The Calm Before The Storm: Oil Undervaluation Climbs After Storage Surplus Slides To A 30-Month Low As Hurricane Harvey Looms Large

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Includes: BNO, DBO, DNO, DTO, DWT, OIL, OILK, OILX, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWT
by: Force Majeure

Summary

The crude oil storage surplus has now been halved since March after the EIA reported a bullish -5.4 MMbbl weekly drawdown in Wednesday's Petroleum Status Report.

Headline-making growth in domestic production has been more than countered by declines imports and growth in exports and refinery inputs (a proxy for demand).

Oil prices have not responded to this dramatic improvement in the supply/demand balance and remain significantly undervalued according to my Fair Price model.

Impacts from Hurricane Harvey will be seen beginning with next week's Petroleum Status Report with oversized oil storage builds, but total petroleum inventories--and the bullish thesis--should remain intact.

Hurricane Harvey may be (finally) dissipating over the lower Ohio Valley this morning, but its numerical impact on the oil markets will not be realized until next week. Nonetheless, oil fell by 48 cents or 1% to $45.96/barrel as investors remain concerned about a supply glut amidst refinery shutdowns even as the EIA announced Wednesday morning that crude oil inventories fell for a ninth straight week and for the nineteenth time in the last twenty one weeks. This article will analyze the most relevant details of the report and what it likely means for the price of oil going forwards.

For the week of August 19-25, the EIA announced that crude oil inventories fell by -5.4 MMbbls, 400,000 barrels smaller than the API's -5.8 MMbbl forecast, but an exceptionally bullish 6.7 MMbbls bullish versus the 5-year average +1.3 MMbbl injection. In fact, as Figure 1 below shows, it was the second largest weekly storage withdrawal for the August 19-25 period in the full 34 year period for which EIA storage data is available, topped only by 1985's -6.2 MMbbl draw.

Figure 1: Largest crude oil storage withdrawals for August 19-25 in the last 34 years showing that this year's draw was the second largest on record [Source: EIA]

Notice that the majority of these larger draws occurred during the 80s and 90s. Before this year, the largest draw this decade had been a mere -1.6 MMbbl draw from 2014.

With the -5.4 MMbbl draw, crude oil inventories fell to 457.8 MMbbls, which is the lowest since January 15, 2016, nearly 2 years ago. More importantly, the storage surplus versus the 5-year average fell to +74.6 MMbbls, the lowest since February 20, 2015, 30 months ago. As Figure 2 below shows, the surplus has now been halved since reaching +148 MMbbls On March 3, 2017, less than 6 months ago.

Figure 2: Crude oil storage surplus versus the 5-year average over the past 3 years showing a rapid contraction in the surplus over the past 5 months. [Source: EIA]

Overall, the crude oil surplus has fallen eight out of the last nine weeks and twenty out of the last twenty three dating back to March. Crude oil inventories are now down 37.4 MMbbls compared to last year, the largest year-over-year deficit since August 8, 2008, more than 9 years ago!

The accelerated rebalancing of domestic supply/demand balance comes at a time when crude oil domestic production is once again approaching all-time highs, a fact that seems to have stolen more headlines that the decline in inventories. However, cheap US oil allowed other elements of supply and demand to pick up the slack, as shown in Figure 3 below.

Figure 3: Crude oil supply/demand balance compared to 2016 showing how rising production is more than cancelled out both declines in imports and gains in exports and refinery inputs resulting in a tight year-over-year market. [Source: EIA]

While production is up over 1 MMbbl/day year-over-year, this is nearly cancelled out by declines in oil imports alone which, at 7.905 MMbbl/day last week, are down 1.01 MMbbls from 2016, likely thanks to efforts by OPEC to curb worldwide supply and a growing gap between WTI and Brent prices. Additionally, the EIA reported that while crude oil production inched higher 2,000 barrels/day last week, lower 48 production fell by 12,000 barrels/day and continues to show sides of plateauing along with the Baker Hughes Rig Count. Further, on the demand side, exports are up 210,000 barrels/day and refinery inputs--a proxy for demand--are up 1.11 MMbbls from 2016. As a result, US supply/demand balance is averaging more than 1.3 MMbbls/day tight or over 9 MMbbls/week tight year-over-year. Even looking at the past 5 years, supply/demand imbalance is averaging a stunning 5.4 MMbbls/week tight versus the 5-year average over the past month.

Because of this ongoing tightness which I expect to continue (excepting the next few Harvey-influenced weeks--more below) through the rest of 2017, crude oil inventories will likely continue to contract. Figure 4 below plots projected crude oil inventories for the next 6 months through February 2018.

Figure 4: Observed and projected crude oil storage levels for the next 6 months showing continued declines in inventories. [Source: CelsiusEnergy.Net]

And Figure 5 below plots the projected storage surplus and deficit versus both the 5-year average and year-ago levels.

