Why Sub $50 Oil Is More Likely Than $70 Oil

Tyler Durden's picture

Submitted by Arthur Berman via OilPrice.com,

It is more likely that oil prices will fall below $50 per barrel than that they will continue to rise toward $70. Prices have increased beyond supply and demand fundamentals because of premature expectations about the effects of an OPEC production cut on oil inventories.

Last week’s 13.8 million barrel addition to U.S. storage was the second largest in history. It moved U.S. crude oil inventories to new record high levels.

Meanwhile, 130 horizontal rigs have been added to tight oil drilling since the OPEC cut was first announced in September. That means that U.S. output will surge and will continue to be a drag on higher prices.

Comparative inventory analysis suggests that the current ~$53 per barrel WTI oil price is at least $6 per barrel too high. Don’t hold your breath for $70 oil prices.

Inventory Is The Key

Most analysts believe prices will increase steadily now that OPEC has decided to cut production. Their logic is that over-production caused lower oil prices and lower output should bring markets into production-consumption balance.

The problem is that production is not the same as supply and consumption is not the same as demand. Inventories lie in-between and modulate the flows from both sides of the production-consumption equation.

Inventory is clearly part of supply but is also a component of demand. Excess production goes into inventory when demand is less than supply. When consumption exceeds production, oil is withdrawn from inventory reflecting increased demand.

The International Energy Agency (IEA) reported last week that global liquids markets would move to a supply deficit by the first quarter of 2017 if OPEC production cuts take place as announced (Figure 1).

Figure 1. IEA Demand/Supply Balance until 2Q17. Source: IEA February 2017 Oil Market Report.

Yet the OECD inventories on which IEA’s forecast is based have increased and are now more than 400 million barrels above the 5-year average (Figure 2). In order for a supply deficit to develop in the first quarter of 2017, those stocks would have to be drastically reduced over the next 6 weeks. Comparative inventory analysis provides some context for the necessary magnitude of that reduction.

(Click to enlarge)

Figure 2. OECD Incremental Inventories Are At Record High Levels Although Absolute Inventories Have Flattened in Recent Months. Source: EIA and Labyrinth Consulting Services, Inc.

Comparative inventories index current storage levels against a moving average of values for the same calendar date over the previous 5 years. This provides the most reliable way of understanding oil-price trends by normalizing stock changes for seasonal variations and comparing them with 5-year average values.

Figure 3 shows that current OECD comparative inventories (C.I.) are at an all-time high level of more than 300 million barrels (absolute inventories are 3.1 billion barrels).

C.I. values around zero (+/- about 50 mmb) correspond to periods of high oil prices (>$80 per barrel) over the past decade. That suggests that comparative inventories need to fall approximately 200 to 300 million barrels to support $70 to $80 per barrel oil prices.

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Figure 3. OECD Comparative Inventories Are At An All-Time High & Need to Fall 200-300 mmb To Support $70-$80 Per Barrel Oil Prices. Source: EIA STEO and Labyrinth Consulting Services, Inc.

What the IEA is apparently showing in Figure 1 as a “demand/supply balance” is really a demand/production balance. If OPEC cuts move forward as announced, consumption will exceed production in the first two quarters of 2017 and withdrawals from storage will occur. That is a legitimate demand increase.

The billions of barrels of working capacity remaining in inventory are not considered supply in this calculation of balance. That distorts the supply-demand relationship.* At the very least, it does not treat the ~550 million barrels of incremental inventory that has accumulated since December 2013 in Figure 2 as supply.

Inventory is like a savings account for oil. It may be in a separate account from checking but it is part of total available supply. This sort of confusion over definitions of supply and demand is easily avoided by considering comparative inventories. Related: Is $60 Oil Within Reach?

Figure 4 is a cross-plot of OECD comparative inventories and Brent prices. It shows that current prices of ~$55 per barrel are approximately $10 per barrel over-valued compared to the trend line. It further shows that comparative inventory levels must fall ~200 million barrels to support ~$70 per barrel oil prices.

(Click to enlarge)

Figure 4. OECD Comparative Inventories At Record Highs–Comparative Inventory Suggests That Current Prices Are ~$10/Barrel Over-Valued. Source: EIA and Labyrinth Consulting Services, Inc.

Movement toward market balance cannot help but accelerate as a result of OPEC production cuts. Still, the massive stock reductions necessary to support higher oil prices will only occur over a much longer period.

It will take at least a year to reduce OECD inventories 400 mmb down to the 5-year average. This assumes that all OPEC cuts take place as announced and continue beyond the 6-month term of those agreements. It also assumes that non-OPEC production declines or at least remains static.

U.S. Production Will Not Remain Static

It is worth recalling that over-production by the U.S. and Canada was the trigger for the global oil-price collapse in 2014 (Figure 5). These two countries accounted for almost half (44 percent) of the incremental increase in crude oil and lease condensate production in the world as of March 2015 peak production levels.

