Author: Brynne Kelly 9/11/ 2022
The drawdown in US SPR inventories has been one for the record books this year. Russia's invasion of Ukraine defined 2022, but so did the equal response from the US to release a million barrels per day of inventory from the government coffers. The result is that US strategic reserves are now at historic lows. The risk to energy supply though, has begun to normalize this summer as supply chains were renegotiated across the globe.
Over the weekend we heard that "Putin is finished. The Ukrainians have him on the ropes with a stunning victory in their sights." In just 72 hours, the Ukrainian Armed Forces have retaken over 2,500 sq. km of Russian-occupied Ukraine. While the 'war risk' hasn't been eliminated, it has started to take a back seat, at least in the US.
A question remains though: Do we need to refill the SPR?? More on that later.
Oil Prices are Rangebound
The highs and lows of the last 2 years are both stunning and disappointing at the same time. For the most part, crude oil futures have stayed neatly between $50 and $100.
Extremes outside of that range attract wild speculation, but usually don't last that long. The reasons for the extremes have been newsworthy, and for much of 2022 kept us focused on geopolitical events from Putin's Russia, to US Sanctions, to face-offs with OPEC+, but the market itself has been all in all mostly in that range.
Another crisis averted?...
Despite warranted concerns, potential accelerators of an 'energy crisis' have been, for the most part, waning in the petroleum complex. One by one bullish price drivers have stood up and been knocked down: The Tropics are dead, Ukraine appears to be gaining the upper hand over Russia and the Biden administration is (believe it or not, with oil well off the highs) weighing the need for further releases of crude oil from the nation's emergency stockpiles once the current program ends in October. What remains is winter weather risk, which we've covered several times before and will come back to soon in all likelihood. .
With prices seemingly under control, it's time to deal with inventory levels. After all, it is inventory that supplied us this year during the chaos that resulted from the war.
Price Patterns vs Inventory Patterns
A look at continuous WTI futures over the last 8 years reveals that prices in 2022 (Gold) are following a similar pattern to those of 2014 (in Red). In both years, prices are trading above historical ranges.
Both price and trajectory in 2022 (gold) are tracking 2014 (red) very closely...
Do we find similarities between 2022 and 2014 inventory levels to explain the similarities in price patterns? Not exactly. The correlation between inventory levels and price is not an exact science. Commercial crude oil inventories (which excludes SPR) in 2022 are higher than in 2014 (gold line vs red line below).
2022 Commercial Inventory has no similarity to 2014. Stranger, it has no seasonal seasonal build/draw cycle either...
In fact, given the global attention on Oil and its Products on the supply side, the most remarkable thing about this year's inventory line is the almost engineered lack of volatility relative to more normative years. Did we say almost? Ok, it was clearly engineered. The SPR, as we all know was sacrificed to keep the commercial levels stable. Taken together this is the bullish footnote that offsets seemingly inconsequential commercial inventory data.
By stripping out the SPR from commercial inventory levels, we can see where the difference lies. This bridges the gap between similar price levels (2014 vs 2022) with differing commercial inventory levels.
SPR Levels have broken the floor and do not seem to be bouncing any time soon...
It is important to note that many of us have been using the SPR storage draws and the assumed eventual refills as one back-pocket reason for the market's stability over the last few months. But does the government, or the industry as a whole, feel that we need restore SPR levels to former glory for a stable market going forward?
The SPR Minimum and The IEA
We're not saying this is justified or even wise, but it must be noted: The Fed MAY not feel the urgency to replenish what it has drawn from the SPR as much as the oil community does. Clearly the government manages risk a lot differently than energy traders do. They may not even be looking at historical levels going forward regarding appropriate SPR levels. What is to stop them from kicking this can down the road. Are there even any requirements surrounding US SPR inventory levels? Turns out there are guidelines.
As a member of the International Energy Agency (IEA), the United States must stock an amount of petroleum equivalent to at least 90 days of U.S. imports. Net imports of US crude oil have averaged around 3.1 million barrels per day this year. Using that as a guide, 90 days translates to 279 million barrels of SPR reserves (we currently have 442.5 million barrels in the SPR). We assume this requirement to mean 'net imports' because using just 'US imports' (which have averaged around 6.4 million barrels per day in 2022) would translate to 576 million barrels of SPR reserves and we are well below that.
We mention this because we, along with the market, assume this year's draw-down NEEDS to be replaced. When in fact, this 'need' is largely fictitious given current levels vs the minimum SPR requirements noted above. We say 'fictitious' because since the emergency SPR draws began in 2022, it has been assumed that we are drawing down to uncomfortable levels. Regardless, historical charts of US SPR inventory levels continue to make headlines as an implied cause for concern.
The SPR Drawdown...
Refilling the SPR is Not A Done Deal
There is no denying that the nation's overall crude stocks have been declining since mid-2020 due to sales from congressional mandates and Biden's price initiative. BUT, perhaps it's time to note the new governmental narrative. That we, as a nation, are no longer politically committed to fossil fuels- like it or not.
