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Why Is The Rising Crude Oil Inventory Not A Bearish Sign At All?

|About: ProShares Ultra Bloomberg Crude Oil ETF (UCO)

Summary

•The current rising crude oil inventory is normal compared to history.

•The record high inventories are mainly driven by oil traders betting a better oil price not far away.

•I formulated an indicator coined ‘Stock Days’ to gauge the inventory level.

After reaching its yearly peak in June, 2014, the crude oil had been plunging to low $40 in January 2015. But the oil bulls were able to fight back strongly in the last few weeks signaling a reversal of the downtrend of this crude commodity cycle. Nevertheless the up trend has been stalled around $50 for WTI and $60 for Brent. I prepared Figure 1.1 and 1.2 to illustrate the crude oil price movement since the beginning of 2014. Clearly the bulls meet strong resistance now at the oil price's 50-days moving average, a pivotal crossroad for oil traders.

According to US Energy Information Administration's [EIA] newly released Weekly Petroleum Status Report, Commercial (Excluding SPR) crude stock was 425,644 (1,000 bbl) as of Friday, 13th February, 2015. This represents a net increase of 7.7 million barrel from the previous week. This is a huge number enough to upsetting the oil market. Mediums headlines have been filled with all kinds of the negatives about the crude oil. I notice that these pessimistic market observers basically have two standpoints, high production and rising inventory. While the high production has been deeply concerned in respect of the steep falling rig counts, I would like to explore more regarding crude oil inventory, an easily distorted and misleading topic. For convenience, I only use Commercial (Excluding SPR) crude stock numbers in this article.

My first question, is crude inventory one of causalities of the oil price movement? One picture is better than thousand words. Here I present two Figures, which should give a firm answer, "Not at All'.

We can see in Figure 2.1 and 2.2 that oil price does not always go closely with that of oil inventories. That is said, oil price and inventory don't move consistently with the same pattern on time. Generally we are not able to find useful clues relying on these two parameters alone. For example, Figure 2.1 shows that in the period of 2014-05 to 2014-09, two lines fell at the same time and with the same altitude. But after September, 2014, the two lines went inversely. SA readers would ask what happened after September, 2014 to cause the inventory increase without taking a breath. Before answer this question, I am going to give a little background knowledge about US Working Storage System. By EIA's definition, there are four types of Petroleum (crude and petroleum products) storage facilities, namely, Refineries, Bulk Terminals, Product Pipelines and Crude Tank Farms.

Bulk Terminal

A facility used primarily for the storage and/or marketing of petroleum products which has a total bulk storage capacity of 50,000 barrels or more and/or receives petroleum products by tanker, barge, or pipeline.

Refinery

An installation that manufactures finished petroleum products from crude oil, unfinished oils, natural gas liquids, other hydrocarbons, and oxygenates.

Petroleum Pipeline

Crude oil and product pipelines used to transport crude oil and petroleum products, respectively (including interstate, intrastate, and intracompany pipelines), within the 50 states and the District of Columbia.

Tank Farm

An installation used by gathering and trunk pipeline companies, crude oil producers, and terminal operators (except refineries) to store crude oil.

Within the above four facilities, only Refineries and Tank Farm have meaningfully capacity to stock the crude oil. As of September, 2014, Refineries and Tank Farm reported crude oil stock of about 240 million barrels, which only accounts for less than 50% of their working capacity. Please note the total crude stock in September, 2014 was 360 million barrels, so the rest stocks were in Pipeline, Bulk Terminal and other storage facilities like off-shore tankers leased temporarily and unloaded vessels with imported crude oil, etc. By law, commercial owners of crude oil storage more than 1,000 barrel have to report to EIA on time, on shore or off shore on US territory. Based on the Storage Facility Utilization report as of September, 2014, I estimated the current facility utilization is about 60% as a whole.

Bear in minds, all these storage facilities are running as ordinary business oriented to make money. They are either used by the storage facility owners or leased to other oil traders. They buy and sell crude oil at their own discretion, by their own interest and judgment. That is said, they are free not to buy any more crude to increase inventory even there is a 'glut' or not to sell more oil to open market even there is a real need. Of course, all is balanced by an invisible hand -- Free Market, regulatory intervention is rare if any.

Now I can give one possible reason why we see the crude stock has been rising since the last September. The oil traders keep buying the crude oil from the market to put it into the storage simply betting the price could be better in future, thus they can buy low and sell high after taking off storage cost. They can do this either by speculation or arbitrage. For example, an oil trader could lease a super tanker to store the crude oil at the current low price and sell future contracts months away (arbitrage) to make a small but more safe profit. In Figure 3, we observe a fourth month future contract contango starting from November, 2014. Before the last November, all future months future contracts were traded in backwardation. In short, deep contango in oil future contracts makes the crude oil storage as an investment vehicle. Thus the current rising crude oil inventory can be interpreted as a positive sigh of market sentiment, not the opposite. In this respect, it is the low crude price making the inventory increase, not the high tight oil production alone. Up to now, we still import about 7.2 million barrels per day for all kinks of needs, which partly contributes to the rising crude inventory either. In short, the crude oil stock is more directly driven by oil price rather than the crude production.

In the last part of this article, I am going to introduce my crude oil storage indicator to check if the crude oil inventory number is 'low' or 'high'. This indicator is experimental and has little value in daily trading but could help us to grasp a broader view of the oil market trend. This is my stream of thoughts. I think the crude oil inventory should change proportionally with the crude oil production, because the crude oil storage serves as a buffer between supply and demand. In this context, supply, demand and inventory should expand and contract together. I call it 'Stock Days' in short. It is calculated by dividing the crude oil inventory [bbl] by crude oil production (bbl/day). Thus the 'Stock Days' is actually the total days needed for the crude oil production to build up whole crude oil inventory. I prepared Figure 4.1 and 4.2 to demonstrate its two applications. Figure 4.1 compares 'Stock Days' to the crude oil production since 1982. It is understandable that a high production results in a lower 'Stock Days'. We also learn from Figure 4.1 that the current 'Stock Days' is just a little lower than the average since 1982, but is comparable with its historical lows in 1980s. Figure 4.2 is more interesting as I pick up WTI price to check the sensitivity of my indicator 'Stock Days' with it. I am glad to see that two curves move so nicely in the same direction. Though smoothing oil price yearly is tricky, I am encouraged by the fact that oil price and 'Stock Days' are two completely independent variables.

In conclusion, the current rising crude oil inventory is a normal phenomenon under the nowadays crude oil market. It can not be served as a barometer of the future oil price, let alone a harbinger of a prolonged oil bear market. A better understanding of the dynamics of the crude oil inventory build-up can surely help us to make the right investment decisions on crude oil investment vehicles such as the popular ProShares Ultra DJ-UBS Crude Oil (NYSEARCA:UCO) and other Leveraged 2x and 3x Crude Oil ETFs. For those scaring forecasts, estimates and projections about the crude oil price, my answer is one word - Ignore.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Additional disclosure: These are just my personal opinions formulated when trading crude oil stocks other than OIL ETFs without any third party interest, which cannot be interpreted as trading or investment advices and suggestions in anyway. Readers should be aware of high investment risk in energy sectors, especially in coal, natural gas and oil industries, which are highly speculative. Readers should consult their own financial advisers before making any investment decision and trading. It is to the best of author's effort to collect public available data with accuracy. Readers should take due diligence in reading all numbers and are not encouraged to use these numbers in any purpose without their own validation.