Barbeque Vs. Bolsheviks

Clearly something has happened.

Back in June, West Texas Intermediate crude was at $44 per barrel and seemingly headed lower. Five months later here we are at $58 per barrel — a 31% increase.

That is a pretty big move and a huge boost to cash flows of oil producers across the globe.

chart: WTI on a tear

So what happened? Why has the oil market suddenly come back to life?

Rather than speculate, let’s take a look at the data

Surprise, Surprise – Global Oil Consumption Is Growing Rapidly

I’ll admit it. I’m as guilty as the next guy about getting excited about the electric car. Ten years ago I didn’t expect to see a serious level of electric car usage in my lifetime.

Now widespread roll-out of the electric car seems almost imminent.

Maybe, but the electric certainly has no impact on the global thirst for oil in 2017.

In fact global oil consumption has been growing very rapidly. Over the past three years daily oil demand has posted increases as follows:

2015: Global oil demand increased 2 million barrels per day

2016: Global oil demand increased 1.6 million barrels per day

2017: Global oil demand will have increased by 1.6 million barrels per day

That means that over the past three years global oil demand has move higher by 5.2 million barrels per day. Three years ago global demand was 92 million barrels per day, now it is over 97 million barrels per day.

For some perspective the significance of a 5.2 million per day demand increase, consider that growth basically consumes 100 percent of the entire daily production from U.S. shale oil.1

An extra 5.2 million barrels per day of oil demand consumes 1.89 billion barrels more oil per year than what was being used in 2014 before oil prices crashed.

No sign of the electric car making an impact here!

The Saudis And Russia Have Significantly Curbed Supply

In determining price, demand is only half the story. The other half is supply.

Last December, OPEC and some non-OPEC countries agreed for the first time since 2001 to cut production. OPEC alone had cut production (successfully) in 2008 to shore up oil prices in the wake of the Financial Crisis, but this time the cartel also had some friends agree to help.

When I say “friends” I’m using the word very loosely. The most significant friend who joined in this time was Russia. The terms of the production cut involved OPEC reducing production by 1.2 million barrels per day and non-OPEC reducing by another 600,000 barrels per day.

Russia and the Saudis are far from being on friendly terms.

Yet here we are a year later and I can confirm for you that these two key parties in the oil production group have followed through on their pledge.

Production in Saudi Arabia has dropped by roughly 600,000 barrels per day during 2017. While Russia has come through with a similar effort, taking production down from 11.4 million barrels pre-agreement to under 11 million barrels during 2017.

With OPEC and Russia production restricted and no growth from anything other than U.S. shale (which has levelled off) global supply growth has stalled while demand has been surging.

Growing Demand + Decreasing Supply = Shrinking Oil Inventories

Inventory levels are the most concrete piece of evidence that oil market investors can look to in order to determine how tight the supply/demand situation is.

Particularly, U.S. inventory levels — which are by far the most reliable.

In 2017, those U.S. inventory levels have confirmed that the global oil market has significantly tightened. In my opinion these numbers have been the main driving force behind the rising price of crude.

The chart below tells the story quite clearly. This graphic shows the change in U.S. raw crude inventories between the start of each year and the first week in November for the past 11 years.

Do you notice anything different about 2017?

Take a look at crude inventories — they’ve decreased for the first time since 2007…

chart: crude inventories

What you can’t see in this chart and what makes the oil story considerably more bullish is that finished product inventories (gasoline and distillates) have been decreasing even faster. If refiners had been processing enough raw crude to keep finished product inventories flat the decrease you see above would be much larger.

Globally inventory levels have also been decreasing on the back of steady demand growth and falling supply, but it is the decrease here in the U.S. that has really caught the oil market’s attention.

The Trillion Dollar Question Where Do We Go From Here?

The key determinant of where the price of oil heads over the next year is the will of two men.

The first man is the Crown Prince Mohammed bin Salman of Saudi Arabia who is calling the shots for the Saudis and therefore OPEC. The second man is Vladimir Putin who is calling the shots for Russia.

Given that oil demand is set to rise by another 1.4 million or so barrels per day next year, if OPEC and Russia keep their production restricted the oil market isn’t going to just remain tight It will get tighter still.

I believe that the Saudi Aramco IPO, which is scheduled for 2018, is a huge motivation for the Saudi Prince to keep pushing oil prices higher. What Mr. Putin is inclined to do is not something that my crystal ball has an opinion on.

If they simply do nothing and keep their respective production levels where they are, I believe oil prices are going to continue to trend higher.

If that is what happens, it will be interesting to see how high these gentlemen will be willing to let them go.

Keep looking through the windshield,

Jody Chudley

Jody Chudley
Credit Analyst, The Daily Edge


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