Oil Prices Are Running Ahead Of The Fundamentals

As the pandemic rages, so do oil prices, reaching levels not seen since January 2020, when the virus was still a gleam in the epidemiologists’ eyes. A variety of reasons have been given for this trend, including recovering demand and suppressed supply, the vaccine roll-out, and falling inventories. Indeed, the futures price has returned to backwardation, with the current contract nearly $1 higher than the 4^th month contract, almost the same as early 2020.

Which is a bit perverse, given that the fundamentals do not—at this point—seem to justify such prices, let alone backwardation. Backwardation, when current prices are above future prices, implies that the market is tight, which is why current contracts have a premium. (Remember that futures prices are not predictions of the price in the future but what people are willing to pay today for barrels at a future date.)  The figure below shows the prompt (1^st month) contract minus the fourth month contract, and for most of the past year, the market was in contango: prompt prices were discounted, reflecting the glut in the market.

Without a doubt, the market has been tightening, thanks to the efforts of OPEC+ and the recent voluntary 1 mb/d reduction by the Saudis. Low oil prices have also reduced North American production by as much as 2 mb/d, only some of which can be restored quickly. Still, it might be argued that the price is reflecting the combination of tighter inventories and an optimistic economic outlook.

But, and it is a big but (no snide remarks, please), market fundamentals have hardly recovered. It would be nice to know what global oil inventories are, but that data doesn’t really exist—most non-OECD nations do not report them in a timely way, if at all, and even OECD data is badly lagged. The mid-January Oil Market Report from the IEA shows inventories for end-November, at which point they were about 200 million barrels above normal. For them to have fallen to levels of end-2019 would have required a 3 mb/d inventory draw in December and January, which is not impossible but would certainly be unusual.

The table below compares the oil market in early January 2020, the last time prices were this high, with the current (lagged) data. The best indicators of market fundamentals do not suggest these prices are warranted: spare capacity in OPEC and Russia is much above year-ago levels, implying recovering demand will not tighten markets but allow a relaxation of quotas. (At $60/barrel, some growth in U.S. shale is possible, although the increase by year’s end should be modest.)

Inventories are also a primary indicator of market fundamentals, since they represent the difference between supply and demand, at least kind of, in a vague way. Unfortunately, as mentioned, OECD inventory data is lagged, but the U.S. less so, and traders often focus on that info the way drunks look for their keys under the street light. U.S. inventory data is very timely and does not show a balanced market by any means, which does not support a bullish price outlook.

Some would object that U.S. inventories are a mere 5% above the level of a year ago, which is true, but as petroleum economist Meryl Streep would say, “It’s complicated.” For one thing, actual usable inventories are much smaller than the total, as I discussed last year. Some Clarity On Oil Storage Capacity Estimates (forbes.com) Oil in pipelines remains at a constant level; you can’t draw them down without emptying the pipeline. And storage tanks have to maintain certain minimum levels to operate, so that the amount which can be drawn upon, the ‘usable inventory,’ is a fraction of the total. Thus, with inventories up by 5%, the usable inventories have probably doubled.

A further complicating factor is that the absolute inventory level is less important than the relative level. If demand drops, as it has done lately, less inventories are needed. Expert traders pay sharp attention to inventories in days of consumption or, for crude oil, days of refinery runs. Both are shown in the table above and given the depressed level of demand it is hardly surprising that relative inventories have increased significantly.

Of course, there are two other drivers of oil prices that need to be considered. First are the expectations of traders for future supply and demand, which arguably are having a bullish effect. However, the possibility of a tight market in the fourth quarter of this year should not be elevating prices to the extent seen now (I think, guess, speculate, okay not speculating). This implies to me that oil prices are higher in part because of asset inflation due to the extraordinary fiscal stimuli being enacted (or promised) around the world, including the U.S.

Which suggests to me that current prices might be inflated, such that I wouldn’t expect them to go much higher in the next six months, but the gradually tightening market also implies that they won’t drop significantly. But, and it is another big but, I have been wrong before and there is always the possibility that day traders on social media will talk us into another bubble.