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Supply Issues Point to Bearish Market

October 7, 2016

Written By Tim Danze

The current fundamentals and realities of the energy market are bearish, in my opinion. The question is whether there are longer-term bullish implications we need to consider.

A quick look at supply and demand as of late August shows crude oil stocks in the United States are sitting at 521 million barrels – 64.8 million barrels more than at this time last year and 128.4 million barrels above the three-year average. Similarly, gasoline stocks are 19.8 million barrels above last year’s storage levels and 17.8 million barrels higher than its three-year average. The trend continues with distillate stocks up 4.7 million from last year’s levels and 20 million barrels above its three-year average.

These numbers point to the U.S. energy market as well-supplied and, in all honesty, probably oversupplied. You could argue about whether 4.7 million more barrels of distillates is really an inundated market, but at a minimum I think it is fair to say distillate supplies are adequate.

These facts about supplies are the reason for my bearish outlook. Despite these circumstances, prices have been steadily moving higher since the start of August.

Why, in the face of an abundance of crude, gasoline and diesel, is the market trending higher? That’s a good question.

Weekly gasoline demand has been strong lately at 9.5 million barrels per day for most of the summer driving season. The demand, however, has not been strong enough to eat into the growing supply stocks that are still at record levels. Diesel demand has not been as robust as gasoline, but it is still at a healthy 3.2 million barrels per day. We could potentially see higher diesel prices with enough demand from fall harvest.

Crude oil processing is always an important factor, but oil refineries ran hard through the spring and processed more than 16.6 million barrels per day in most weeks. This strong processing volume has continued to result in building supplies levels – another sign the market is oversupplied.

Future Considerations

With supplies being in such good shape, why are we seeing a rally in the futures market?

Declining rig counts and the loss of U.S. shale production are two of the primary reasons. Last year at this time, the number of U.S. rigs looking for crude oil was around 674. It’s now just more than 400. This has caused domestic oil production to dip from its peak of 9.7 million barrels per day to 8.4 million barrels per day.

Production dropped in response to declining oil prices, and the losses have led to a few companies exiting the market. An important question moving forward is whether prices will be high enough to support shale production. If crude prices could get up near the $60 per barrel level, many shale producers would be able to resume production.

The cuts oil companies made to their budgets and capital expenditures is another important consideration. Consulting firm Woods Mackenzie estimates about $1 trillion has been slashed from budgets running through 2020. This has resulted in a halt to oil exploration activities at many firms. At some point in the future, that probably means production will drop.

While I firmly believe oil prices will eventually rise due to the huge cuts to capital expenditures and budgets by all the oil companies, I see this as a longer-term issue for the energy markets in the next three to five years.

The market seems to be overlooking the current glut of supplies and looking farther down the road at some of these other concerns. The market can and will do whatever it wants – no matter how irrational it may seem. However, the current situation seems to point to an excess of supply that will need to be balanced before these longer-term issues become a factor. It wouldn’t surprise me if we are wondering how crude oil prices got so high again five to seven years from now. While that may come to pass, the current market seems well ahead of itself in preparing for that time.

Want to read more market commentary? Tim Danze shares his thoughts on the energy markets daily at mfaoil.com. Click here to view recent market commentary postings.