(Click to enlarge)

Figure 5. U.S. + Canada Incremental Ouput: The Major Contributor to Low Oil Prices. Source: EIA and Labyrinth Consulting Services, Inc.

U.S. production fell more than 1 million barrels per day (mmb/d) from April 2015 through September 2016 but is now recovering because of higher oil prices (Figure 6). EIA forecasts that field production will increase to 9.28 mmb/d by the end of 2017 and will reach almost 10 mmb/d by December 2018.

(Click to enlarge)

Figure 6. U.S. Crude Oil Production Has Increased 290 kb/d in The Last 4 Months After Falling 1.06 mmb/d From Apr 2015 to Sept 2016. Source: EIA February 2017 STEO and Labyrinth Consulting Services, Inc. Related: Energy Storage Set To Boom In 2017

EIA does not predict that WTI oil prices will exceed $60 per barrel throughout this 2-year period. It is interesting to note that EIA shows prices falling below $50 per barrel in February 2017 and remaining at that level through mid-year.

After OPEC announced that a production cut agreement was evolving in September 2016, the U.S. horizontal tight oil rig count accelerated. Since then, 130 rigs have been added and 67 percent have been in the Permian basin tight oil play (Figure 7). In recent weeks, the Eagle Ford play rig count has made impressive gains and the Bakken rig count has steadily increased also.

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Figure 7. 130 Tight Oil Rigs Added Since Mid-Sept 2016: 67 percent Are In The Permian Basin. Source: Baker Hughes, EIA, Bloomberg and Labyrinth Consulting Services, Inc.

This reflects a massive flow of capital into these plays that will certainly result in production increases. Approximately $10 billion was spent in 2016 on Permian basin drilling and completion costs for horizontal tight oil wells. An additional $28 billion was spent on Permian land acquisitions.

Don't Hold Your Breath for $70 Oil Prices

Traders, analysts and the press have consistently looked for every possible reason to anticipate higher prices since the collapse in 2014. Expectation of an OPEC production cut or freeze has provided an artificial lift to oil prices for at least a year and now, probably accounts for at least $6 per barrel of current $53 per barrel NYMEX futures prices.

A recent Wall Street Journal article noted a new record in long crude oil futures positions during the last week in January. It went on to speculate that this meant a possible end to the over-supply of oil and that prices should increase.

That observation is not supported by history. In fact, record long positions are commonly followed by a drop in oil prices. Notable examples shown in Figure 8 include price declines around the 2008 Financial Collapse, the 2014 world oil-price collapse, and the brief rally to $60 prices in the Spring of 2015.

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Figure 8. Record Long Positions on Crude Oil Futures Suggests That Prices Will Fall. Source: CFTC, EIA and Labyrinth Consulting Services, Inc.

Inventory data provides compelling evidence that present oil prices are over-valued. Last week, 13.8 million barrels (mmb) were added to U.S. crude oil storage. That's the second highest weekly addition ever--the highest was 14.2 mmb on October 28, 2016 when WTI prices were about $5 per barrel lower.

(Click to enlarge)

Figure 9. Crude Oil Inventories Are At Record Levels 140 mmb Above the 5-Year Average. Source: EIA and Labyrinth Consulting Services, Inc.

Comparative inventories are also near record highs (Figure 10). When C.I. was at this level in March 2016, WTI prices were around $39 per barrel. When C.I. was slightly lower in August 2016, prices were about $47 per barrel. The trend line in Figure 10 shows that oil prices are probably about $6 or $7 per barrel over-valued.

(Click to enlarge)

Figure 10. Comparative Inventories Near Record High Levels--Comparative Inventories Suggest Current Prices Are ~$7 Per Barrel Over-Valued. Source: EIA and Labyrinth Consulting Services, Inc.

Oil prices do not always reflect underlying fundamentals but markets eventually adjust because of them. Comparative inventory analysis suggests that current oil prices are over-valued. It is possible that markets have already priced in anticipated uplift from OPEC production cuts. If so, prices may not increase much beyond present levels and expectations of $70 prices any time soon are improbable.

OPEC cuts have almost certainly put a floor under oil prices but volatility will continue to characterize markets as it has for the past 2 years. U.S. production is a wild card that will almost certainly be a drag on upward price movement. My guess is that WTI prices are likely to move below $50 per barrel until effects of OPEC production cuts are reflected in falling global inventories.

*To its credit, IEA shows 2016 inventory declines reaching the maximum levels of the 2011-2015 average. That doesn't change the fact that current stock levels are 400 mmb above the 2012-2016 5-year average. That's why comparative inventories are essential.

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Elco the Constitutionalist's picture
Elco the Constitutionalist (not verified) Feb 17, 2017 5:07 AM

The same reason there is a cap on how much people will pay for bottled water?

