Oil Markets Face the Perfect Storm

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Oil Markets Face the Perfect Storm


By EconMatters

Crude oil prices, along with world stocks, surged on Friday after euro zone leaders reached an accord on directly recapitalizing regional banks as well as measures to cut soaring borrowing costs in Italy and Spain.  Brent crude jumped more than 7% in one day to close at $97.80 a barrel, while WTI also settled up 9.36% to $84.96 a barrel on NYMEX.  However, for the quarter, spot Brent and U.S. oil futures still fell 20.4% and 17.5% respectively–their steepest quarterly percentage drops since the fourth quarter of 2008 post financial crisis.  Looking ahead, we believe this little ‘Euro pop’ will soon fizz out weighted down by the reality of basic market fundamental factor.

First of all, the Euro accord bandaid does not fundamentally change what’s causing the current crisis to begin with–high sovereign debt, out-of-control government spending, and insolvent regional banks.  Add to this scenario is a slowing of European demand, parts of Europe are in a recession, and this not only affects less oil being consumed in Europe, but backs all the way up the supply chain from Ford automobiles being sold and needing to be manufactured, to Chinese factories needing to ratchet manufacturing cycles down to account for less demand out of Europe.

Macroeconomics aside, the oil inventory picture in the U.S. is also quite interesting these days, to say the least. For example, On 1/27/2012 there was 338,942 Million Barrels in US storage facilities, then on 2/24/2012 it started slowly rising to 344,868 Million, then Inventory builds started accelerating as on 3/23/2012 there were 353,390 Million on hand, then we jumped dramatically to 375,864 Million Barrels on 4/27/2012, with another sizable increase to 384,740 on 5/25/2012, and on 6/22/2012 the number stands at 387,166 Million Barrels in US Storage facilities, way above the five-year range. (See Chart Below)

Chart Source: EIA, June 27, 2012

This is taking place despite the domestic refinery run rate has increased from 85% in January to 92% in the week ending June 22 (See Chart Below).  As of June 1, 2012, crude oil inventories held at Cushing, OK were 47.8 million barrels, the highest level on record, according to the U.S. Energy Dept.  These are historically high numbers, but the magnitude of the rise over what is generally the stronger part of the US business cycle each year is the more compelling story.

Chart Data Source: EIA, as of June 22, 2012

With record refinery runs, we still cannot make a dent in the oil Inventories, which implies that there is a lot of oil in the market.  In fact, if this trend continues, even just for the next three months, we are going to shatter previous storage records here in the US.  At current rate, the inventory number could smash through the 400 Million Barrel level over the next quarter.

This does not bode well for the oil market when the slow part of the year comes around in August and September, where Gasoline demand drops off rather sharply, and is usually the slowest part of the year in terms of fuel usage, demand, and prices typically drop significantly each year.  Technically, WTI could easily blow below $70/b with no major support till $60/b comes this August/September, and prices would remain challenged in the short to medium term.

What are the reasons for this glut of oil in the US? There are several, China has slowed manufacturing and exports, i.e., their economy has pulled back considerably. India is having all sorts of credit worthiness concerns, and is also growing at a slower rate. So in short, the emerging market economies are using less oil.

The demand picture in the U.S. is also quite dismal.  EIA data show in the first quarter, total U.S. liquid fuels consumption fell 3.7% YoY due to high prices and record warm weather.  For the second half of 2012, and 2013, EIA expects a YoY increase of only 1.2% and 0.6% respectively in liquid fuels consumption.

Furthermore, there are more domestic oil production mostly from unconventional shale plays, as there are more Capex drilling projects started during the beginning half of the year on high oil price.  This has also pulled a lot more independents into drilling, and we are producing more oil each day than we actually consume or need.  This has been one major contributing factor in these continuous inventory builds during the strong part of the usage cycle, as refineries are operating at record utilization levels since the recovery withthe seasonal spring/summer driving season going from March with Spring Break through basically labor day, (some say July 4th is the peak of the Summer driving season).

Internationally, the Libyan oil is back on line, and other oil producing countries pumping more oil out of the ground compared to the last 5 years during this era of elevated oil prices. The Saudis are producing at the high end of their range as well.  In a recent report, U.S. EIA noted that global company held oil inventories in the major industrialized nations will be sufficient to cover 57.7 days of demand at the end of 2012, the highest level in 15 years.

Basic economics plays a role in this story as well.  Just ask this one question–Where are the high margin business opportunities over the last 5 years? It sure isn`t in the Banking Industry with deal-making and large scale private equity deals falling off a cliff. It hasn`t been in the real estate market either.

Market dynamics 101 stipulates that high oil prices leads to higher margins, which leads to more investment resources being directed to this sector which ultimately rebalances the market, and oil prices come back down. This is why there is often a boom and bust cycle that plays out in many investment sectors, and historically the energy and oil sectors have been the poster kids to this rule.

So essentially, five years of really high prices–higher than the actual fundamentals of the economy should dictate–have caused an artificial market scenario where longer-term demand was being stifled by currency concerns, inflation concerns, while commodity investment in general has served as a case of over investment in this area in relation to true, actual Global demand.

Throw in the fact that it seems everybody (governments as well as consumers) is in debt, nobody has any money, credit issues are becoming increasingly burdensome to deficit financing to artificially stimulate growth via the government intervention route, all these factors are forming a perfect storm for the oil market to face some major headwinds for the next 5 years.

Disclosure: No Positions

Via EconMatters

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