Many crude oil market observers point to current global inventory levels to explain today’s low prices. The recent price decline is also attributed to concern about possible future decline in Chinese demand growth.The problem with both of these explanations is that no one can describe with sufficient certainty the causal relationship between current crude oil inventories or future Chinese consumption and the future price of crude oil. To paraphrase economist Mohamed El-Erian the crude oil market may simply be “repricing to a new volatility paradigm.”
Relationship of Crude Oil Inventory and Future Prices; Theory of Storage Need Not Apply
As Reuters market Analyst John Kemp has written, in a perfect market with perfect information, there should be a relationship between changes in crude and products stocks and changes in prices, but no such relationship has been found in past market data.
According to the late Stanford professor Holbrook Working’s Theory of Storage, the level of commodity inventories should shape the forward price curve. When inventories are low, the market creates backwardation. When inventories are high, the market creates contango.
Historically the crude oil futures market has not seen significant correlation between inventory levels and its forward price curve.
More fundamentally, the market moves on survey and estimated inventory numbers that are subject to significant subsequent revisions. As David Pursell with Tudor, Pickering, & Holt has observed, “the observed OECD inventory builds in late 2014 and early 2015 showed a market that was oversupplied (inventory builds larger than normal) but much less oversupplied than published supply-and-demand numbers would suggest”.
Decline in Future Chinese Crude Demand Growth Speculative
While there is broad agreement that the recent slowdown in the growth of the Chinese economy has caused reduced iron ore and coal imports, China continues to import crude oil at record levels. China appears to be increasing the size of its strategic petroleum reserves by constructing underground caverns.
Although increasing the size of its strategic petroleum reserves may not immediately translate into long term sustainable demand growth, increased imports by teapot refiners and record vehicle sales indicate strong current demand growth that does not appear likely to diminish in the near future.
World’s Oil Market Now Biggest Ever, Demand Growth May Surprise to Upside
The fact remains that the world is consuming 94 million barrels of oil a day, the most ever. Given the record breaking sales of heavier vehicles in the US and China and the additional consumption usually induced by lower refined product prices, demand growth in 2016 could surprise to the upside.
What is Driving Crude Market Volatility?
Robert McNally, a fellow at Columbia University’s Center on Global Energy Policy and the founder of The Rapidan Growth, describes the “Crude Predicament” in his 12-17-2015 paper Welcome Back to Boom-Bust Oil Prices. He accurately describes how the capital intensive and unique geopolitical attributes of crude oil production contribute to a cyclical and volatile market. He states, “Oil’s short run demand and supply inelasticity portends prolonged boom-bust cycles. The absence of an effective short-term price stabilizer will increase investor uncertainty about longer-term prices that factor into major consumption, investment, and government planning decisions. … As we see daily now, global equity, bond, and currency markets are being roiled by violent oil prices moves; oil is the tail that is wagging several macroeconomic and financial dogs.”
Indeed the price of oil options has increased significantly in light of the level of implied volatility in recent weeks. Interestingly the market does not currently appear to price much if any geopolitical risk premium which implies that hedging expenses could increase significantly if a geopolitical event occurred that disrupted supply.
Effect of US Crude Oil Exports?
While market observers agree that few incremental barrels of physical crude will be exported due to the repeal of the 40 year old ban, the effect on the financial derivative market has been immediate and substantial as the West Texas Intermediate (WTI) and Brent Crude contracts reached parity on December 23, 2015. Because futures contracts are settled based on physical crude delivery at contracted locations, the theoretical ability to export US crude to any rule of law nation must be taken into account by market price forecasters.
Volatile May Be The New Normal
Given the inherent opaque nature of oil and gas supply and demand data, the foreign currency risk inextricably intertwined with the global hydrocarbon market, and the complex and shifting geopolitical landscape on which the petroleum infrastructure is built, the crude oil market is likely to see substantial swings in the near future.
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