Consistent with that narrative is the potential unveiling of some substitution calculus in which those SPR draws are being replaced in the form of renewable energy investments, not petroleum reserves. Given the events of the last year and the intractable nature of the current administration towards opening new domestic oil sources would it be surprising if they made the case for replacing oil reserves with MWH and mmbtu instead of gallons?
Would it be shocking to hear from some official that we will replace what we pulled from the SPR with 500 windmills and 3,000 inmates forced to pedal Peletons hooked up to Con-Ed?
Kidding aside...they could be looking at it like this:
Since 2020 the US has drawn down SPR inventory levels by roughly 30%. And this was largely due to an epic governmental response to Russian attacks on Ukraine. Given current 'net import' volumes this would mean the US could 'fund' another economic war against the East and draw down inventories another 30+% before reaching the minimum IEA requirements.
The message here is that there is no inherent requirement to do anything to 'replenish' strategic reserves (but for loan paybacks); at least not on our timeline. Maybe the focus should be on what happens to commercial inventory levels once SPR draws come to an end. We know this is scheduled to happen at the end of October. But, we also know that the US stands ready to release more if necessary after that. We can assume, given past action, that this will be governed by price levels rather than outright shortages.
Quick aside regarding targeting price data rather than actual supply shortages: Goodhart's law states that "once a measure becomes a target, it ceases to be a good measure". Therefore targeting price as justification for using critical reserves may prove to be a problem if/when actual shortages occur. Price-data sets can be massaged, molecules cannot be.
To date, we haven't witnessed any ACTUAL critical supply shortages. This could lead very easily to the very real potential for lackluster SPR refills or more drawdowns dampening prices as we await winter weather.
What we know: there is ample room for SPR inventories to draw-down further. What we don't know is what happens when, or IF we hit minimum required levels. That is more likely the time to think about how crucial reserve replacements are. Until then, there is no real impetus to facilitate SPR purchases except to repay barrels that were given out as loans.
Oil Isn't a Problem. Distillates Might Still Be One
What is clear, however is that the US now has a lot more headroom to purchase oil should we face another pandemic-like demand destruction scenario. Instead of worrying about hitting 'max' storage capacity like we did in 2020. This lends more support to prices on the downside. Not 'regular' downside, but crisis downside. In one sense, the probability of a negative price scenario has been eliminated.
This, of course does nothing for refining capacity. We have what we have and refining cracks are being priced accordingly. Distillate inventories are low and there is no strategic reserve coming to its rescue.
Distillate cracks continue to outperform, for good reason
Another interesting trend is the increase in the ratio of crude oil inventory levels to refined products. On this basis, commercial oil inventories are remain near historical highs. This is a sign that we are storing oil as a proxy for refined products due to the fact that it is more fungible and has a longer storage life.
Ratios are In Support of Crack Spreads
Given how elevated distillate cracks are, it makes sense for refiners to hold oil inventory for the option to refine it and capture high margins rather than hold the refined product inventory itself. As long as refining margins are high, storing oil at a commercial level is profitable even though the oil market is in backwardation. Once refining margins come down, holding oil will lose its luster and commercial players will begin to dump barrels.
As it stands now, we may either have too much oil in commercial storage or too little refined products. Historical comparisons show that refined product inventories are indeed at the low end of their historical levels.
Distillates are on track for the lowest inventory in a while...
When you take SPR inventory levels out of the equation and compare apples to apples: Commercial crude oil inventory levels (as seen in earlier charts) vs refined product inventory levels show above, there is a case to be made that the mechanics exist to hold on to oil, refine it and deliver products in to the spot market. Once this option loses value, oil will be sold.
A Note on Spreads
We are seeing this play out in oil spreads, which are coming under pressure. The Dec/June WTI calendar spread is coming under pressure, yet still remains well above historical levels.
Dec/ June is well off its highs, but still sticky given current flat price....
This may be the interesting trade regardless if you are bullish (it's cheap relative to ULSD?) or bearish ( it's rich compared to flat price?).
The SPR drawdown and subsequent refill may not be the bullish driver we think it could be due to political machinations and global biases. The government's short term priority is price right now. Its very long term structural energy priority is replacing Oil in the future. It seems to have little regard for the intermediate/ macro priority like refilling the SPR given recent ( bluff?) statements it may draw it down more if need be. If the supply side isn't as big a worry to them as it is to end users, perhaps a delay in its replenishment or worse is in the wings.
EIA Inventory Recap - Week Ending 9/02/2022
The EIA reported a total petroleum inventory BUILD of 1.80 for the week ending September 2, 2022. Commercial inventories however, posted a weekly BUILD of 8.90 as SPR inventories DREW by (7.50).
YTD total petroleum EIA inventory changes show a DRAW of 174.80 through the week ending September 2, 2022.
Commercial Inventory levels of Crude Oil (ex-SPR)