Barrels are showing up in storage uninvited

Thousands of market participants, companies, individuals and governments, track US crude inventories. These weekly inventory levels remain the best data point for market participants to gain a relatively current view on the global supply and demand balance. If inventories are building it means the market is likely oversupplied, while if storage is being reduced then the oil price will rise to the point that it incentivizes additional production (in the US or globally). Historically this has been a fairly good system to provide industries and individuals with a fairly consistent price for a valuable commodity that factors into almost everything we do.

Recently though the US inventory data has surprised almost everyone to the point that entities don’t know what to do with it. This has created significant uncertainty, which is not what you want for an industry that demands constant investment to avoid shocks in the future. The first surprise has been the steady storage builds. We remain of the view that US storage should be structurally higher now and for the foreseeable future, due to the recent pipeline and terminals buildout. All that additional infrastructure requires product to sit in those assets going forward (you can’t empty all the product in a pipe if you still want to use that pipe). This product makes its way into storage numbers but could never actually meet consumer demand, implying that the market is tighter than it looks. We think participants will slowly start to recognize that US crude storage can no longer be compared to the five-year average because of this recent build out, and we have written about this in the past. The larger and scarier surprise though has been the increasing EIA adjustment factor, which by its very nature is designed as a plug when the numbers don’t make sense. This adjustment factor has been steadily increasing to the consternation of market participants (we always fear what we don’t understand), and this is what we will address today.

A simple relationship exists that drives inventory data: Production + Imports = Refinery Inputs + Exports + Stocks Change. These are the places crude can come into the system and the way crude can be used (you can process it into products, store it for later, or export it to other markets). The EIA collects survey data for imports, exports, refinery inputs and stocks. Weekly production data is not surveyed but monthly production data has always served as a guide (and we don’t believe this relationship has changed). As you can expect, these survey elements never fully balance and therefore an adjustment factor exists, which represents the difference. Usually, these differences will rectify themselves over a period of time. For example, maybe exports are overestimated during one period but they will, therefore, adjust back in the future. Everyone is used to this back and forth and the historical adjustment usually averages approx. ~200,000 bbls/d. What really scares the market is steady adjustments, at levels above the historical norm, and all in one direction. This is exactly what has been occurring with adjustments in excess of 800,000 bbls/d for the past four weeks. This steady stream of unexpected crude, without a cause, leaves people guessing. Is production that much higher than expected? Possible, but not likely if you track associated gas which has levelled off in the basins driving supply growth. Is demand much lower than expected? This is also possible, but less likely the way the data works. We are therefore left to examine the possibility of something new entering the system, a recent change perhaps.

In January of this year, the United States government implemented sanctions on Venezuela in an effort to increase pressure on the current regime. A lot of the press around the sanctions was that Venezuela could no longer export crude to the US, and this was certainly the largest result. Another critical factor though was that oil and petroleum products produced in the US could no longer be exported from the US to Venezuela. These products consisted primarily of lighter crude, or condensate, which was ideal for blending with the heavier production from Venezuela. For the past twelve months prior to sanctions, these exports of US product to Venezuela averaged approx. ~140,000 bbls/d. These are volumes that have now had to find a new end market. The interesting thing about condensate is that if it is extracted (from a facility) it is not included in crude production volumes by the EIA. These are barrels we haven’t historically seen in the crude weekly report and have not been a factor previously. If a company suddenly can’t sell their condensate to Venezuela though, in compliance with US regulations, the next best course of action for these entities that produce/owned that condensate is to blend it into local crude streams. By doing this they get to sell the blended stream at a benchmark price, and whether used by a refiner or put into storage, the stream will now suddenly have those “new” barrels in it. Given this course of events and the classification methodology applied to products, we believe it is very possible that condensate that was previously exported is now being blended into US domestic crude and showing up in crude storage. While we cannot yet quantify the impact, this seems like a plausible cause for the sudden appearance of barrels in storage over the last few months. This certainly doesn’t account for the entirety of the adjustment but we think upcoming timing reversals, combined with further clarity on plant condensates being blended into crude (especially those that can’t access their historical markets), is a pretty good place to start when trying to explain the recent persistence of a large adjustment factor.

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Mark Le Dain