Crude Oil Buyers Beware

| About: The United (USO)

Summary

It was reported today that the Saudis and Russia agreed to an oil output freeze, this is a positive move but the oil markets remain oversupplied.

Crude oil and petroleum product inventories are well above historical levels.

Continued high production and weak consumption growth are forecast to add to these inventory levels through mid-2017.

As the outlook shifts towards the second half of 2017, expectations for an eventual balancing of production and consumption will eventually pressure prices back up.

This article takes a look at the factors that influence crude oil prices and what they currently indicate for crude oil prices. The announcement today that the Saudis and Russia agreed to an oil output freeze, while a positive move, does not change the fact that the oil markets remain oversupplied.

Factors that influence crude oil price

Crude oil prices are influenced by many different factors and the relative importance of these factors changes over time. The main factors that influence crude oil prices can be grouped into three broad categories:

  1. Inventories of global crude oil and petroleum products
  2. Expectations of future crude oil supply and consumption
  3. Potential for actual crude oil supply and consumption to differ from expectations

Before looking at these factors, it is worthwhile to look at historical crude oil prices and the futures curve.

Historical crude oil prices and the crude oil futures curve

Click to enlarge

When forecasting future prices, it is often helpful to look at historical price data. We tend to remember recent events and prices fairly well while more distant events and prices are harder to recall. The chart above shows historical prices (in real 2010 dollars) going back prior to 1970 and lists some of the events that influenced prices over this period.

In 2014, US shale oil production continued to increase and the Organization of the Petroleum Exporting Countries (OPEC) chose not to cut production to balance the market. This resulted in expectations of crude oil inventory builds and then actual crude oil inventory builds, putting downward pressure on prices.

Crude oil futures curve

Click to enlarge

The chart above displays the crude oil futures curve through 2024. (The chart is as of 15 February 2016, prior to today's announcement.) The futures market projects crude oil prices increasing from current levels to near $40 per barrel ($/bbl) at the end of 2016 and then increasing gradually to approximately $52/bbl by the end of 2024. This relatively low price level can only be sustained over this period of time if OPEC continues to produce at close to maximum capacity and US shale producers are able to increase production to make up for natural field declines and meet future worldwide consumption increases. It seems unlikely that these price levels will support investment in high-cost crude oil production such as deep water and oil sands.

Crude oil inventories

Inventories are categorized as strategic reserves, controlled by governments, or commercial inventories, controlled by commercial participants. The US Strategic Petroleum Reserve currently holds more than 700 million barrels of crude oil, while members of the International Energy Agency (IEA), including the US, hold about 1.6 billion barrels. Strategic reserves play an important role in minimizing price volatility in times of disruptions. During normal times, strategic reserves have less influence on prices, although their existence likely reduces the "risk premium" associated with crude oil prices.

Markets are typically more focused on commercial inventories than strategic reserves. The U.S. Energy Information Administration ((NYSEMKT:EIA)) publishes their Short Term Energy Outlook monthly which includes the Organization for Economic Co-operation and Development (OECD) commercial inventory figures shown in the chart above (these are used as an alternative for worldwide inventories which are not published on a regular basis and typically less reliable when published). As can be seen from this chart, OECD commercial inventories began to increase sharply in 2015.

The shaded areas indicate the minimum to maximum inventories in the prior 5 years. These have been updated with 2015 data that extends the range much higher than in previous years. Prior to 2015, the peak in days forward supply was right at 60, compared to 65 days today and forecast to increase to 70 days in early-2017. The builds in inventory were due to US shale oil production increases and OPEC's decision to increase production at the same time. OPEC's decision to increase production, in the face of quickly rising US production, caused the markets to become oversupplied.

High crude oil inventories in the OECD will continue to put downward pressure on crude oil prices.

Expectations of future crude oil production and consumption

As the chart above displays, world liquid fuel inventories are forecast to grow further in 2016 and into 2017 as production continues to exceed consumption.

