Is there more to OPEC’s strategy than meets the eye?
When oil prices soared to $100 plus for a sustained period of time, the ‘capability to produce more’ was born. The US and other producing nations rushed to unlock technologies that had previously been uneconomic and unnecessary. Was OPEC watching as that last barrel came on-line and broke the camel’s back or did they severely underestimate the innovation that soaring prices would create?
Sustained higher prices fueled innovation in drilling and extraction and also fed the renewable enthusiasts. The subsequent fall in prices then led to cost cutting and production efficiency. At $100 a barrel for oil, it was easier for ‘green’ technologies to get their foot in the door using the economic argument. We then saw stricter fuel efficiency mandates, government subsidies that encouraged ‘switching’ to renewable sources, and the idea of energy ‘choice’ became more mainstream as electric vehicles and solar panels gained momentum. This left the world with a slump in organic demand for oil and oil products and consumers with the idea that they can ‘choose’ the type of energy they buy.
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When OPEC finally announced production caps at the end of 2016 the substance was interesting from two perspectives. One is the bulk of them came from members exporting medium and heavy sour oils, another is the impact the light/heavy spreads are having on the economics for global oil movements.
It has now been telegraphed that OPEC may agree to extend the production caps at their upcoming meeting. Is there something more to this strategy than meets the eye? As they face growing competition from other producers like the US, OPEC’s motives may extend beyond just general price support. Meaning, is their strategy intended to support their ‘brand’ of crude over lighter brands and will that lead to more disparity in light/heavy crude spreads. How will that impact the growth of US exports?
Let’s look at the price impact of reducing the supply of heavier crude grades from the market so far this year:
The value of WTI relative to both USGC Sour and Canadian heavy crude fell. We know that refineries are specifically configured to process the most economic grades of oil available to them. This is how they work their strategic advantage. For example, since the US has historically been a net importer of oil, and heavier grades were the cheaper option to import (from Canada, Mexico and the Middle East), many US refineries were configured accordingly over time. In addition, many of Asia’s new refineries are designed to run on medium and heavy crude that has a higher diesel yield. With their proximity to the Middle East’s supply of heavier production, this made sense.
In the mean-time, new supplies of US shale production are now ready to hit the global market and it’s primarily light, sweet oil. The US has invested heavily in and around the Gulf Coast to accommodate exporting their new-found supplies as slowing local demand has spurred a search for new markets. They are now juggling the task of importing the slate of crude grades that meet local refiner specifications along with exporting excess production of those that don’t.
Of the 3 main benchmark oil futures contracts, WTI, Brent and Oman/Dubai, WTI is the ‘lightest’ and Oman/Dubai is the ‘heaviest’. With OPEC cutting the supply of heavier grades from the market at the same time lighter supply is growing, spreads between benchmark oils continue to reflect that.
The loss of premium of WTI over the OPEC basket price can also be seen in the spot market.
The question is, how much of this can be attributed to the heavy US refining maintenance season this past spring and how much is attributed to tighter supply of heavier grades?
Even with the rally in outright prices this week, WTI was the weakest performer.
Brent crude lost value relative to the heavier Dubai grade, but gained slightly relative to the even lighter US grades. This has been the general trend all year, but has gained some momentum as talks of continued output cuts emerged.
However, it’s interesting to note that while December 17 vs 18 spread in both WTI and Brent futures dipped into contango territory briefly when the market sold off early this month, Dubai(Oman) didn’t follow suit.
I take this as a sign that the market realized any tightness created by summer seasonality and production cuts will be short lived. Said another way, inventory levels are still high and the market doesn’t want to create incentives to store more via contango. At this point, any rally in outright prices needs to be led by the front of the market in order to disrupt the mind-set that historically high inventory levels equals low prices.
It’s worth noting that crack spreads moved higher this past week in tandem with the oil price rally.
Spot gasoline prices have been lackluster so far this month with the exception of the West Coast which is still experiencing refinery outages and are now well above levels seen this time last year.
Turning to EIA Inventories. Was a small draw of (0.4) in gasoline inventories this week all it took to change sentiment?
With this week’s crude draw of (2.5), the total change in inventory over the past 6 weeks have been impressive relative to the same 6 weeks in prior years:
Gasoline inventories, however, remain a net injection over the 6 week period. The picture is quite different from this period last year which points to the difference in the refinery maintenance season year over year. Now that the Gulf Coast refiners are mostly back on-line (as seen in the refinery utilization rate for PADD 5 in the inventory table above), it remains to be seen if summer gasoline demand (plus exports) will outpace production and draw down inventory.
We have watched the increase of oil storage capacity over the past year as the market caught up to growing production and the desire to have export facilities. Growth in both storage capacity and the inventory to fill it has weighed on the market heavily. Take a look at a comparison of WTI prices to ending inventory levels over time:
Does adding more capacity to store automatically mean lower prices once it has been ‘filled up’? The success of our ability to absorb this storage capacity as the ‘new norm’ seems to hinge on the viability of the export market. As noted above, for now, OPEC cuts have been more helpful to heavier crude markets. But, might it be reasonable to think that with this expanded capacity comes a higher base level of oil in storage to support an export system? If so, prices have room to move higher.
For now, the US is brimming with light, sweet crude oil in a global market dealing with OPEC’s attempts to tighten heavy and sour oil supplies, but it’s a long way from where we were this time last year before any cuts and still just getting our feet wet with crude exports.