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How Long Can Inventory Fill The Production Gap?

Author: Brynne Kelly 9/12/2021

The US Energy Information Administration (EIA) revised lower its price outlook for 2021-2022, dropping its annual 2021 Brent estimate to $68.61 per barrel and its annual WTI estimate to $65.69 per barrel. The EIA now sees US oil production averaging 11.08 million b/d this year, and 11.72 million b/d in 2022.

As of Sunday September 12, the BSEE reported that 48.56% (883,755 bpd) of oil is still offline. Pipelines damaged by the storm are leaking throughout the Gulf, although so far it seems that none of the spills have reached the Louisiana coast. “Hurricane Ida's damage to U.S. offshore energy production makes it one of the most costly since back-to-back storms in 2005 cut output for months, according to the latest data and historical records,” Reuters reported this week.

US Commercial crude oil inventories are at their lowest levels since 2019 (right chart below). US supply of crude oil (production plus net imports) continues to remain below refiner demand (left chart below, US weekly supply less demand). This has led to continued draws out of storage to make up the difference.

As of the September 3 EIA inventory report, combined crude oil, gasoline and distillate inventories in the US are the lowest they have been since 2014. Last week alone, the complex reported a draw of 11.8 million barrels of the aforementioned products.

Finished motor gasoline supplied by refiners, often used as a proxy for demand, has returned to pre-pandemic levels (left chart below) while US gasoline inventories are approaching their typical seasonal lows. Historically, gasoline inventories reach their lowest levels during September or October as summer driving season comes to an end (right chart below) before beginning to build ahead of the next driving season.

With refinery utilization registering just under 82% in last week's EIA report, it's reasonable to expect these draws will continue for a few more weeks unless significant refined product imports are received. It's normal and expected that once refiners exit fall refining maintenance that gasoline inventories will build significantly throughout the winter to replenish themselves ahead of the next summer driving season.

In anticipation of the drop-off in demand and steep winter gasoline builds, the market values Fall barrels more than Winter barrels. Gasoline supply is still tight and that has pushed the Oct/Nov spread in RB gasoline futures to their highest level in years due to the refinery outages caused by hurricane Ida (light green line below).

The thought, of course, being that this year is no different than prior years and inventories will rapidly increase into year end. Let's hope so. Until we see the turn however, there will be a preference for the front of the curve. The key to watch here is how low inventories get before they turn the corner and begin to build. It's still quite possible that we see a lower trough this year than in prior years.

Next up is the winter heating season when distillate prices take the lead. We define the winter heating season as the 5 month period from November to March. True to form, the 'winter' strip in US distillate futures is trading higher than its gasoline or crude oil counterparts (yellow line below).

Gasoline spreads will remain strong until we have clarity on how deep the trough will be, but the market is beginning to take an interest in calendar spreads along the winter strip in distillate. US distillate inventories are hovering near 6-year lows (see Inventory Recap section at the end of this report). In other markets, one might expect a contango structure to develop in order to reflect an incentive to store barrels ahead of this demand season. Instead, 1-month spreads along the winter strip are in backwardation. They reach their peak in February with Feb-22/Mar-22 closing at new yearly highs last Friday (purple line, right chart below). Relative weakness in spreads in the early portion of the season is the only thing keeping a governor on flat price (the 5-month strip, left chart below) which is hovering just below $90/bbl.

Similarly, the winter strip in WTI has also been facing some headwinds (left chart below) and has been unable to regain the $70 level seen back in July. Unlike the gasoline and distillate markets though, one month WTI calendar spreads have been under pressure (right chart below).

Much of this can be attributed to the loss of refining capacity due to hurricane Ida, the on-going fear that Covid-19 will cause another slowdown in demand and the gradual monthly production increases by OPEC+. Even with this uncertainty, oil markets still remain in backwardation as far as the eye can see (year/year calendar spreads below).

The weakness in calendar spreads has been unable to make a significant impact on outright oil prices though. Last Friday, the calendar 2022 WTI 12-month futures strip settled at $66.56, which is only $1.29 shy of it's yearly high made on July 13 at $67.85. During that same time period the calendar spread between January 2022 and December 2022 has dropped almost $2.00. The curve is flattening out while outright strip prices remain close to their highs.

With inventories being cleared out across the globe and the uncertainty that production will allow them to be easily replaced in the future, owning molecules in the short term seems to be the best way to guard against that. We have seen this happen in the natural gas complex before. In 2018 when US natural gas inventories were relatively low ahead of the winter season, at the first sign of cold weather the market bought spot molecules instead of withdrawing from inventory. The caused the winter futures curve to move in to severe backwardation before winter really got under way. In other words, the market was willing to pay up for MMBtu's in the spot market to meet demand (instead of drawing down inventory) in order to safeguard their remaining inventory. In that way, backwardation is seen as cheap insurance.

Comparing year-to-date inventory changes in the petroleum complex (this year vs through the same point in prior years) the data reveals that the US has withdrawn almost 25 million barrels more than it injected in to inventory last year (2020 injection of 99.4 vs 2021 draw pf 124.2 seen below, black bars).

If anything, the market should welcome inventory stabilization or growth from here. The rise in prices this year appears to have done little to entice US producers to increase production meaningfully. Backwardation has, to-date, only led to inventory draws this year.

That said, this pace of inventory draws is not sustainable. The market continues to absorb OPEC+ production increases and yet prices continue higher. Both the US and China are releasing barrels from their strategic petroleum reserves (purchased last year at much lower prices) to avoid paying ever increasing market prices. Still prices are moving higher. What will happen when inventories are no longer able to fill the supply gap?

The market seems very focused on demand growth, or lack thereof. This becomes less of an issue when you realize that every serious climate plan out there for reducing emissions an adequate amount by 2030 involves cutting energy use — a lot.

Dare we say that it's time to start thinking about upside price levels that will lead to demand destruction? We cleared out a lot of demand in 2020 that may never return, but we also hindered supply growth for years to come.

Of Note Over the Weekend:

Platt's reported that Kuwait Petroleum Corp. lowered its official selling prices (OSP) for October loading crude being sent to Asia, while keeping prices unchanged for cargoes bound for the US, Northwest Europe and the Mediterranean, according to a company pricing email on Sept. 12.

This appears to be a theme as of late, OSP's are being lowered for Asian countries but not for the US or Europe.


EIA Inventory Statistics Recap

Weekly Changes

The EIA reported a total petroleum inventory DRAW of 11.80 for the week ending September 3, 2021 (vs a net DRAW of 7.20 last week).

YTD Changes

Year-to-date cumulative changes in inventory for 2021 are DOWN by 124.20 million barrels (vs down 112.40 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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