The crude oil market tends to focus on the individual elements, within this overall production and consumption outlook, which are changing or driving the markets. Recently, the market has focused on three main areas:

  • OPEC production and, in particular, Saudi Arabia's and Iran's production - has Saudi Arabia's position changed or will they continue to accept low oil prices and how fast will Iran be able to increase production now that they have returned to the export markets.
  • Non-OPEC production and in particular US production - how will US shale oil production be impacted by low crude oil prices?
  • Non-OECD consumption growth slowing and, in particular, with the economic slowdown in China, how will this affect oil consumption in China and the region?

These questions play an important part in determining the direction of crude oil prices. The EIA's Short Term Economic Outlook forecast is a reasonable starting point for evaluating these questions. Although actual production and consumption will certainly be different than forecasts, the forecast, at least, provides a baseline to track actuals against expectations. The EIA's February 2016 Short-Term Economic Outlook forecasts the following:

  • OPEC production will increase from 38.19 million barrels per day (MMBD) in 2015 to 39.20 in 2016 and 40.07 in 2017 (while the EIA does not break out forecast OPEC production by country, they do state that Iran accounts for most of the increase).
  • US production will decrease from 9.43 MBD in 2015 to 8.69 MMBD in 2016 and 8.46 in 2017
  • Non-OECD consumption will increase from 47.46 MMBD in 2015 to 48.50 in 2016 and 49.62 in 2017

Expectations of further inventory builds in 2016 and the first half of 2017 will continue to put downward pressure on crude oil prices. As consumption continues to grow in 2016 and 2017 and production growth slows, expectations for a more balanced market in the second half of 2017 will eventually lead to price increases.

Potential for actual production and consumption to differ from expectations

There is the possibility of an unexpected event that changes actual, or the expectations for, crude oil production and consumption. These events include geopolitical incidents, extreme weather and unexpected OPEC actions and are typically difficult to forecast. When inventories are high (like currently) or substantial spare production capacity is available, unexpected short-term supply disruptions or weather-related increases in consumption do not typically increase the price as much as when inventories and spare capacity are tight.

The announcement today that the Saudis and Russia agreed to an oil output freeze, while a positive move, does not change the fact that the oil markets remain oversupplied and the majority of production increase over the next year was expected to be from Iran, who will unlikely agree to a freeze.

Supply disruptions and OPEC production cuts are hard to predict but the chance of further OPEC action to reduce production is a risk to the forecast of downward pressure on prices.

Other Considerations

  • There is a relationship between crude oil prices and other financial and commodity markets and the commodity and financial markets have recently fallen together.
  • The use of EIA data. There are a number of sources of crude oil fundamental data including JODI, OPEC and the IEA. Each source has advantages and disadvantages, the EIA data was used in this analysis because of its availability in the public domain.

Conclusion

Through the end of 2017, crude oil inventories are expected to remain well above historical levels. In addition to the current high inventories, continued high production and relatively weak consumption growth is forecast by the EIA to add to these inventories through mid-2017. This will continue to put downward pressure on prices. As consumption increases in 2016 and 2017 and the outlook shifts towards the second half of 2017, expectations for balancing of production and consumption will eventually pressure prices back up.

The announcement today that the Saudis and Russia agreed to an oil output freeze, while a positive move, does not change the fact that the oil markets remain oversupplied and the majority of production increase over the next year was expected to be from Iran, who will unlikely agree to a freeze.

Addendum

Sectors and stocks impacted

  • The United States Oil ETF (NYSEARCA:USO)
  • Integrated oil companies - Exxon Mobile (NYSE:XOM), Chevron Corp. (NYSE:CVX), and ConocoPhillips (NYSE:COP).
  • Oil service companies - Schlumberger (NYSE:SLB), Halliburton (NYSE:HAL), Baker Hughes (NYSE:BHI), Fluor (NYSE:FLR), and Weatherford International (NYSE:WFT)
  • US shale oil producers - Marathon Oil Corporation (NYSE:MRO), Continental Resources (NYSE:CLR), Southwestern Energy Company (NYSE:SWN), and EOG Resources Inc. (NYSE:EOG)

A look back at previous crude oil price forecasts

Similar crude oil price analyses were published in February and September 2015. At those times, many people were looking for a quick rebound in prices. Those analyses correctly forecast downward pressure on prices. As additional data have become available, the period of downward pressure keeps getting extended further out as OPEC production continues to increase and US production holds up better than forecast. These articles are published here:

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.