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 percent 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. (click image to enlarge).
A year ago, WTI rose 41 percent 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. (click image to enlarge).
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. (click image to enlarge).
This coincided with the onset of declining U.S. crude oil production after April 2015 (Figure 4).
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 2015, 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.
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.
Crossing A Boundary
The current oil-price rally is based partly on a weaker U.S. dollar but mostly on hope that OPEC and Russia will cut production. For now, that is not even on the table. Rather, a somewhat meaningless production freeze is possible. Some rightfully believe that a dialogue about a production freeze may lead to a production cut some time in the relatively near future. I agree with that but it is a rather empty reason for oil prices to increase by almost 50 percent.
Traders are “following the tape,” meaning they have covered previous short bets and are following the momentum testing increasingly higher price thresholds as long as someone is willing to take the other side of the bet. That’s the way the market works.
It would not surprise me if this price rally lasts a while like the 2015 rally. I am interested in the requisite conditions that would allow a meaningful and sustainable price rebound. Early in the 2014 oil-price collapse, I thought it was a relatively straight-forward matter of reducing production so that the market could balance.
As low prices persisted, I recognized that a boundary had been crossed and that somehow, the principles that seemed to govern oil markets before September 2014 no longer applied in the same ways. I now believe that the world economy has been substantially weakened and injured by debt following the 2008 Financial Collapse and the easy-credit monetary policies that followed.
At some time in the not-too-distant future, the relentless depletion of legacy production and underinvestment in current exploration and production will result in much higher oil prices. The global economy will have to be much stronger to adjust to that.
The investigation I have presented here about the possible similarities between the present increase in oil prices and the false price rally of March-June 2015 reinforces my sense that a return to higher oil prices is not at all straight-forward. Oil markets are a leading indicator for the broader economy because the economy runs mostly on energy and not so much on money.
It seems that price and demand may be range-limited. Small changes in demand move prices up and down until those price changes feedback to changes in demand. Production has been like a machine working tirelessly in the background as easy money has kept it moving regardless of low prices and the absence of profit. That is how distorted the market has become.
World production now appears to be falling and that is certainly a necessary step in the right direction toward market balance. I anticipate an OPEC plus Russia production cut in 2016 and that will unquestionably move the market to some kind of balance. I suspect, however, that the new balance may be one in which prices and demand both remain lower than on the other side of the price-collapse boundary that was crossed in 2014.