Another False Oil Price Rally: Crossing A Boundary
The oil-price rally that began in mid-February will almost certainly collapse.
It is similar to the false March-June 2015 rally. In both cases, prices increased largely because of sentiment. As in the earlier rally, current storage volumes are too large and demand is too weak to sustain higher prices for long.
WTI prices have increased 47% over the past 20 days from $26.21 in mid-February to $38.50 last week (Figure 1).
Figure 1. NYMEX WTI futures prices & OVX oil-price volatility, 2015-2016. Source: EIA, CBOE, Bloomberg and Labyrinth Consulting Services, Inc.
A year ago, WTI rose 41% in 35 days from $43 to almost $61 per barrel. Like today, analysts then believed that a bottom had been reached. Prices stayed around $60 for 37 days before falling to a new bottom of $38 per barrel in late August. Much lower bottoms would be found after that all the way down to almost $26 per barrel at the beginning of the present rally.
Higher prices were unsustainable a year ago partly because crude oil inventories were more than 100 mmb (million barrels) above the 5-year average (Figure 2). Current inventory levels are 50 mmb higher than during the false rally of 2015 and are they still increasing.
Figure 2. U.S. crude oil stocks. Source: EIA and Labyrinth Consulting Services, Inc.
International stocks reflect a similar picture. OECD inventories are at 3.1 billion barrels of liquids, 431 mmb more than the 2010-2014 average and 359 mmb above the 2015 level. Approximately one-third of OECD stocks are U.S. (1.35 billion barrels of liquids).For 2015, U.S. liquids consumption shows a negative correlation with crude oil storage volumes (Figure 3). During the 2015 false price rally, consumption began to increase in April and May following the lowest WTI oil prices since March 2009-response lags cause often by several months. First quarter 2015 prices averaged $47.54 compared to an average price of more than $99 per barrel from November 2010 through September 2014 (44 months).
Figure 3. U.S. liquids consumption, crude oil stocks and WTI price. Source: EIA, Bloomberg and Labyrinth Consulting Services, Inc.
This coincided with the onset of declining U.S. crude oil production after April 2015 (Figure 4).
Figure 4. U.S. crude oil production and forecast. Source: EIA March 2016 STEO and Labyrinth Consulting Services, Inc.
Net withdrawals from storage continued until consumption fell in July in response to higher oil prices that climbed to $60 per barrel in June. Production increased because of higher prices from July through November before resuming its decline after prices fell again, this time, far below previous lows. This complex sequence of market responses shows how sensitive the current market is to relatively small changes in price, production and consumption.
Most importantly, it suggests that a price variation of only $15 per barrel was enough to depress consumption a year ago. That has profound implications for the present price rally that is now $12 per barrel above its baseline and has already increased by a greater percentage than the 2015 rally.
Why Storage Matters
Although most analysts pay attention to storage volumes, market balance is generally thought of as a simple balance between supply and demand. But U.S. production is difficult to measure with confidence until several months after-the-fact and the EIA reports crude oil production but not supply. Likewise, EIA reports consumption but not demand.
That's because supply and demand can only be determined by evaluating stock changes and how storage modulates production and consumption. Production plus available storage equals supply. In today's over-supplied market, consumption plus withdrawals from storage equals demand.
Since April, U.S. production has declined 583,000 barrels of crude oil per day. With 163 mmb of crude oil in storage, that net production decline could be eliminated and April levels of production maintained by storage withdrawals for more than 9 months. That is why storage volumes must fall probably into the 2011-2014 range before a meaningful price rally can be maintained. That assumes that demand can tolerate those higher prices.
Oil is accumulating in storage because of low demand and low prices. It makes more sense to pay the monthly storage cost (~0.65 per barrel) and sell the oil forward with ongoing futures contracts until the spot price increases and, hopefully, demand also increases.
Many people think that the strip of futures contract prices are a reasonable guide to future prices. They are not. Futures prices mostly reflect the supply and demand of futures contracts.(1)
That in no way discounts the profound effect that futures trading has on oil prices. The WTI futures market is one of the biggest gambling casinos in the world. Bets are often made on sentiment that in turn is related to world events. Price fluctuations that are based primarily on sentiment, however, have little chance of lasting longer than the sentiment or related events that produced them.
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- J.M. Bodell (personal communication). Mike has taught me most of what I know about storage and comparative inventories.
- Nate Hagens (personal communication). Nate has taught me most of what I know about the relationship between energy and the economy.
This article is for information and discussion purposes only and does not form a recommendation
to invest or otherwise. The value of an investment may fall. The investments referred to in this
article may not be suitable for all investors, and if in doubt, an investor should seek advice from
a qualified investment adviser. More
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