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Abstract
As crude oil demand was decimated at the start of the global coronavirus pandemic, storage around the world began to rapidly fill causing commodity prices to tank. The supply and demand imbalance was corrected when producers came together to make global production cuts thus stabilizing prices. When economies began to restart and consumers began to leave their homes, demand started to climb to outpace supply. As storage levels began to fall, prices remained constant but when there was a tiny inventory build at the beginning of September, prices went into a freefall highlighting the growing disconnect between free market principles of supply and demand and emotion driving the actual price of crude oil. Instead of following commodity principles, pricing has become largely influenced by market sentiment.
Introduction
A disconnect has been growing between crude oil prices and the principles of supply and demand that set commodity prices. Since the dual black swan events of the Saudi-Russia Price war and global pandemic, the oil industry has been rocked by volatility and violent price swings. The growing supply/demand imbalance experienced in March and April was a key driver setting the price of crude. Over the past six weeks, domestic crude oil inventories have been falling indicating the tides have turned and the industry is moving back into balance. The result has led to stable prices near the $40 range since June with little movement or volatility. That is until the week of September 7th when prices violently dropped after Saudi Arabia cut its official crude selling prices to Asia and U.S. buyers in an attempt to boost demand. Oil prices have since been on a losing streak after optimism about demand recovery got crushed. Doubts about China’s capacity to continue buying record-high amounts of crude and Saudi’s sharp reduction in October prices for Asian and U.S. buyers signaled a marked change in the upbeat attitude from earlier this year. The move struck fear in market participants highlighting the growing disconnect between free market principles of supply and demand and how emotional bias can influence the actual price of crude oil. Instead of following commodity principles, pricing has become largely focused on overall market sentiment.
Crude Oil Storage
As global demand for petroleum liquids declined significantly in March and April 2020, global oil inventories increased at record levels, rising by an average of 5.9 million barrels per day (b/d) in the first quarter and 7.2 million b/d in the second quarter of 2020 [9]. As a result of lower demand and ample global oil inventories, global crude oil futures fell in March and April to record lows forcing producers of the world to jointly enact global production cuts. Global cuts topped 10 million b/d in June and July halting the excess inflow into global storage. With continued cuts and a return in global demand, for six straight weeks from July 17th to August 28th there has been a drawdown in domestic crude oil inventories, each surpassing the expected level of decline. After months of build-ups following demand destruction from the global pandemic, inventory drawdowns provided a breath of fresh air indicating a correction to the out of control supply/demand imbalance. Figure 1 shows this move in oil stocks, or supply, back towards the 5-year range. American crude inventories, which are a key metric used to gauge global supply, have slipped from record highs in June each and every week since July 24th [3]. The Energy Information Administration reported a crude oil inventory draw of 9.4 million barrels, the highest draw since inventories began to build, driven by Hurricane Laura for the week ending August 28th [7]. The hurricane made landfall on August 27th near Cameron, Louisiana, as a Category 4 hurricane with wind speeds of 150 mph making it the strongest to ever hit the state [1]. It spent days moving through the U.S. Gulf of Mexico forcing operators to shut in an estimated 1.55 million barrels of crude production per day, almost 85% of the region’s total [1]. Based on data from the U.S. Energy Information Agency, the evacuation of nearly 300 platforms and widespread shut in of Gulf production led U.S. total production to drop below 10 million b/d for the first time since 2018 [1]. Crude inventory drawdowns paired with domestic production data proves that demand is currently outpacing supply. Based on this information, supply and demand principles indicate the price of oil should rise. But that has not been the case.
The price of oil remained low following weekly inventory drawdowns while inventory builds have continued to cause the price of oil to fall. A potential answer to how this is possible might be uncovered by investigating Gulf Coast refining. Since over 45% of total U.S. petroleum refining capacity is located along the Gulf Coast, hurricane related shut-downs can severely affect crude oil demand. According to the EIA, around 3 million barrels a day of U.S. refining capacity was closed or reduced when Laura made landfall [2]. Gulf coast oil production facilities, refineries and energy infrastructure projects are designed to withstand harsh weather conditions like these, but extreme weather will still shut these facilities down. In normal times, hurricanes may cause substantial but temporary disruptions to refinery operations, gasoline distribution, and create local shortages given the concentration of U.S. refineries in the Gulf Coast. Such a shutdown resulting in a 3 million b/d drop in refining capacity would create an equivalent reduction to crude demand. That correlation holds true in normal times. However, since U.S. refineries are currently operating well below their designed utilization there is sufficient refining capacity outside of the Gulf Coast to contain a widespread supply disruption [2]. The ability for other refineries to make up hurricane related deficits in the Gulf Coast does not appear to be what has ensured elongated, depressed oil prices as inventories are drawing down at historic levels.
