The oil price finished flat on the month, with the underperformance of the service and exploration and production (E&P) sub-sectors leading to weaker performance from the Fund. Fundamentals continued to improve as we began to see evidence of inventories drawing in the OECD June numbers (IEA operate with a two month lag).
August saw a continuation of heavy inventory draws in the US and evidence of draws in the Antwerp, Rotterdam and Amsterdam (ARA) region, non-OECD and OPEC countries. On a ‘days of forward cover basis’, the US has seen its crude, gasoline, distillate storage surplus shrink from 25% in February to just 4% today. In fact, since March we have witnessed a 650kbbld fall in inventories versus a seasonal norm of 9-10kbbld increase.
Interestingly although OPEC have delivered a high compliance to their production cuts averaging 93% or approximately 1.1Mbbld. However this has not translated into meaningfully high export cuts. Tanker data points to the fact that exports have only fallen by c.335kbbld. Considering Saudi were responsible for 0.33Mbbld of those, the rest of the OPEC nation’s contribution has been fairly derisory. In fact, the second largest contributor to exported cuts was from Iran who cut 206kbbld. The country was in fact exempted from cutting and allowed to increase production by 90kbbld in the agreement set last year.
There are three key points. Firstly, OPEC nations are a law unto themselves except for Saudi who do still act as a significant swing producer. Secondly, if all members but one produced less oil, choosing to use stored oil as a means to bump up exports, perhaps the belief that OPEC (ex-Saudi) were overstretching production going into the November agreement last year holds true. If this is the case, then we may have less to fear from a winding down of OPEC’s cuts when it eventually comes as an increase from countries outside of Saudi may prove more difficult than the market assumes.
Thirdly, inventories in OPEC nations have continued to trend lower with Saudi falling over 10% below its five year average production days of forward cover. Consequently when production does return from OPEC countries there is likely to be a period of inventory repair. As such the market may only see a return of the more modest 330kbbld of oil that has currently been removed from exports and not the full 1.1Mbbld that has been removed from production.
The question we have to therefore ask is, why have inventories improved so strongly if OPEC exports have failed to fall as much as the market had hoped for. The answer is, demand.
The US Energy Information Administration stated recently that demand in the third quarter should be 1.51 million barrels per day above the second. In the fourth, it should be 1.67 million barrels per day above the second. OPEC's forecasts are even more bullish, with demand being higher to the tune of 1.63 and 1.98 million barrels per day, respectively. If global demand remains strong and fault lines start to appear in OPEC supply, then perhaps the market complacency over falling summer inventories may be misplaced.
However there remains one problem that is bound to a certain amount of volatility in the market – Hurricane Harvey. The devastation that Harvey has wreaked in Texas and Louisiana is sure to complicate the short term reading of data and the market is vulnerable to ‘side swipes’ as we may see a short term reversal of the bullish picture that was unfurling.
Energy investors have been worried that refining capacity coming offline implies growing crude stocks in the future. However the negative effect on demand will be moderately offset by a fall in supply, due to the fact that certain pipelines have been taken offline and production both in the Gulf of Mexico and Eagle Ford (south west Texas) were taken offline. Although we will be susceptible to US data focus, it is also worth pointing out that European refineries are bringing back capacity to produce more gasoline and distillates for export to the US. Nevertheless in the short term there is likely to be a short term build in crude barrels which the market may choose to ‘look through’, as the longer term effect is likely to be positive for US demand when rebuilding infrastructure and homes.
The overall effect will also be dependent on what recovers first – production or refiners (supply or demand). We are also yet to see whether E&P companies will choose to return all production that has been effected. There is certainly a cost to bring back a number of the more mature stripper wells that have been shuttered over the last couple of weeks, a cost that many producers will choose not to take on. At the time of writing, 10 days after Harvey made landfall, prices of both West Texas and Brent are up slightly.
While the energy market focuses on Harvey, three Libyan fields have been taken offline. Prior to the hurricane, much of the energy markets focus was on the resurgence of Libyan and Nigerian crude, focussing on the prospect of Libya growing production to 1.3Mbbld by year end. This production number looks unlikely as rogue militants managed to take three fields out of production, thereby cutting production by 350kbbld to 650kbbld. As we have said in the past, Libyan production will be highly susceptible to these volatile movements, making the region extremely tough to model.
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