We expect oil and oil product inventories to rise around this time of year.
In the cyclical nature of the oil market, January traditionally has been a time when refineries raise both crude oil on hand and gasoline being produced in anticipation of a coming rise in demand a few months down the road.
Of course, gasoline is hardly the only oil product. Unusually cold winters will increase the need for low-sulfur heating oil and propane (a higher-end distillate that serves as the major heating fuel in most rural areas nationwide), too. And then there is the ongoing difficulty of producing an adequate volume of diesel (a middle distillate).
This time, however, it is not the inventory expansions, but their actual size that is prompting some jitters in the market.
In its weekly figures (released Wednesday, January 19), the Energy Information Administration (EIA) – a division of the U.S. Department of Energy – reported that both crude oil and gasoline inventories are at 10-month highs and well above five-year averages.
As I am writing this, the price of crude oil is down about 3% from its last high on January 12.
RBOB (Reformulated Blendstock for Oxygenate Blending), the NYMEX gasoline futures contract, has also declined. Yesterday it fell almost 2.5% – the single largest daily drop in three months.
With crude above $90 per barrel and gasoline at $2.47 a gallon before this slide, these percentage falls are not overly disconcerting in themselves. However, any time we see a short-term spike or dive in prices, the analysts and pundits need to explain why.
And it is here that they continue to get only half the picture.
Two demand elements are paramount to – and figure prominently in – the sound bites now permeating the airwaves: concerns over demand in the U.S. market and questions about the impact of inflation in China.
But, as you will see, most analysts are missing something. And it points to serious profits for us…
Two Demand Concerns Are Causing Market Jitters
First, deliveries from refineries in the U.S. to wholesalers continue to be down. That guarantees that we'll hear a broad-based assumption about the strength of the recovery in the American market.
Of course, one could just as easily ascribe the brunt of it to other factors – the continuingly bad weather in places like the Northeast (cutting travel), for example, or the fact that this is the time of year in which demand usually declines, for cyclical reasons.
I would suggest in response that the more pervasive dynamics in the market ought to be the overriding indicator.
Keep in mind the following: While the inventories of finished product are increasing, so are the processing runs. In other words, refineries were operating at 83% of capacity last week (the Wednesday EIA figures tell us what the market was doing as of the previous Friday) but actually producing more while moving less onto the market.
Translation?
Refineries are building inventories of both raw material and finished product in anticipation of the normal yearly rise in demand starting in March. They want to be ready to profit.
And this year, that demand surge is shaping up to be an unusually pronounced one. So concerns about genuine demand levels in the current – very short-term – window seem unwarranted.
There is one anecdotal way of seeing this trend. The February contract gasoline crack spread (comparing contracts in crude oil to contracts in gasoline) is narrowing. This usually happens when a balancing is taking hold between the two.
Looks to me like a base is forming for the move up.
Then again, the decline in pricing has been quite subdued.
Despite the continued angst over the demand-economic recovery connection, the futures trade is actually taking place in a rather narrow band. Daily trading must consider short cycle demand concerns. Yet the subdued pricing declines means there is considerable upward pressure in the market suppressing more pronounced declines.
Second, the Chinese situation poses a longer-term question.
With the introduction of mechanisms to cool off a clearly overheated economy, Beijing's decision to raise interest rates and bank reserves is a sign that the specter of inflation is raising its head.
Analysts rightly note that a slowdown in Chinese development should translate into a reducing need for energy. This aspect of the demand equation would then lead to a further depressing of prices for both crude and finished oil products.
Yet I find the basic argument unconvincing.
Despite Beijing's moves, Chinese performance continues to accelerate, as does the need for gasoline in a rapidly expanding personal transport sector and for petrochemical feeder stock and products for a developing industrial network.
There is no energy crisis, industrial contraction, or domestic market implosion coming around the corner in China. And demand is moving north elsewhere in the world, too.
The two primary demand-side concerns, therefore, while valid, are hardly a disaster waiting to happen.
It is the other side of the situation that the pundits are missing…
The Real Reason Oil Inventories Are Soaring
The consolidation occurring in refineries is happening in the shadow of a much more protracted upward pricing pressure.
The traditional factors I follow in estimating future pricing levels – demand (especially industrial), currency exchange (forex) developments, supply concerns (more quality and processing costs, rather than simply availability), infrastructure strictures (like inventories), and sector M&A (concentrating control, reducing competition) – are still pointing strongly up.
The new element in the mix is the uncertainty of where to place the acceptable futures pricing levels (volatility).
We have seen such an element before, indicating a difficulty in equating proper pricing for futures (paper barrels) with consignments of actual oil (wet barrels).
But nothing like the one that is developing this time around.
What's occurring very short-term (next month's futures contract, for example) may be the horizon that limits the talking heads.
On the other hand, we know that the more encompassing combination of traditional elements and rising volatility will be driving these prices higher moving forward…
…and our profits right along with them.
Disclosure: None
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