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Higher Prices are Needed to Cure High Prices

Inventories are tapping out while supply growth lags. This leaves balancing the complex up to 'Price'

Author: Brynne Kelly 1/09/2022

The first trading week of 2022 was a good one for oil futures. This says a lot given the blockbuster rally seen in 2021. By the close of business on Friday, January 7, front-month WTI futures were up another 5% from year-end 2021 levels.

The difference between last week's rally and the rallies of 2021 is that they were not necessarily led by calendar spreads (left chart above = flat price, right chart above = one-month calendar spreads). Yes, spreads ended the week strong, but not even close to levels they reached during the last flat price rally. This is notable considering that term oil prices are keeping pace with prompt futures. The theme for most of 2021 is one of demand recovery. Not much attention paid to the back of the curve as oil was basically left for dead. No matter how strong prompt month futures were, they were unable to impact long-dated prices which began 2021 below $50.

Nevertheless, it's difficult to fade the rally as long as the spreads remain strong. But if they weaken, we would become aggressively bearish very quickly.

The Events That Shaped Last Week


The 24th OPEC and non-OPEC Ministerial Meeting was held via video conference on Tuesday, January 4, 2022. The outcome of this meeting was the confirmation of the production adjustment plan and the monthly production adjustment mechanism approved at the 19th OPEC and non-OPEC Ministerial Meeting. It wasn't really a surprise when the meeting ended with the decision to continue adjusting upward monthly overall production by 0.4 mb/d for the month of February 2022, as per schedule.


Last week, Libya's oil production fell to 729,000 bpd, down from a peak of almost 1.3 million bpd in 2021 due to pipeline maintenance work. Production is expected to return to 1 million bpd over the next several weeks.


On Jan 4 Reuters reported that protests erupted in several Kazakh towns and cities after the Central Asian nation's government lifted price caps on liquefied petroleum gas (LPG) and the cost of the popular alternative to gasoline rose. Kazakhstan's government has resigned and a state of emergency has been declared in parts of the country following violent protests over rises in LPG prices. Police uses stun grenades, teargas to disperse crowds as government restricts access to social media. Kazakhstan is Central Asia's largest oil producer and second largest non-OPEC+ producer at approx. 1.7 million barrels of oil per day, led by its mega-projects Kashagan and Tengiz.

On Sunday, it was reported that Kazakhstan's largest oil venture Tengizchevroil (TCO) is gradually increasing production in an attempt to reach normal rates at the Tengiz field after protests limited output there in recent days.


*Goldman Sachs: Over the next six months, the oil market might become very tight.

*Morgan Stanley: Our balances look softer in H1, but the oil market could see a triple-deficit by H2.


A quick moving nor’easter tied up air traffic across the U.S. Northeast, closing government offices in Washington and blanketing New York with enough snow to make the morning commute a bit of a slog.

This all comes at a time when US crude oil inventories are at their lowest levels in the last 5 years, thanks in part to the continued draw down of US Strategic Petroleum Reserves. In fact, total US inventories are lower than they were during the price rally in Q4 of 2021 (below).

The lag in calendar spreads noted earlier has largely been attributed to Omicron-related fears dampening prompt futures relative to longer-dated futures. It's a bull market with front month demand fears. Ironic considering the amount of inventory that was cleared out in 2021. Over 54 million barrels had been added to US oil inventories by the end of 2021 while almost 68 million barrels were pulled out of storage in 2021, making it the largest decline in inventories since at least 2015 (green bars below).

Translating the above yearly changes into inventory levels below, we see that the combined crude oil, gasoline and distillate inventories in the US are at their lowest level in recent history (purple line below).

What a turnaround from the inventory peaks of 2016, 2017 and 2020 to where we are now! And yet, there is no incentive to store oil given the current backwardated structure of the futures curve. On the other hand, with prices above $60 all the way out to 2026 there should naturally be more incentive to invest longer term in production. Prior to now, one might expect this to happen. However, natural market responses to price signals are clashing with climate change commitments being made at national levels across the globe in an attempt to phase-out fossil fuels sooner rather than later. In addition, countries like the US have tapped in to their Strategic Petroleum Reserves in an attempt to fill the void left by the lack of production growth. Last year we wrote about inventory being used to fill the supply gap. That card has been played. Of course we still have the monthly 400k bpd production increases from OPEC to look forward to. Per the Sunday 18 July 2021 OPEC meeting however, those are set to end in September, 2022 and some are even questioning whether or not they even have the capacity to do that as a group, given all of the geopolitical risk emerging.

