The price of crude oil currently drifts between the Scylla of uncertain physical supply demand balance and the Charybdis of speculative financial derivative products.Macroeconomic investors in financial products such as oil futures contracts speculate on commodity pricing trends. Because their participation in markets is purely financial, speculators, notably hedge funds, are motivated by a different business strategy than producers and users of physical crude oil. Exploration and Production companies are engaged in the physical activity of exploring for and producing oil and natural gas. Refineries must purchase crude and natural gas to make gasoline and other refined hydrocarbon products.
The recent increase in crude oil prices may have been driven by hedge funds buying net long positions in Brent and WTI derivatives by 7 million barrels to a record 663 million in the week ending April 26, 2016. Crude oil prices have shown a strong correlation with hedge fund positions in WTI in the last 18 months.
Correlation does not equal causation. Hedge fund managers may have been moving into a net long position speculating that a global rebalancing of a current perceived oversupply of crude to a state of equilibrium is occurring. This speculation may have been fueled by comments by Faith Birol, chief of the International Energy Agency (IEA) that … “under normal conditions toward the end of this year, second half of this year but latest 2017, markets will rebalance.”
The reconciliation between the financial and physical product occurs at delivery points agreed upon in standard contracts. The agreed upon delivery point for the West Texas Intermediate (WTI) contract is the intersection of pipelines in the middle of crude oil tank farms in Cushing, Oklahoma.
The recent retracement of crude oil prices may be attributed to physical reality pulling market perception closer to the Charybdis of global storage numbers.
The irony is that perception of global inventory levels are driven by what would otherwise by seen as relatively insignificant observable details in a global industry that consumes close to 100 million barrels of oil a day.
For example, the angle of ladders on top of tanks in the Cushing, Oklahoma is producing price swings that literally affect the value of hundreds of millions of dollars invested in financial products on an almost daily basis.
These ladder swings have been amplified by the U.S. decision in January 2016 to allow the export of crude oil. The May 3, 2016 Cushing inventory increase partially contributed to a significant decline in crude oil prices that day.
Cushing inventory level data is surveyed, estimated, and published by both governmental and private entities. The government data is public and free. Private publishers such as Genscape sell data frequently used by market analysts. Genscape flys helicopters above Cushing twice a week to judge the level of crude oil in the tanks, and the angle of the ladders which rest on top of the tops of the tanks that float on the crude oil contained inside, among other data points, is observed to deduce the tank’s fill rate.
One physical reality surrounding the Cushing level is the mismatch between pipelines bringing crude oil into and leaving the tank farm. Midstream developers have added significant infill capacity to accommodate the rapid increase in crude oil produced in unconventional plays in recent years. While Cushing take-away capacity has been added, it has not kept pace with the increased fill capacity. This possible bottleneck can cause Cushing inventory levels to rise even as global inventory levels decrease due to reduced production outside of the Cushing gathering basins.
The market also closely watching Chinese crude oil imports for signs of inventory rebalancing. A recent factor influencing global consumption numbers is the Chinese government decision to allow liberalized imports by independent “teapot” refineries. The refineries took advantage of low crude oil prices to buy a lot of supertankers of oil. Because the refineries lack sufficient pipelines and storage tanks to quickly unload and store all the bought oil, there are a lot of ships full of oil anchored off the Chinese coast waiting to unload. One supertanker holding 2 million barrels of oil is being unloaded by thousand trucks of trucks. This can take a long time.
If all data for physical supply and demand for hydrocarbons were timely and accurately available to all market participants, then the market would work perfectly. Unfortunately no one has access to perfect and timely data for this market. Market analysts must make the best use possible of the most timely and cleanest data sets available to draw reasonable inferences about the location of physical supply and demand which ultimately drives financial derivative product prices.
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