Why Crude Inventories Are High Now (And They Better Stay That Way)

| About: The United (USO)


Each week we are treated to reading about EIA weekly crude inventories at highest level "in 80 years".

People are making a huge mistake comparing current inventories to past numbers.

The missing data is the context from OPEC withdrawing from its stabilizing role in oil markets.

Waiting until inventories are at normal historical levels for a now-disappeared world of OPEC stability may lead to investing mistakes.

oil Investors are constantly being barraged by bearish news in the oil markets these days. Many have given up on energy completely, like mutual fund managers publicly swearing the sector off forever. Oversupply conditions created by over-investment in several locations, like North America and Brazil, have led to tremendous price drops in world oil prices. With these awful oil prices have come disastrous results in energy investments across the spectrum from The United States Oil ETF (NYSEARCA:USO) to even the most stable producers like Exxon Mobil (NYSE:XOM).

While the danger has not fully past, I strongly believe that energy will again have its cyclical day in the sun (at least from where it is now) and want to be ready for that. Therefore, as world oil prices reach historic lows in this crash, I have been beginning to move more into energy investments, and therefore have been trying to establish the correct context for my investment data in this new world.

One of the data points that is most closely watched is the EIA Weekly Petroleum Status Report. One of the phrases seen very often these days is reproduced below, quoted from the 1/27/16 EIA weekly report:

At 494.9 million barrels, U.S. crude oil inventories remain near levels not seen for this time of year in at least the last 80 years

Many bears see these numbers as solid, irrefutable proof that oil is dead money and will remain so into the future. After all, the whole world is producing flat out, as cited by dozens of media articles, oil minister comments, and publicly available analyses. Bears will point out that with inventories so bloated how could any oil or gas investment possibly succeed? While I agree that oil has been sorely treated in the past year for reasons that I think are well understood, I would like to make a point that I think is being ignored in critical forward investment analysis.

That point is that OPEC now is in an open price war for market share (I could quote a few dozen articles about Saudi Arabia, Iran, and Russia here to extend the article, but really?). There is no more OPEC spare capacity available to the markets for any practical purposes. Not only that, but all producers are slashing productive capacity and cannibalizing absolutely anything they can if they are not using it. There is nothing "spare" anywhere in anyone's cost structure.

So if you want additional oil these days, you will have to raise the price of Brent and WTI and wait for drillers to respond. The behavior of all the major oil producers over the past year proves to me beyond a shadow of a doubt they are holding nothing back, at least nothing that is connected to piping and terminals and ready to be shipped tomorrow. It is undeniable that both of the world's largest politically centralized producers, Russia and Saudi Arabia, are producing at the highest levels in decades, if not ever. They are doing this from fields that are in some cases over 50 years old, and both are straining to keep it up.

It's hard to imagine Russia or Saudi will discover some easy to add new oil in the near term. In short, I can see no evidence of any producer in any country holding back anything voluntarily, in the old sense of "spare capacity." Before this crisis, countries like Saudi Arabia would have huge amounts of ready-to-run oil production capacity, sometimes as much as 3 or 4 million barrels a day total, waiting to cover any unanticipated issues. Having a few hundred wells waiting to be fracked in North Dakota is not going to be the same kind of spare capacity the world was used to in the past.

This means that when investors are looking forward and considering the petroleum inventory levels as a key metric to measure when they should return to the oil markets, they may make a large mistake. Crude inventories in a world that has effectively zero spare capacity should remain much higher than a world where all consumers knew that 2 million barrels of quality, pre-prepared, connected production was available from OPEC producers during any kind of crisis or demand issue.

Indeed, it is my contention that inventories are now the only spare oil capacity in the world. You may find yourself too late to make profits in the energy markets if you wait for inventories to return to what had always been normal levels. Surely, they will decline, but an oil inventory level that was appropriate in a 2.5 million barrel of oil per day spare capacity world will be dangerously low in a zero spare capacity one.

As the market moves into balance more and more (and we have started to see progress at recent low oil prices in that regard with project cancellations, shut-ins, and massive capex cuts at almost all oil producers worldwide) it's strongly my opinion that until a much larger buffer of spare oil production capacity can be proven to exist again, investors should realize that inventories will remain much higher than otherwise would have been the case and that this fact does not represent as bearish an item as it would have in times before this particular oil crash.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.