Market Reaction and Sentiment
So why has the price of oil remained low after inventory drawdowns? The market is misbehaving. Oil price no longer seems to be following a free market where supply and demand principles set a commodity price. RARE PETRO has reported on this issue before in the articles Crude Utilization and Commodity Pricing: The Relationship between Storage at the Cushing Hub and its Influence on WTI Pricing and Differential Price Recovery: How Regional Forces Are Bringing Benchmark Prices Back Towards Equilibrium. Instead, the latest oil market turmoil comes during major turbulence in the stock market and has been mimicking its behavior. When it comes to the relationship between oil and stock pricing, conventional wisdom states that the two have an inverse correlation. In the simplest of terms: as oil prices rise, composite equity valuations are driven down and as oil prices fall, equity valuations are driven up [6]. The underlying assumption adopted by this view is when oil prices rise the associated price for energy increases as a whole. This causes systemic inflation, increasing the sunk costs absorbed by companies during the execution of everyday business operations [6]. In turn, profitability is hurt, and as a result traders and investors are prompted to sell off corporate stock which drives share price down [6]. Currently oil prices and the stock market are mimicking one another by falling in tandem. WTI prices plunged 7% on September 8th to $36.76 a barrel, setting off crude’s worst day and lowest closing price in nearly three months [5]. The same day, the three most widely followed indexes in the U.S: the S&P 500, the Dow Jones Industrial Average, and the Nasdaq composite dropped 2.8%, 2.3%, and 5% respectively [8]. Figure 2 shows the correlation on this date between all three major indexes and crude price.
If inventories are being drawn down, demand is outpacing supply and the price of crude should rise. If oil prices drop, the stock market is expected to rise. Neither of these two actions took place over that week.
Figure 3 is the trend since March showing crude inventory builds and drawdowns compared to oil prices. When global inventories increased, supply outpaced demand and the price decreased. As inventories have drawn down, demand has outpaced supply and prices increased or at least remained neutral. This logic was thrown out the window the week of September 7th when after six straight weeks of drawdowns and limited price movement, a miniscule uptick in crude oil inventories cratered the price of oil by 7%. The timing within the month also does not lend to the same explanation from April when the contract was about to expire. The fierce selling in the energy market is being driven largely by rising concerns about how much crude the fragile world economy needs. With Labor Day in the rearview mirror, summer driving season in the United States is over, jet fuel demand remains extremely weak because many people don’t want to fly during the pandemic, and no one knows how long it will take to recover [5]. Oil prices are now following sentiment and the overall stock market trend instead of supply and demand principles.
“Oil is getting caught up in the risk-off trade,” said Jeff Wyll, energy analyst at Neuberger Berman. He added that “nothing changed” in the fundamental supply/demand picture for oil to “warrant this kind of drop”[5]. Just as investors are hitting the exits on tech stocks, they are unwinding speculative bets on crude oil. The result: supply and demand principles that have governed the price of oil for decades is being thrown out the window. Global supply is still down thanks to OPEC+ cuts and a low price environment hampering production while demand is on the rise. Road traffic has nearly recovered, and Bank of America expects global oil demand from road use to go positive year-over-year in the next few months [5]. Although air travel is nowhere near pre-COVID levels, which has been keeping demand for jet fuel very depressed, this is nearly the only metric not quickly approaching “normal” levels. From an inventory perspective, oil demand is still below pre-pandemic levels, but recovery has increased faster than the supply ramp-up. From a technical standpoint, as long as this trend continues it should point to bullish oil prices. Either the market is not accurately reflecting the amount of inventory that has been drawn or it has been influenced by overall bearish sentiment in all sectors during the week and knowledge outside of crude supply data.
Conclusion
A growing disconnect between oil prices and the actual availability of crude oil has arisen resulting from the influence of market sentiment. Plain and simple, oil cannot survive in a sub-$40 price environment because not enough oil can be economically produced to meet world demand at that price. The drop to sub-$40 oil is a dangerous price for any oil company in the U.S. and is simply unsustainable. This type of low price environment forces companies to shut-in production or go out of business, pulling more crude off the market. When this happens, supply dries up, demand remains neutral or increases, and prices are forced to rise. That logic follows the principles of supply and demand economics, and at a basic level is how commodity prices are set. The problem is, when the market doesn’t follow these principles a correction is inevitable. Either oil price must correct upward to meet current supply and demand levels or new information must be presented to commensurate the reduced demand and associated market slide. Based on available data, more oil is currently being demanded than supplied which should keep prices stable or allow them to rise. Instead, a one week miniscule inventory build caused prices to wildly drop even after six weeks of drawdowns held the price constant.
A major influence on the sentiment causing this disconnect relates to refinery runs and associated refined crude products. Next week we will investigate how a key player in lagging crude oil demand, jet fuel, is influencing prices more than it should. Since borders have been shut down and travelers fear leaving their homes, jet fuel demand has tanked. As predicted in our piece Post-COVID Global Oil Demand Series – Part 4: Global Oil Demand, other sectors’ increased consumption, like gasoline for personal vehicles, will offset the reduced demand in this sector. Demand for jet fuel is considerably down with an unknown recovery date which is causing fear for the global demand picture. This fear is biasing sentiment and forcing the market to misbehave. The fear is misplaced since available data proves more oil is currently being demanded than supplied, regardless of the oversupply in processed fuels for the aviation industry. Clearly a disconnect exists between recent price movements and the supply/demand principles that have historically determined prices. If the market continues to misbehave by following negative investor sentiment rather than technical fundamentals a strong, bullish correction on oil price will be inevitable.
References
[3] https://www.investing.com/economic-calendar/api-weekly-crude-stock-656
[4] https://www.eia.gov/petroleum/supply/weekly/pdf/figure1.pdf
[5] https://www.cnn.com/2020/09/08/investing/oil-prices-drop-saudi-arabia/index.html
[7] https://oilprice.com/Energy/Oil-Prices/What-Explains-The-Sudden-Drop-In-Oil-Prices.html
[8] https://www.marketwatch.com/investing