Via Wesley Fryer & John Hill

Friday will be the end of the first quarter of this year. We began 2017 with high expectations for crude oil and refined products. Many analysts anticipated being on track with crude oil production cuts from OPEC and expected only slightly higher production here in the US. Most expected higher prices for a barrel of crude oil too, and many in financial circles were predicting a balance between world crude oil supply, and world demand sometime in the second quarter of this year. The International Energy Agency, IEA even predicted world per day demand would grow by as much as 1.4 million barrels this year, but also noted that 2016 outperformed expectations as demand grew by 1.6 million barrels versus expectations. We’re not expecting to see that kind of growth this year, though.

Overall world production seems to be on pace with expectations, though the Saudi’s are bearing most of that burden, and the Russians to date have only accomplished 37% of their reduction since the beginning of this year, according to the IEA. The price of West Texas Intermediate, W.T.I. however, is not where most expected either, and demand for crude oil is not delivering as hoped. Crude oil stocks are soaring to near record highs, and the Baker Hughes rig count keeps growing, yet I keep reading analysts from the major financial institutions and brokerage houses predicting a rebalancing of production and demand by mid-2017 and meaningful reductions of crude oil stocks by the end of the year. Where does this unsupported optimism come from? We needed answers, so, as usual, we crunched the numbers ourselves, and this is what we found.

Having a good look at US production and supply should provide an adequate measure, but we needed more to counter the IEA projections, so we took a look at four separate measures to see if our numbers support the current price of WTI crude oil and the projections from the IEA. Those four measures were:

1. US crude oil stocks

2. US crude oil production

3. US refinery demand for crude oil

4. Baker Hughes rig count: US

US Crude Stocks

Crude oil in storage, also known as crude stocks, represents the amount of crude oil that is currently in storage facilities within the US and available to be marketed. The crude stocks number is reported both inclusive and exclusive of what’s called the Strategic Petroleum Reserve, SPR. This special crude oil reserve is maintained by the US Department of Energy and holds up about 713 million barrels.

The President is charged with the decision of when to use portions of the SPR. It is to be used only in the event that the US faces another embargo, like what we saw in 1974, or some other calamity that might create a supply crisis like what we saw in 2011, which was the last time the President released crude from the SPR. The S.P.R. stays relatively constant at about 695.1 million barrels. For our purposes here, we used the crude stocks number that was exclusive of the SPR.

For the week ending 3-24-2017, crude stocks stood at 534 million barrels and shows solid growth for the first quarter, as seen in the graph below:

The problem is this: With solid growth comes pressure on prices. We must also understand that US storage facilities are either at or close to their capacities. According to the EIA, 521 million barrels equals 100% capacity in the US; however, there is an additional capacity of about 120 million barrels that goes unmeasured, because it resides in rail cars, ships, private storage and pipelines.

What this graph shows is that US crude oil stocks increased 55 million barrels; a ten percent gain in three months. That didn’t help global oversupply at all, and will serve to keep pressure on the price of crude oil and the products, well past the end of the first quarter. It also represents an increase in US stocks of 151.6 million barrels since January of 2015 – a 40% increase! This is a bearish signal for the price of crude oil.

US Crude Oil Production

Crude oil production is at the center of the controversy (as is usually the case), and it always gets blamed for pushing prices up or pulling them back. US production has been growing for some time now, and stands at 9.147 million barrels per day, as of today’s Energy Information Agency (EIA) report. That’s a per day increase in 2017 of 377,000 barrels. With OPEC cutting production and the US increasing production, it’s a fool’s game to assume a different outcome, especially if the Saudi’s tire of the game and OPEC does not extend their production cuts past June.

The graph below shows US production of crude oil from January of 2017 to today:

Once again, as we saw in the US crude oil stocks, higher production will keep a lid on prices and most of the time will pull them back. For the record, US crude oil production has been growing since September of 2008 when it bounced off a low of 3.988 million barrels per day. What a rally we’ve had… and are apparently having again.

We could stop right here and deliver a pretty convincing argument as to why crude oil prices are trading back down in the upper forty-dollar range, but we need to continue if we’re going to have any hope of understanding where the price of crude oil will go for the second quarter and the rest of the year.

