Sunday, August 28, 2016

Higher Oil Prices Must Contend With Too Much Inventory

Crude oil prices spiked above $50/bbl in early June and have fallen back to $47/bbl as of Friday's close. The high $47 level remains above the early August low of $39.52. Further weakness in oil prices is likely as a result of stubbornly high crude oil inventories (excl. the Strategic Petroleum Reserve.) On Wednesday last week, the Energy Information Administration (EIA) reported weekly inventories increased 2.5 million barrels and is a reversal of the 2.5 million barrel decline in the prior weekly report. Not that one or two weekly reports tell the entire story, but, as the below chart shows, inventories remain at very elevated levels and prices are not likely to move higher until this elevated inventory is reduced.

With inventories at significantly high levels, then demand is necessary to draw down this higher inventory. As the Berman article also shows, the supply/demand balance has improved, but not to the extent necessary to reduce inventories. Historical current 'supply/consumption' levels would have equated to oil prices in the $80-$100 range.

Berman notes though, "As long as oil prices are are range-bound between about $40 and $50 per barrel, it makes more sense to store oil than to sell it. The carrying cost of storage is less than what can be made by rolling futures contracts over each month. Inventories will stay high until prices break out of their current range but out-sized inventories make that impossible. Catch-22."

Other factors potentially placing downward pressure on oil prices:

Increasing rig count:

Mid May of this year represented the low point in drilling rigs totaling 404 in the U.S. The Baker Hughes rig count report on Friday noted U.S. rigs totaled 489. Most of this increase is associated with the Permian Basin located in Texas and New Mexico. These two states have seen rig counts increase by 75. The increased drilling activity in some of the shale regions will certainly add to supply and keep downward pressure on oil prices.

Stronger US Dollar vis-à-vis Higher Interest Rates:

The U.S. Fed certainly desires to push up interest rates after a lone rate hike last December. Friday's Jackson Hole comments from Fed chair Janet Yellen made clear of this desire with the only question being timing. The relationship between higher interest rates and oil prices lies in part on the impact to the US Dollar. As the below chart shows, oil prices move inversely to a rising Dollar with oil's correlation of minus .85 to the trade weighted Dollar. The second chart below shows the Dollar is positively correlated to interest rates, a plus .56 correlation; thus higher rates likely translate into a stronger Dollar and this places downward pressure on oil prices.

Historically, and from a technical perspective, the Dollar has followed a 7-Year cycle. If this plays out in the current Dollar cycle, two or so years remain for additional Dollar strength.

In spite of what one might hear on television business shows, oil has a positive .54 correlation to the stock market (S&P 500 Index) going back to 1986. This correlation broke down at the height of the fracking boom as oil price weakness was largely due to oversupply and not economic weakness.

The bigger concern with weak oil prices is the influence the oil sector has on business outside the energy companies themselves. We have noted the negative impact lower oil prices have had on S&P 500 earnings due to weakness, not only in energy earnings, but weakness in some of the  industrial and material companies that have exposure to the energy sector. As one looks out into mid year 2017, an improvement in S&P 500 earnings is partly predicated on an improvement in energy or energy related business earnings. Lower oil prices in the near term could jeopardize this improvement. Given the elevated oil inventory levels, significantly higher oil prices seem more a wish than potential reality.

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