The recent oil price pullback has elicited fears that the market is in for a replay of last year in which prices rallied markedly in Q2, only to fizzle out through the balance of the year. The comparison is not warranted, in our view.
Last year's Q2 rally was premature and fundamentally baseless. Saudi Arabia at that time was still bent on shattering the US shale oil industry, and other variables that had large bearish implications on oil price, such as the path of both Iranian and US production, were still unknown at the time, but have since become visible and had been priced-in. Now, we have more visibility on the near-term trajectory of global output, which moderated significantly by early Q2 this year.
There are near term hurdles (such as the gasoline inventory glut), which need to be cleared up (via economic refinery run cuts, in addition to scheduled fall maintenance) before the market paves the way for a structural move higher in prices later in H2. There's evidence that the US gasoline glut is dissipating, and it may be just a month or so before cracking and refining margins will turn-around.
The accumulation of gasoline stocks in the United States has been driven by excess gasoline production rather than by the lack of demand, according to Valero, the largest independent refiner in the United States (see chart above). It was more a result of opportunistic utilization, especially utilization in periods where we typically see refineries cut.
Typically, refineries cut in the fourth quarter and in the first quarter, but this year we saw refineries running very high utilization rates (96.1% at some point) due to the steep contango in the gasoline futures market. The glut formed due to the natural tendency of refiners to front-run gasoline demand (by an average of 4 months). But we have probably seen the worst of the glut conditions in the US: capacity utilization collapsed from a peak of more than 96% a few weeks ago, and the inventory of gasoline stocks had already topped out and rolled over (see chart below).
There was a global glut in gasoline
What exacerbated the product glut, was that it was global in scope. Saudi Arabia, China, and India all are making concerted efforts to boost refining capacity, which is leaving them with surplus product that ends up being sold in export markets. The US is not the only country that has issues with a surfeit of products inventory. We expect to see this issue to recur in the coming years.
Refinery throughput/input - i.e., the inflow of crude into refineries - is surging in Saudi Arabia, China and India. This is leading to dramatic growth in refined-product exports, particularly gasoline and diesel fuel, from these countries (see chart below). This surge in refining and exporting is altering trade flows in global crude and product markets, now and in the future, which will force market participants to deal with a larger number of fundamentals upstream and downstream factors.
Latest data: from January to May this year, Saudi Arabia's diesel exports were up more than 300 Mb/d over the comparable period last year. Saudi exports of diesel and motor gasoline surged in the first five months of the year by 112% and 76%, respectively, due to new refining capacity brought on line in 2014. China's monthly average gasoline and diesel exports over the January - June 2016 period are up 72% yoy at 205,444 b/d, and 233% yoy at 282,039 b/d, respectively. That redounds to average gain of just over 86 M and almost 200 Mb/d yoy over the January - June period for gasoline and diesel exports. India's average gasoline exports over the January - June period this year were at circa 416 Mb/d, a rise of more than 80 Mb/d, or 24%, over the comparable period in 2016. Diesel exports from India averaged over 541 Mb/d during the January - June period, a 19% increase over comparable 2015 exports.
The gasoline glut in the US is over
The global case for oil is therefore still not benign, but we have reasons to believe that the gasoline inventory glut in the US, for all intents and purposes, is over. The pertinent and operative dynamic is that gasoline inventory changes are 4 months ahead of the changes in gasoline consumption, gasoline production, and even gasoline imports. So by definition, there is a 4 month gap when the pace of gasoline inventory build can be faster than the actual gasoline consumption rate. This simple mechanics tends to produce an imbalance, and every now and then, a glut. The inverse process is true; as demand peaks, the pace of the diminution of the inventory build picks up pace. In the current case, US peak gasoline consumption has already been reached (based on historical norms), so mechanically, that should result in even faster gasoline inventory draws from here on as gasoline imports and production all fall (see chart below).
The entire process is being paced by - and is tending to follow -- the changes in refinery capacity utilization, which lead the changes in gasoline inventories and consumption by a wide margin. Capacity utilization peaked well ahead of gasoline inventories, as well as the peak in demand (which is probably occurring just now, at present). An actual roll-over in demand, expected any day, truly signals that the glut in gasoline inventory is over - however that may seem counter-intuitive.
That summation becomes clearer if we remember that the rise in inventories was predicated on a corresponding rise in demand (actual and expected), and that the glut was due to an opportunistic build in gasoline inventories that has gone awry. Therefore, when demand falls, the glut necessarily has to disappear. We illustrate that process in the chart below.
