Reviewing Our Oil Thesis For 2017 (Part II) - Fundamentals

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Includes: BNO, CR, CRAK, DBO, DDG, DIG, DNO, DRIP, DTO, DUG, ERX, ERY, FENY, FIF, FXN, GUSH, IEO, IEZ, IYE, NANR, NDP, OIH, PXE, PXJ, RYE, SOP, UOP, USO, UWT, VDE, XES, XLE, XOP
by: Open Square Capital

Summary

Update on our oil thesis and whether fundamentals are improving; our thoughts for 2017.

Recent data on oil market fundamentals show improvements, with a crude draw that’s likely to carry over from 2016 to 2017.

OPEC and Non-OPEC likely to extend their agreement to cut production, thereby rebalancing the market before the year-end.

As we've delved into oil's Q1 issues in a prior article, this article will tackle the fundamentals and how we're really assessing the oil market today.

First things first, oil data is a mess. It's opaque and incomplete because countries clutch their data tightly for competitive and national security reasons. The US, via the Energy Information Agency ("EIA"), is perhaps the best source with weekly releases of petroleum status reports that track the US market, and provide useful data on supplies, demand and inventory. For worldwide data, the International Energy Agency ("IEA") and OPEC are great sources, and include data from OECD countries (e.g., US, Canada and much of Europe) and non-OECD countries (e.g., China and India). No matter the source, frequent "true-ups" are made to the data when new information is available or when things need to balance properly. Throw in a mix of third-party information/subscriptions there's no dearth of information, but insights are harder to come by.

EIA data garners significant attention from the media and money managers because of its regularity, despite the fact that the weekly information can be noisy. When US inventories failed to drop in March, both US and global oil prices subsequently fell. The US, however, represents only a tenth of global supply and demand, so a singular focus on US data can distort your perspective on the underlying trends. So if we know much of the recent US inventory build is caused by temporary factors, what is the longer-term broader data telling us? For all of the temporary issues and turmoil above, the long-term fundamentals are improving.

a. Those Who Suffer Together, Stay Together

In order to appreciate what's really happening to oil, we need to step back a bit, so here's a big picture view for you:

The general consensus is that there are 285M barrels of excess oil in storage and the Vienna Agreement was designed to whittle down the excess in 2017. Although various factors weigh on the speed of rebalancing, the production cuts (if extended) should substantially reduce inventory by year-end. Market pundits originally predicted OPEC's compliance would hover around 60-70% based on prior OPEC agreements. Since implementation, OPEC compliance has been exceedingly high and Non-OPEC compliance is beginning to ramp up.

OPEC & Non-OPEC Production Cut Compliance

(Millions bpd)

Promised Cuts

January

February

OPEC

(1,164)

(1,286)

(1,078)

Compliance %

111%

93%

Non-OPEC

(558)

(248)

(270)

Compliance %

44%

48%

Total

(1,722)

(1,534)

(1,348)

Compliance %

89%

78%

Bloomberg, March 17, 2017

We've written previously

"For us, it's important to remember a key idea in the prelude leading up to the OPEC agreement and its aftermath, and that is this: [s]elf- interest will broker the deal, and self-interest will enforce it." - The Oil Deal - Pay Attention Because the Game Just Started (12/2016)

High compliance rates aren't surprising with the severity and length of today's oil price declines. Many countries can't fulfill their political promises at $40-$50/barrel, thus better to share some painful cuts in hopes of shortening it. When OPEC meets again on May 25 they'll only have 4.5 months of lackluster inventory data. Given the continuing weak oil prices and high compliance rate, we believe OPEC/Non-OPEC will extend the Vienna Agreement until year-end and put rebalancing on a much firmer footing.

b. Inventories

Even without the Vienna Agreement, it's becoming clearer that oil inventories worldwide are drawing down. Inventory levels, based on import/export data, help us to interpret the mosaic of supply/demand information. IEA and EIA data have been reporting a glut of oil because supplies have exceeded demand in 2016 (i.e., by 700K bpd or 250M barrels over the year), yet if supply/demand figures were correct, inventories levels should have increased substantially. The opposite is occurring, which likely means IEA and other agencies may have underestimated demand. Here's the 2016 monthly data from the IEA's Oil Market Report, notice the accelerating decrease in inventories?

(Millions bpd)

June

July

August

September

October

November

December

Total Oil

0.19

1.05

-0.32

-0.57

-0.90

-0.39

-1.16

According to this, OECD inventories have been decreasing by approximately 700K bpd since August 2016. Now certainly OECD stock doesn't contain non-OECD countries (e.g., China and India), but as OECD countries account for close to half of worldwide oil consumption and have a sophisticated storage infrastructure, it's a solid indicator for where oil is headed directionally. IEA has also historically underestimated demand, and if supplies actually exceeded demand, where's the extra 250M barrels (e.g., equivalent to 125 large supertankers)? It's likely these "missing barrels" don't exist and will be cleared when the IEA adjusts its demand figures. This is one of the key reasons why we believe that the oil market was already balanced by mid-2016, and since then, demand has eclipsed supply.

What's also interesting is that OECD crude inventory "only" increased in January and February by 45.2M barrels and 16.3M barrels, or a total of 61.5M barrels. Remember this build occurred despite US inventories increasing, OPEC's overproduction, floating storage destocking of over 70M barrels and higher refinery outages. This likely means that the underlying inventory draw has carried over from 2016 and should accelerate in 2017 when the Vienna Agreement's impact is felt and the temporary factors masking the decline fades away.

We'll tackle international rig counts and production in the next article, but for now, let's just say the data is trending on our side.

As always, we welcome your comments. If you would like to read more of our articles, please be sure to hit the "Follow" button above.

Relevance: USO, BNO, CR, CRAK, DBO, DDG, DIG, DNO, DRIP, DTO, DUG, DWTI, ERX, ERY, FENY, FIF, FXN, GUSH, IEO, IEZ, IYE, NANR, NDP, OIH, PXE, PXJ, RYE, SOP, UOP, UWT, VDE, XES, XLE, XOP

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.