One of the more interesting developments in the oil markets is the fact that oil inventories have not had their seasonal build. We don’t blame you for not noticing. This news was likely drowned out by all the macro “noise” around trade wars, flattening of yield curves, rise in inflation, tax reform, new Fed Chair (hawkish or dovish?), spike in VIX, and volatility in FANG stocks. Admittedly, there is a lot of macro news to digest.
Typically, during the winter months, oil demand wanes (less gasoline demand during winter months) and refineries take the opportunity to go through seasonal maintenance (i.e., demand less crude); thus, crude inventories build. Over the past 15 years, inventories have built between 20 - 60+ mmbbls.
In 2018, inventories are up less than 1 mmbls.
In fact, one would have to go back to 1996 and 1994 to see flat to declining Q1 inventories. The two charts below provide a more detailed visual (Chart 1 shows builds by year and Chart 2 is for the numerically inclined).
Chart 1: U.S. crude oil inventories excluding SPR (strategic petroleum reserves)
Chart 2: Quarterly U.S. crude oil inventory builds / (withdrawals)
In both 1994 and 1996, crude prices from January to December rose 30% - 50%. That would imply a $80-$90/bbl target for oil in 2018. “Well, what’s different this time around” is the fact that U.S. shale has emerged as one of the most prolific short-cycle production sources. No one can deny this.
That said, one might wonder if the combination of (1) rising demand (from U.S. and abroad), (2) determination of OPEC+ producers to rein in inventories, (3) slowing non-OPEC non-shale growth (the vast majority of which were projects commissioned when oil prices were $100+), and (4) consensus view that oil prices will be range-bound (most peg it at $55 - $65 WTI, barring large exogenous factors), could set up for an unexpected rally in oil prices in 2H2018.
Even more interesting is the fact that takeaway capacity in the Permian Basin appears to be hitting bottlenecks (see Chart 3 below). The spreads between WTI and Midland (Permian hub) have widened to levels not seen since 2014 (when Brent oil, the international crude benchmark, was above $100). While admittedly, the extent of the spread in 2018 is likely transient (there are planned pipeline expansions for 2019 in-service), this underscores the potential limitations of U.S. infrastructure (pipeline or otherwise) in efficiently getting Permian crude to market. Put differently, the key takeaway is that spontaneous and dramatic growth in oil production growth is unlikely in the near future.
Chart 3: Spreads between WTI and Midland (Permian hub)
This development is also interesting because pipeline bottlenecks that depress U.S. (Midland or otherwise) prices will be a boon for international (Brent) markets. This is one of two main hopes (goals?) of Saudi Arabia - namely, to create an environment where U.S. crude trades at a discount to international markets, and to create a backwardated crude curve. (For reference, a backwardated market means near-term prices (ex: next month futures) are higher than long-dated (ex: 6 months from now) prices. This is important because Saudi Arabia and many OPEC producers sell on the spot market, whereas many U.S. producers hedge and drill based on longer-dated prices). This could limit or at least slow U.S. oil production growth as realized prices in the U.S. will lag international prices. And the more the U.S. produces, the lower the relative realized prices.
On balance, the oil market set-up appears to be constructive through the end of the year. OPEC+ producers are continuing to cooperate, demand is grinding higher, and inventories are normalizing. The summer oil demand season will be interesting to watch as investors could get excited about oil equities once again.
Interested in reading more of our market insights on Oil?
Check out this RSQ blog post from January-
Oil: Don't hold your breath on rig counts.
As international equity investors, the team at R Squared Capital Management (former team at Julius Baer / Artio Global) utilizes fundamental and macro analysis in our quest to correctly identify structural tailwinds and headwinds at the geographic, sector and company levels.
FROM THE DESK OF LUIS AHN
Luis Ahn is a Partner and Analyst at R Squared Capital Management.
Prior to joining R Squared, Luis was a Senior Analyst at Bloom Tree Partners.
Luis received an MBA from The Wharton School and Bachelor of Science in Quantitative Economics and Computer Science from Tufts University.
To view the firm biographies of RSQ, click here.