Barring some extraordinary new coronavirus-induced lockdowns to stop demand in its tracks, it seems the only tool left to bring supply/demand back in to balance and lower prices would be demand destruction induced by high prices.

This is exactly why backwardation can continue to rally. Consumers pay spot and have not yet shown signs of stress. Inventories are low and production is not growing. This means that there is competition for the incremental barrel produced (from consumers and from storage).

Comparing weekly refiner demand for crude oil to weekly finished motor gasoline supplied (proxy for gasoline demand) we see the typical year end lull in gasoline demand (purple line below). Weekly demand for crude oil (blue line below) has recovered, yet still hasn't been able to break above the 16 million bpd level they had been sustaining before the pandemic hit.

Gasoline demand typically increases during the first half of the year. If the same holds true in 2022 we will see refiner throughput increase to meet that demand. Refiner throughput is key, as we saw what happened when the refining complex lowered operations in response to the demand shock created by the pandemic in 2020. Produced barrels were left without a home and prices cratered. Fast forward to today and we have the complete opposite scenario. Refiners are bringing capacity back online and demanding more crude. US production is also attractive globally again now that export arbs have opened back up. As long as those two things remain true, crude oil will remain strong.

In the medium-term, one of the few things that could derail the current trajectory is a collapse in refining margins. Sideways motion from here won't do the trick.

Once again, it comes back to demand destruction caused by high prices or low margins. Although, historically 'low margins' haven't been a very effective tool as they are generally seen as temporary (whether that be due to wishful thinking or reality). Bringing the onus, once again, back to the demand side. The market needs to slow the pace of demand growth to match that of real supply growth (not inventory draws). Higher prices are one of the few immediate tools left in the box to effect this.

This is supportive of backwardation and the reason 12-month spreads (like the Dec/Dec shown below) remain strong.

Bottom Line

The market is on edge, rightfully so. The inventory cushion that developed in 2020 has vanished while production has remained anemic. Backwardation persists and in this environment there is less incentive to hold barrels in storage. It's time for higher prices to do its job on the demand side.

Something to Keep an Eye on

Intercontinental Exchange Inc. (ICE) is renaming its Permian West Texas Intermediate (WTI) contract as part of a previously announced plan for the physical delivery of crude in the Houston area. Currently, the ICE Permian WTI futures contract is based on Magellan Midstream Partners LP supply capacity and is deliverable at Magellan’s East Houston (MEH) terminal.

As part of the effort, ICE is now working to add the Enterprise Crude Houston (ECHO) terminal as a delivery point, increasing the inbound supply capacity to underpin the contract to more than 4 million b/d of Midland-quality WTI crude.

With both MEH and ECHO as delivery points, ICE said, the futures contract would have export access to 14 ship docks in the Houston area. Together, the Magellan and the Enterprise Products Partners LP Houston distribution systems offer 60 million bbl of combined crude storage capacity. These distribution systems connect to a further 90 million bbl of storage capacity and also provide direct offshore access for exports and floating storage.

The new contract is expected to take effect later this month.

Of Note Over the Weekend

  • Asia's markets traded gingerly as investors braced for bond market turbulence and assessed the economic impact of the fast spreading Covid omicron variant.

  • South Korean stocks dipped, while those in Hong Kong and China varied amid a turbulent start. US futures bounced between gains and losses as the S&P 500 had its worst start to a year since 2016, as bond markets were roiled by predictions of faster-than-anticipated US interest-rate increases.

  • The Nasdaq 100, which is focused on technology, suffered its worst week since February due to a rotation out of high-growth sector firms. Japan is shut due to holiday.

  • Treasury futures continue to fall after marking the largest one-week drop since February 2021. Australia's 10-year bonds have plummeted. Treasury yields rose across the board last week, following a selloff triggered by Federal Reserve minutes indicating a willingness to begin raising rates as soon as March. Because of the Japan holiday, cash treasuries will not trade in Asia. The dollar remained stable.

  • This week's US inflation figures will be closely watched as concerns rise that the Fed is falling short in combating rising pricing pressures. Employers in the US gained fewer employees than predicted in December, but wages climbed more than expected, bolstering the Fed's case for tightening liquidity.


EIA Inventory Recap

Weekly Changes

The EIA reported a total petroleum inventory BUILD of 11.0 for the week ending December 31, 2021 (vs a net DRAW of 8.20 last week).

YTD Changes

Year-to-date cumulative changes in inventory for 2021 are DOWN by 151.90 million barrels (vs down 162.90 million last week).

Inventory Levels

Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years are have gone from way above historical levels to surprisingly below historical levels and should continue to draw as long as backwardation in the market persists.


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