The focus now shifts to the Asian refiners
For the short term therefore -- perhaps another month or two -- the global product overhang and continued output from the Asian refineries will keep distillates from rallying -- which will mean refining margins will stay under pressure. This will force refiners to cut runs further, which will back crude up, keeping product prices in their current range until enough refining capacity is forced off line to draw products down to more manageable levels. This also will keep crude oil price from rallying, and will keep prices rangy around current levels -- price levels which are insufficient to incentivize drilling for all but the most efficient shale and OPEC producers. And even the big ones are balking at the current lower price of crude oil. Hess and Anadarko early in the year said that they would need crude to reach $50 a barrel before resuming drilling. This week, despite higher prices and lower costs, the E&P industry has raised the bar, signaling it will take $60 or better before meaningful production can resume. Apparently, the industry doesn't want to ramp things up until they are fairly confident prices will hold up.
That is the self-correcting mechanism provided by the crude oil-oil product feedback dynamics.
Expressed another way, consumers do not buy crude oil -- they buy oil products, mainly gasoline. Therefore, gasoline tends to be the price setter for the entire energy sector, as gasoline inventory tends to dictate the subsequent crude oil inventory level three months later (chart below). This relationship has deep implications in the analysis of oil prices, as we will explain later.
In and of itself, this fast-receding gasoline glut episode doesn't force crude or product markets to break down. However, it does mean that the global crude supply destruction will continue, as markets continue to clear below the marginal cost of most producers worldwide, excepting the most efficient shale-oil operators and key OPEC producers like KSA, Iraq and Iran. As we discussed earlier, even the big E&P operators intend to hold back on new activity due to this current episode of falling oil prices for fear that they will be trapped in another cycle of lay-offs and stoppages if the oil price continues to fall again. This reticence (or newly found prudence, if you may) will act as regulator of the tendency to ramp up production on higher oil prices.
In addition, it means refiners likely will take maintenance early and switch to winter-specification product, and re-start in a month or two at a lower run rate than they assumed even a month ago. Meanwhile, however, oil prices will likely tend to consolidate, with a slight downward bias in the short-term.
We have been calling this oil market correction since Q1 due to several reasons: (1) A sideways consolidation is suggested by the correlation between capex and output, shown in the chart below.
(2) Readers of our blog knew as early as Q1 2016 that there will be a deep correction during Q3 2016, thanks to the chart shown below. They have had access to this chart shown below as early as March, when we first published the VAR's forecast. The efficacy of that VAR-derived forecast seems to be being validated.
There are several, inter-linked primary fears in the oil market which subsequently brought down the crude oil price in the past few weeks:
1. There are fears that the refined products market will face the issue of oversupply.
2. There is the consequent market fear that the refiners might start cutting back production, reducing refinery crude input - hence cutting back demand for crude oil
3. This will add further to inventory builds in crude oil.
4. All of the above work together to set crude oil prices back, as incentivized hedge funds bail out of their long oil positions and go net short.
This week's report that Gulf Coast inventories increased by 1.5 million barrels obviously did not help, as so far there has only been limited progress in reducing the Gulf Coast oil stocks in the current driving season. But for us, this inventory report as a reason to sell crude oil is somewhat lame, as changes in oil inventory only remotely impinges on changes in the oil price and the oil term structure. Actually this pair work together whether to incentivize inventory build-up in crude oil or not (see chart below).
So the real price setter is gasoline price, and the build in gasoline inventory that it incentivizes - that sets off a train of events which culminate in a consequent and corresponding build in crude oil. We reprise the previous chart shown earlier, with an expanded view and an inverted WTI price. There are no correlations being invoked here but the comovements do show how development in gasoline inventories do tend to coincide with the WTI price, and lead subsequent changes in the oil inventory build (see chart below).
The lesson I see here is that we have to focus on the gasoline inventory, not on the crude oil inventory which merely responds (after a significant lag) to the requirements of producing gasoline and other products.
So with the gasoline inventory glut dissipating in the US, it is just a matter of waiting for the Asian refiners to clear their backlogs. We believe that it could happen within a few weeks; perhaps by early September, this episode of a monumental glut in gasoline inventory all over the world is history. We also believe that by late H2 2016, the determinants of crude oil prices should again focus on the ongoing supply destruction in the global oil supplies and slower pace of oil output growth in the OPEC relative to what the EIA and IEA have expected, against the likelihood of strong global oil demand by H2 2017 (see chart below).
We believe that our call for a sharp rise in oil prices by the late part of H2 remains on track, and that we could see oil prices at $60/bbl-$70/bbl in late 2017. The arguments set forth in this article are continuation of the thesis which argues for higher oil prices in 2017 we discussed in detail at a recent article: "A Crude Oil Price Weakness In Q3 2016 Hastens A Multi-Quarter Rebalancing And Sharply Higher Oil Prices Into 2017"; you may read it 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. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The company the author represents may have outstanding long or short positions in the commodities discussed in the article. The company may also initiate new positions, long or short, in any of those commodities mentioned, within 72 hours of publication of this article.