Escrava Isaura's picture

Why Sub $50 Oil Is More Likely Than $70 Oil

I love Berman’s work but I have a problem here: Make America Great Again.

So, if Trump is to make the “less educated” class Great Again, and let’s use 2007 as a baseline, but, in reality, Trump will have to make bigger than 2007, that means, to match 2007 we’ll need 3 more million barrels of oil a day, meaning, US will have to import ‘an additional” 3 Australia’s every day.

The only way oil will stay on $50 dollars is if Trump doesn’t succeed.

 

YouJustMadeTheList's picture
YouJustMadeTheList (not verified) Escrava Isaura Feb 17, 2017 5:24 AM

"Why Sub $50 Oil Is More Likely Than $70 Oil"

 

Because Gartman owns $70 calls & has a stop loss at $50.

 

mind reset's picture
mind reset (not verified) YouJustMadeTheList Feb 17, 2017 5:26 AM

I'm making over $7k a month working part time. I kept hearing other people tell me how much money they can make online so I decided to look into it. Well, it was all true and has totally changed my life. This is what I do... http://bit.ly/2jdTzrM

Escrava Isaura's picture

C’mon. No trash here, please. We have plenty of fake stuff to deal with.

 

 

07564111's picture

Here's some not fake news for ya..

Russia will pay back the last of the Soviet debt by years end...Thanks Putin and co !!

Forward Russia !!

https://www.rt.com/business/377676-russia-pays-soviet-debt/

Kurt2's picture

In the land of blind people, the one eyed man is king.

07564111's picture

ameritards will forever be slaves ;)

BuddyEffed's picture

The low cost of oil keeps those still employed able to get to their jobs and producing and keeps their functionality stable and the larger communities functionality stable.  Obviously with low prices there is unrealized profit on the extraction/supply side.   But is there a backdoor where those companies and players get to still make bank due to QE types of support for the overall economic system?  If the making bank is covered independently, then playing for stability makes a lot of sense.

Arnold's picture

Some one mentioned the other day that $50 oil was a caveat of the ARAMCO IPO.

 I could use some filler on that thought.

Another piece of the crazy puzzle.

 

https://moneymorning.com/2017/01/04/as-the-saudi-aramco-ipo-date-nears-3...

 

https://www.fxempire.com/news/article/saudis-need-stable-oil-price-50-ar...

UncleChopChop's picture

whats' REALLY funny about this article, is that a) gartman may actually read this comment, and b) he may actually have that trade on. i quite enjoy imagining the brick he shits.

YouJustMadeTheList's picture
YouJustMadeTheList (not verified) UncleChopChop Feb 17, 2017 7:55 AM

The Gartman pinata is full of candy.

jus_lite_reading's picture

Damn right.

With the powder keg of Iran starting to spark, I think oil could go to $80 in short order. JMHO.

BuddyEffed's picture

We know which side of calls/puts your money is on jus_lite

Ace in the hole's picture

This is a problem many people do not understand.  Yes, when water hits $4/bottle, you might instead buy a bottle of diet coke for $3.  Not so with oil  There is a graph included that shows oil ranging from $30/B to $140/B.  People will pay $140, and inventory will drop.  But the price will be paid.  Why?  You can't switch to diet coke.  You can't decide just not to drive to work or to get groceries.  You can cut back your driving, and demand does fall at higher prices, but the world runs on oil.  Don't forget that fact.

UncleChopChop's picture

interesting article. but i feel like it's missing a focus on the us dollar. oil is, effectively, a currency and to treat it as such invites considering its relationship to other currencies.

 

new game's picture

because much of this oil(in merica) is refined and exported, i think we should be focused on distilate inventories and that demand.

anotherwards end use. I think that is flat, therefor article is spot on with supply glut coming...

and of course, china is the marginal demand offsetting contracting demand from western econs, due to efficiency and japan style growth.

oil is and always will be extremly difficult investment play. no insider lock on the future. many varibles inplay, political in nature and revolving around the mic, hitmen, "nation building" moar war thyme.

i see iraq is back to full capacity. where is that billions going? cia funding of 4th column?, hmmmm.

BritBob's picture

Falklands Oil

 

Rockhopper Exploration has issued an update on planning for Phase 1 of the Sea Lion oil field development in the offshore North Falkland basin. Operator Premier's latest estimate of capex to first oil is US$1.5 billion, with life of field costs (capex, opex, and lease) of around US$35/bbl for Phase 1.

 Rockhopper CEO Sam Moody described this as “highly attractive” in the context of the current oil price. The estimated break-even price is US$45/bbl.
The partners have submitted an environmental impact statement and revised draft field development plan to the Falkland Islands government, and discussions are set to continue on a range of operational, fiscal, and regulatory matters.
They have also reached a settlement on an insurance claim relating to costs incurred on the Isobel Deep exploration well during the 2015/16 North Falkland basin exploration campaign. Value is US$90 million (after deductions) on a gross basis. (MercoPress 23.12.16)

What about the Argentinians?

