How My Hallway Closet in Moscow Predicted Today’s Oil Market
For anybody who has spent time in developing market economies, there is a pervasive aspect to the way of life. You hoard.
Years ago in tougher times, the hallway closet in my Moscow apartment would be filled with stuff I didn’t really need at the moment.
Some of that excess was there because nobody could predict when a shortage would appear. But there was another reason I would stand in line for just about any non-perishable product…
This is how an entire population balanced a market that could not balance itself. A personal stockpile was leverage. It maximized income, provided commodity for trade or sale, and took on a function quite apart from its apparent disuse.
Matters are now better in Russia. Yet the oil market today looks a lot like my old closet back in Moscow…
Crude Inventories Just Hit A 27-Year High
Not so long ago, what has been happening this week in oil trading wouldn’t have been imaginable.
Despite the fact that crude and crude product stockpiles are at their highest levels since November 1983, oil prices are dancing to a different tune.
The Energy Information Administration (EIA) reports weekly inventory figures each Wednesday. Those figures tell us what the market looked like the previous Friday. What this week’s figures told us was remarkable.
Inventory levels just hit a 27-year high.
When crude oil is combined with refined product, especially the so-called distillates (more correctly, this is actually the “middle distillates” – primarily diesel and low-sulfur heating oil), the EIA tells us that there are more than 1.13 billion barrels of excess volume in the market.
The last time we saw anything at this level, a bit less than 1.12 billion in July of 2009, crude was trading $10 lower than the current price. That means the market is putting a premium on the price of unused supply – a $900 million premium.
Is there something in the water they’re drinking down on Wall Street? Futures traders are not known for throwing money away (at least not intentionally).
No folks, this is a signal for the new order of things rapidly besieging the market.
The first thing analysts will turn to is a well-worn explanation, that this merely indicates that crude prices are following the equity markets. There are a number of reasons why that is the explanation of first choice. However, the major one among them has become almost a mantra among the talking heads – periods of sluggish oil demand reflect concerns about overall economic development.
In short, the one-size-fits-all answer is to say that oil traders are continuing to focus on broader economic indicators and the performance in the equity markets as a way of gauging futures pricing, with the prices continuing to provide a rough indicator of demand keeping up with supply.
Such an equation (something like “equity performance = demand – supply”) is not altogether irrelevant. After all, we have become accustomed to considering industrial recovery and energy usage almost in the same breath over the past 18 months.
But the real problem arises when you understand that this explanation really doesn’t tell us anything about what is actually underpinning the oil pricing activity. If this relationship to stock market direction were the real bellwether, crude should be trading at about $62 a barrel, not $75.
So what gives? The analysts can say whatever they wish. But the refineries stockpiling inventory and the futures traders pegging contract prices are looking at something else. And what they see is changing how the pricing dynamic is going to be operating.
Rapidly Approaching Supply Constriction
The reason the price is higher despite lackluster equity performance and demand still being withdrawn from the market addresses the limitation in the current explanation. If you listen closely to what the analysts are saying, they are expressing concern over whether demand can keep pace with supply.
That is simply a knee-jerk reaction to unusually high inventory levels. Stand it on its head and you will have what the traders and processors see – a rapidly approaching supply-constricted oil market. The reason why we have an apparent premium in the crude oil pricing level – beyond what the normal “it’s just a reflection of equity performance” view would require – reflects rising concerns about adequate supply to meet returning demand.
So long as you look at the day-to-day market performance and the recent inventory surpluses, you miss the overall picture. It hits you down the road when demand returns to the market, inventories suddenly collapse and crude prices begin accelerating… well beyond what any equity trading direction would justify.
The current inventories are not refiners making mistakes or traders over-estimating needed volume. It is deliberate… to balance out value-added sales moving forward. If the old saw for stock trading said “buy low, sell high,” the crude oil equivalent says “buy raw material flow low, sell processed inventory high.”
I am feeling some déjà vu here, Moscow style.
The relationship between demand and supply in the oil market will be impacted by two overarching factors.
The first is the ability of supply to meet rising demand (the demand returning to the market as economic recovery finally takes hold and the new demand generated in parts of the world where development is taking hold quickest).
We currently have daily demand worldwide at about 86.5 million barrels a day, with overall supply available at 91 to 92 million barrels. That security margin, however, is narrowing.
As demand returns, and it is doing so in other parts of the world more rapidly than in the U.S. and Western Europe, the “excess crude” will be priced higher. Fill up now, the refineries are telling us, before the price goes up. With the refinery capacity in the U.S. at above 90%, there will be straining there to meet rising demand. So expect increases in imported oil products to go with more imported crude as we move forward.
The second factor brings us back to my hallway closet…
Oil is now both a commodity (the liquid in the physical “wet” barrel) and an asset in its own right (the “paper” barrel reflected in the futures contract). It has a market function beyond the value associated with delivering product to an end user. That dual nature assures the trade in oil will reflect more than simply the needs of an end user.
Both of these factors mean increasing periodic inventory surpluses will not translate into declines in pricing as steep as the overall equity market might seem to dictate. That is because such periodic surpluses are providing a current balance for rising profits later.
These stockpiles are used as leverage. They maximize revenue flow, provide commodity for sale or swap at better prices, and they’re taking on a function quite apart from their apparent disuse.
Sounds like I’ve been here already.