison could expand on this OPEC+ capacity gap in a deeper analysis of global spare capacity.

The end result of this inventory analysis: a convergence of factors has made the market tighter and more sensitive to rapid price increases than in previous years.

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Felix J. Dixon