Falklands – Territorial Waters: https://www.academia.edu/10574593/Falklands_Islands_Territorial_Waters

 

All hot air...

07564111's picture

Would not the 'British' need a functional navy to hold those islands and that oil ;)

Like the stupid poms can barely get to the Med with a breakdown..something to do with ships that can't take the heat ;)

HaHaHaHaHaHa

Escrava Isaura's picture

Falklands (oil) – All hot air...

Correct.

 

brushhog's picture

It'll be $60 by July.

sinbad2's picture

Only if Russia and Iran wish it to be $60.

Wahooo's picture

LOL Tylers. Just keep trying to drive it down, it will not go where you want it. It is going UP UP UP. BTFD!

mjcarr51's picture

Oil is $3.50 away from $50.00 and $16.50 from $70.00.

d stephan3771's picture

Interesting that ZeroHedge is always bearish crude.  I can't remember seeing a bullish crude story in the last year.  Crude now is pretty balanced.

Last of the Middle Class's picture

The supply of natural gas worldwide is for now virtually unlimited with new fracking practices. That will hold oil down for the foreseeable future. Too bad the house of Saud can't issue a statement and drive it up to $100 a barrel like they used to. Losing your monopoly is a bitch.

sinbad2's picture

But is the gas located where the demand is?

The US has huge reserves, but not much demand, so it has to be liquified for export.

The US is making inroads into Europe, via Russian sanctions, coups etc, but Russian gas is cheaper, because it's piped.

Iran also has huge conventional gas fields that could supply Europe and India, but again US sanctions, wars prevent that.

Japan wants to pipe in Russian gas, and China is also arranging to buy piped gas from Russia.

The Saudis are running out of oil, that's why they are invading their neighbours, to steal the oil and gas.

MalteseFalcon's picture

That's the beauty of natural gas.

Oil lends itself to easy storage, easy transportation and, thus, global three card monte.

With gas, alas, not easy to pull a fast shuffle.

Cloud9.5's picture

On one side you have a contracting economy that cannot afford today’s prices.  Then you have the guaranteed income class, government workers, contractors and dependents that can afford a doubling or tripling of price.  Then you have the government itself that can afford gas at any price because it will mouse click the payment.  All of that is at play on the demand side of the equation.  Then you have the geopolitical plays followed by the natural decline rates of existing fields.  Then you throw in the fact that new discoveries are nowhere near current production rates.  And finally you factor in the declining EROEI and you wind up with a very opaque picture of where prices are going.

If we collapse, what is in reserve may very well last us a decade.  If we go Zimbabwe, it may go to fifty trillion a gallon.  If we go Venezuela it may be 99 cents a gallon with none available.

 

 

Stan Smith's picture

Well Duh....

We're storing oil on SHIPS in the water because we've run out of tanks on land to put it in.    Do we have to start putting it in mason jars before we start seeing the price per barrel drop?

Thrown in the fact that if anyone believes Iran is going to start really "cutting" oil production, folks are high off their asses.   After all those years of sanctions they are going to cash in.   

Oil should be down from where it is now.    As to where?   I'll let others figure that one out.

OccamsCrazor's picture

Not factored into any of this, is increased output from Iran, Iraq, and many other nations struggling economically, and having to increase volume to make up for low prices.  Also, OPEC cuts have ALWAYS led to CHEATING, and members producing more.  Russia will be continuing to set new output records as they adopt our technology. 

Folks, we're looking at sub-$50 oil for at least the next decade.  Extraction Technology is continuing to improve, and we keep finding more and more oil to tap as it gets better.  

Besides, for us here in the US, the dollar is only going to continue to get stronger as the Fed raises rates.  

OIL as far as the eye can see, for years folks.  

 

The new price trading range is between $40 and $50, with occasional short period above $50, and periods below $40.  

shortandcaught's picture

Because a 6% down move is more likey that a 45% up move?

 

Houses Depreciate's picture

Considering production cost of $6/barrel, oil has a long way to fall.

tbone10's picture

Hahahaha frack it!

PhiBetaZappa's picture

A 'supply & demand' graph, how fucking quaint.

How about a 'manipulated daily' graph based on "unexpected" news.

Just another market/casino joke. 

Opportunity Hunter's picture

Maybe. Maybe not. 

Own above $50. Below $50, it's someone else's problem.

http://opportunityidentified.com/2017/01/24/this-is-what-drives-next-big...

makinbacon's picture

You can all rest in peace....

Gov. Jerry Brown ( CA ) will make it feel like it's a $100 a barrel.

IronForge's picture

Because IRQ and IRN.  They don't care, as long as people are buying from them.