U.S. Crude Inventories Are Set To Decline In 2H 2019: Take A Look At Refinery Throughput And Adjustment Factor

Summary

• KSA will keep exports low until they balance US market.
• Unusually low US refinery throughput and extremely high adjustment factor explain to a large extent the recent surplus in US crude inventories.
• These trends should reverse over the driving season.
• If everything goes back to "normal", US crude inventories are set to decline materially in the second half of the year.

2018: It was all about the Saudis.

Last year was a massively disappointing year for oil bulls. WTI price dropped from $76 to $45, more than 40% in just weeks. What was thought of as one of the most bullish events for the oil thesis - Iranian sanctions - turned out to be a nightmare for bull investors.

The announcement of Iran sanctions led the Saudis to increase their exports in order to calm the oil markets from fears of oil prices going through the roof. Started in May/June, KSA flooded the market as we can see below:

"Source: Author based on EIA"

What made it worse was that Trump granted 8 countries waivers to keep importing Iranian, in early November, just few days before the US midterm elections. Iran did not see their exports reduced as expected and the Saudis had already flooded the market. Combine with an extraordinary shale growth and a global slowdown and WTI dropped +40% in just weeks.

Once the driving season finished, the market could not absorb this new wave of supply and by the end of the year US crude inventories rose by almost +60MM barrels from its bottom:

"Source: Author based on EIA"

Saudi Arabia will not be fooled again

KSA realized they made a mistake by increasing exports and oversupplying the market. However, they are really gone 180 degrees.

Their goal now is to reduce stocks until 10Y average or ~390MM US crude inventories, where historically one could see much higher prices:

"Source: Author based on EIA"

US Crude Inventories: Key Variables and what to expect for 2H 2019.

• Crude Imports: KSA and their new policy towards US.

The Saudis are serious about bringing US market to balance. They have been trying to do so since December. Not only KSA, but also Iraq and Venezuela (although not voluntarily) have seen their exports reduced:

"Source: Author based on EIA"

It seems KSA have been quite agressive and committed to its purpose. The problem and most frustrating thing so far is... they have failed.

Year to date, US crude inventories have surged from ~440MM barrels to 468.5MM. So, is this normal? Apparently it seems to be a significant increase, so let´s see if this trend is seasonal or not:

"Source: Author based on EIA"

Despite the fact there were lower than expected KSA+Iraq+Venezuela imports and lower US production growth, inventories are at 470MM.

This could put more pressure on KSA. In fact, we think their exports to US will remain low for the next 6 months, in the range of 400kbd-500kbd. Note that, from May 18 to Dec 18, KSA exports to US averaged ~900kbd, so that means more than 50% cut. That should be enough to balance US crude inventores by the next year.

However, getting back to the initial question, what went wrong? All of this could be explained by two variables: refinery throughput and adjustment factor.

• Refinery throughput: Much lower than expected

Crude throughput is the total amount of crude that goes into a refinery before it comes out processed. The lower it is, the higher the inventory is.

Year to date, refinery throughput has been 217kbd lower vs 2018 in the same period. The first 26 weeks of 2018 vs 2019 show the math:

• First 26 weeks of 2018: 16.745mbd, weekly average.
• First 26 weeks of 2019: 16.528mbd, weekly average.

We can see it below:

"Source: Author based on EIA"

This lower throughput has meant an additional 39.5 million barrels of crude vs 2018. There could be some reasons that explain this lower refinery input:

1. Lower final demand.
2. Unplanned refinery outages.
3. Higher product imports.

So let´s see just for the time being the first point. US total liquids demand- 4 weeks average shows strong demand. In fact there is no significant change vs 2018:

"Source: Author based on EIA"

Then, should refineries increase throughput or not? Refineries are fixed cost beasts, so keeping utilization high is their main priority.

In fact, gasoline demand is about to enter its seasonally strong period, so if refinery throughput doesn't pick up, we should see even lower gasoline storage as long as product imports don´t increase that much:

"Source: Author based on EIA"

Actually, we have seen the sharpest drop in "US big 4" liquids in the last 4 years:

"Source: Author based on EIA"

• Adjustment Factor: wild card

First, let´s see what adjustment factor is. As EIA states:

"This adjustment reflects the combined uncertainty around each of the crude oil data elements that EIA uses to assess the balance between U.S. crude oil supply and its disposition. Key weekly crude oil quantities are linked through the following balance relationship:

Domestic Production + Imports = Refinery Inputs + Exports + Stock Change,

with stock change defined as the difference between stock builds and stock draws.

Each week, EIA collects survey data for imports, refinery inputs, and stocks.

Because this calculation can fluctuate between positive and negative values, a four-week or eight-week average adjustment is often even smaller than 2%."

Over the last 8-weeks, EIA's weekly US oil storage report showed +687k b/d average adjustment. This means +38.4MM barrels of unaccounted barrels:

"Source: Author based on EIA"

Also, it seems also too high if we compare it with historical trends:

"Source: Author based on EIA"

Year end balance: forecast

If we gather all the information mentioned above, we can conclude that US crude inventories might decline by ~50MM to ~70MM barrels:

"Source: Author forecast"

CONCLUSION

In essence, the main reasons why we have seen US crude inventories going through the roof are:

1. Unusually low US refinery throughput YTD.
2. Extremely high adjustment factor YTD.

However, the bullish side here is:

1. KSA will keep exports even lower until stocks decrease to desired levels, that is ~390MM barrels of US crude inventories.
2. US production is not growing as much as forecasts predicted, and we think it will remain stalled with these prices.

For the time being, key question remains just how "wild" the unaccounted for crude oil barrels will be in H2 2019, and how high refinery throughput will be. If everything goes back to "normal", these two variables should reverse its trend and US crude inventories might decline materially in the second half of the year.

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.