US Refinery Demand for Crude Oil

Refinery demand is a good indicator, which shows the movement of crude oil out of storage, through the pipeline system and into US refineries. As a general rule, for the last couple of years, we should expect to see around 16.5 million barrels of crude oil make its way to a refinery each and every day. That number increases in the summer during the drive season and falls in the winter due to less demand in the off season. Since the beginning of 2017, Refinery demand has fallen and has remained low during the entire first quarter, averaging 15.9 million barrels per day. As a matter of reference, refinery runs in 2016 never dipped below 16.1 million barrels. Refinery runs this past month averaged 15.97 million barrels per day; finally, an increase, but still below last year’s average! As mentioned earlier, last year’s demand for crude oil worldwide increased on a per day basis, 1.6 million barrels. Demand in the US was surging as well and the Chinese, Indians and Japanese were importing crude from around the world at a good pace.

The graph below shows US refinery runs, also known as refinery demand, through the first quarter of 2017:

This graph depicts a declining run for the refineries and demonstrates sluggish demand for the first quarter. Higher production, higher stocks on hand, and lower demand from the refineries will have the effect of lowering prices, and are just about the only measures that can create movement in the price of a barrel of crude oil. For our research purposes, it appears the price of crude oil is going lower, unless demand increases “quick, fast and in a hurry.”

Baker Hughes Rig Count

The final measure we looked at, and arguably one of the most recognizable, is provided by the Baker Hughes Corporation as it publishes its weekly count of active crude oil, natural gas and miscellaneous drilling rigs. This report serves as the gold standard for many, as it represents the most accurate number of rigs, for the longest period of time in the oil patch.

Last Friday’s Baker Hughes rig count showed another big increase in the number of active crude oil and natural gas rigs working in the US. Friday’s number showed an increase of 21 crude oil rigs and a decrease of two natural gas rigs and an increase in one miscellaneous rig. Below is the graph showing activity in the first quarter of 2017:

This graph shows an increase of 144 rigs drilling for oil and gas on the continental US, since the beginning of the year. That’s an increase of 22% since the beginning of the year, and provides yet another bearish indicator for prices as we move into the second quarter of 2017. Even though this number will have the effect of pushing prices lower, because it assumes more production, it also represents growth in the industry, as it creates more jobs and generates more tax revenues for states and communities. Here’s a quick tip; it is widely held that for every drilling rig that goes up, 100 additional jobs are created and that’s boots in the mud, so to speak!

Conclusions

When you tie in all four measures, stocks, production, demand and the Baker Hughes (BHI) rig count, each of these metrics provided a bearish signal for the price of crude oil and explains why crude prices struggled to rise above $55 per barrel and why they are struggling to stay afloat in the upper $40 range right now. What should concern us all is the amount of crude oil in storage in the US and sluggish demand, represented by slower than usual refinery runs. I think it is obvious that pressures on crude oil prices are significant and a change will need to come soon if we’re going to see much more of a recovery.

One such change that is on the very near horizon and adding to the worries of OPEC and their production cut partners are revelations by the “Big Three” oil companies, Exxon Mobil Corp. (XOM), Royal Dutch Shell Plc (RDS.A), and Chevron Corp. (CVX), and their plans to spend $10 billion in the Permian Basin. They expect profitability in most of their new production around $40 per barrel. There are also areas in the Permian Basin that will yield production at around $20. In economic terms, we call this an economic dislocation. The price curve is shifted so dramatically that prices actually fall, and that is big news. Reduction in the production cost of crude oil is, as big a game changer, as increasing demand, maybe bigger this time.

Consumers, on the other hand, will reap the benefits of cheaper oil and lower production costs by paying less at the pump. It’s hard to imagine a scenario of higher production and lower prices giving a benefit like this that doesn’t hurt the market place, but here it is. Right now, all signs point to lower prices, and if the production costs in the Permian Basin play out, the US will become energy independent much sooner than we all expected… and the beneficiary will be the US economy. Remember: A rising tide raises all ships!

If you want more information on the energy markets and what is making prices move every day, go to our website www.crudefunders.com and scroll down to where it says “Subscribe”. There you will find our link to the daily commentary “Energy Wise”, a comprehensive piece that includes both fundamental and technical analysis of the day’s energy markets and provides you with the detail that you need. For more on Energy Economist Tim Snyder and his company, go to www.matadoreconomics.com.

By Tim Snyder

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