Oil Inventories Draws Are A False Positive For Prices

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Summary

U.S. oil inventory declines are a poor indicator of market balance over the summer months.

Summer demand increases will come from gasoline and diesel, and thus light tight oil supply will soak up incremental demand, driving down inventories.

The North American rig count will give investors a dataset that can help predict how far costs have fallen, and how quickly supply can respond.

It is becoming clearer that oil is moving away from the cartel and towards a free market where the marginal cost of supply sets prices.

Each week much is made about the oil (NYSEARCA:USO) stock movements week to week. Investors see declines as bullish and rises as bearish. However, the truth lies with neither. As I have covered before, there is an oversupply of light oil in the U.S. in the neighborhood of 2 mmbpd. As the summer driving season picks up, light oil will increase in consumption as it has a high percentage volume of diesel and gasoline components.

Due to the breakdown of light oil, and the focus of summer incremental demand from petrol and diesel, the increased consumption can utilize light oil. Thus, U.S. imports of heavy oil will flatline, and inventories will drop. This is an effect we see every summer as refineries increase light cat gas oil production (LCGO).

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Data Source: EIA

Focus On The Rig Count

The primary focus of investors through summer and into fall needs to be the North American rig count. While I had stated before that the NA rig count was not the most correlated signal for oil prices for the last six months, it will now move to the forefront - due to the testing of the supply response.

Oil companies in Canada and the U.S. have worked to cut costs sharply over the past two years, and as a result, the economics of new wells has changed dramatically. Shale oil has given the U.S. the chance to be the world's swing producer and price controller - It will respond quickly to price shocks in either direction. Canada will increase rigs dramatically once the summer is over.

This summer will give us a much better picture of just how far those costs have fallen and how the market will move in the later stages of the year. I expect a slow rising rig count as oil sits around $50 and a rapidly rising rig count if prices rise significantly. While nearly 400 rigs would be required to stem production losses, a rig count that grows too fast will signal to Saudi Arabia that the concern of a rapid price response is justified. If long-term confidence at $50/bbl sets in for crude producers, then the price ceiling will be partially established in Saudi Arabia.

Light Tight Oil

Saudi may be fearing U.S. light tight oil for another reason. U.S. refineries have spent millions building their refineries around high margin heavy oil. As time moves forward and confidence in light oil supply grows, there will be an increase in demand from domestic refining. Furthermore, as Gulf Coast refineries begin to accept the continuity of shale supply, new projects can be brought on board to increase the possible consumption.

Takeaway

Compounding the movement toward light tight oil consumption is the fact that stricter regulations for the primary market for U.S. refining demand, gasoline, and diesel, will result in long-term demand destruction. Saudi Arabia will need to fight for market share across the world. Inevitably, the cartel will continue to lose its ability to maintain high prices. With each day that passes, the oil market will look more like a typical commodity market where supply can respond quickly. Prices will stagnate at the marginal cost of supply. Most oil companies have seen great 6 month returns on higher prices, but with sentiment so positive, there remains plenty of room to fall.

Company Ticker 6 Mth Return
ExxonMobil XOM 17.91%
Chevron CVX 14.25%
Shell RDS.A 20.37%
British Petroleum BP 10.84%
Petrobras PBR 58.85%
Total TOT 8.24%
Conoco COP -2.70%
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