Figure 5: Observed and projected crude oil departure from the 5-year average and year-over-year storage levels showing building year-over-year deficit and transition of surplus versus the 5-year average to deficit. [Source: CelsiusEnergy.Net]

Should the current rate of contraction continue, crude oil inventories could fall under 400 MMbbls by December while the storage surplus could potentially flip to a deficit versus the 5-year average by January 2017 for the first time since October 2014. Perhaps most impressive, should these projections verify, the year-over-year deficit would fall to around -120 MMbbls by February 2018 doubling the previous high of -58 MMbbls from 2008 in the entire 34 year history for which EIA storage data is available.

Given this dramatic improvement in the domestic supply/demand picture, it is rather surprising that crude oil remains as cheap as it has. Even before the Harvey-induced sell-off last week, crude oil was languishing under $49/barrel. Much of the ongoing concern seems to stem from the fact that investors expect rising domestic production to lead to a new supply/demand imbalance. However, for that to happen in the setting of stable demand and imports, production would need to rise by over 0.7 MMbbl/day just for the supply/demand balance to loosen back to the 5-year average. With production currently appearing to plateau and the rig count having seemingly peaked, this seems very unlikely. It is also very unlikely that demand will fall or imports will rise for a sustainable period at current prices. I expect oil would need to average over $60/barrel before we will see significant demand erosion or increase in imports.

My Fair Price model, which compares current inventories and oil price to storage/price pairs over the past 10 years, shows just how undervalued oil is relative to historical averages. Figure 6 below plots the actual futures price of oil versus the calculated Fair Price of oil based on current inventories alone and then based on projected inventories for the next 8 months.

Figure 6: Current and projected Fair Price versus Futures price showing a large undervaluation. [Source: CelsiusEnergy.Net]

Figure 7 plots the percent undervaluation, or the difference between the Fair Price and Futures Price.

Figure 6: Crude oil percent undervaluation based on current and projected inventories. Source: CelsiusEnergy.Net]

Based on current inventories alone and a +74 MMbbl surplus versus the 5-year average, crude oil is undervalued by a whopping 27% versus its Fair Price of $62.5/barrel. And based on projections that crude oil inventories will continue to contract, the Fair Price balloons to average $82.13/barrrel over the next 8 months, a whopping 43% undervaluation. A few things on these gaudy numbers: First, assuming that the market remains similarly tight as it is now takes a lot for granted. Should the price of oil climb to match its Fair Price, there will likely be a demand erosion and further rises in imports and domestic production as profitability increases, loosening the market. Indeed, one reason that the undervaluation is as large as it is now is that oil has remained so cheap despite improving fundamentals, allowing this favorable supply/demand environment to persistent longer than it would with a more typical price response.

Even assuming that these projected Fair Prices are somewhat exaggerated, I remain bullish on the prospect of crude oil long-term and continue to feel that, at minimum, oil trades north of $60/barrel by this winter. I remain long oil and my trading strategy is unchanged despite the recent dip in prices. I am long oil via my preferred strategy of selling short the inverse 3x ETF, in this case DWT, in order to counter long-term contango-related losses with leverage-induced decay as I plan to hold this position through the end of 2017. For the more risk-averse, a long-term hold in the 1x United States Oil Fund (USO) is not unreasonable and a buy-and-hold of the 2x leveraged ProShares Ultra ETF UCO or even UWT, assuming volatility and choppy, sideways action doesn't become a problem, is an option, although gains will be mitigated by contango and/or leverage-induced losses. Overall, I feel that this Harvey-fueled dip is a buying opportunity and will consider adding to my position over the next 24-48 hours.

It is worth mentioning that Wednesday's Petroleum Status Report will likely be the last "clean" report for several weeks as impacts from Harvey are likely to be felt through the end of September. I expect that we will see a series of exaggerated crude oil storage builds beginning next week due to shut-downs of major Gulf Coast refineries leading to a dramatic decline in demand that could exceed 2 MMbbls/day should these shutdowns drag on for the next 2 days through the end of the week. Storage injections in crude oil will be countered by large draws in refined product inventories such as gasoline and distillates as refinery output plunges. Total production losses will only average around 0.350 MMbbls/day. As a result, while crude oil inventories will likely grow, total petroleum inventories--which include crude oil, gasoline, and distillate--will probably remain unchanged or even dip depending on the magnitude of production losses. Further, unless refineries suffer long-lasting damage, such shutdowns should be temporary and I expect a normalization of supply/demand balance by late September or early October. Even with the expectation of large crude oil storage injections beginning next week, this should not significantly impact my Fair Price model as it uses "total petroleum inventories" as the basis of its calculation rather than crude oil inventories alone.

In summary, the EIA reported yet another large crude oil inventory draw for August 19-25 with the storage surplus versus the 5-year average falling by 50% in under 6 months as US supply/demand balance has quickly rebalanced since March. Based on current and projected inventories oil is significantly undervalued versus its historical Fair Value. For this reason, I feel that the recent dip in oil below $46/barrel represents a good entrypoint for a long-term buy-and-hold. Crude oil supply/demand balance will be dramatically disrupted beginning with next week's report due to the impacts of Hurricane Henry, but offsetting expected builds in oil inventories and declines in refined product inventories will result in minimal net change in total petroleum inventories and should not dissuade potential investors.

For more on current crude oil inventories, projections, and Fair Price data, please see my website CelsiusEnergy.Net.

Disclosure: I am/we are short DWT.

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.