Truth Shall Set You Free(Fall)

A long time ago in a high school far, far away, I passed or failed classes based on whether my grades on tests and homework assignments met certain absolute grading criteria.  If I understood the subject well enough and could remember this information on tests, I would receive superlative scores on my report card.  Scholastic performance by anyone else in the classes was theoretically irrelevant, as my grades were based on my individual knowledge and performance.  Upon entering college, I found that many professors chose to assign grades according to a bell (or other distribution) curve, meant to reflect the relative performance of the entire body of students in these classes, rather than an absolute performance standard.  This system was intended to be more equitable and reflect the quality of instruction, as well as student effort.  Such systems are certainly capable of being gamed, however.  If a top student had a poor showing, or could be convinced to underperform, students in the middle of the pack were in an excellent position to post a good score, without having excellent absolute performance.

Saudi Arabia, with support from the other ROPEC (Russia + OPEC) nations, is the curve-setting, A+ student of the oil producing world.  They are able to extract oil for a price below $5/bbl, with most of the world’s oil well extraction costs and break evens at several multiples of this number.  The curve that oil prices are graded on is something called comparative inventory and the underperformance item used by Saudi Arabia to lower the curve for everyone else is production cuts. 

Comparative Inventory

Art Berman, a geological consultant in the oil and gas sector, maintains an oil pricing model based on comparative inventory that is used in presentations to industry groups and leadership of exploration and production companies and capital groups in the energy sector.  Over the past 5 years, Art’s work shows that oil prices have moved up and down in conjunction with rising and falling levels of comparative inventory.  Comparative inventory, in this case, is the difference between 5-year average amounts and the current inventory level.  Although not as rigorous as Art’s models, graphing U.S. petroleum and products vs 5-year average levels using EIA inventory data allows one to quickly ascertain the general validity of his work.

The A+ student, Saudi Arabia, manipulates U.S. comparative inventories by increasing or decreasing their own production levels, which results in stockpiles in the U.S. moving up and down.  In 2014, Saudi Arabia boosted production at a time when U.S. shale production was recording impressive production gains, contributing to the realization of massive domestic actual and comparative inventory levels.  Crude pricing has tended to move in opposition to large changes in comparative inventories.  Inventory levels are near the 5-year average at present, which indicates that crude pricing could be quite volatile over the next few weeks and months if a new trend in inventories is established. 

Inventory Plus…

Given the enhanced chance of price volatility, what factor(s) could function as a catalyst to swing prices either up or down? Outside of sociopolitical factors, a significant change in U.S. comparative inventories would most likely shift prices a good amount.  A summary glance at the markets would indicate that inventories have been brought into alignment, assuming comparative inventories are used as the benchmark metric, and prices are similar to year ago levels, near the halfway point between recent highs and lows. These 2 factors alone would seem to portend a fairly stable trading range in the near future.  If inventories swung much higher, however, we would expect prices to drop.

There is a lightly discussed change in U.S. export laws that could result in such an impact.  Year-end 2015 saw the United States remove a 40-year ban on oil exports that was passed in 1975 to counteract the OPEC oil embargo and work to alleviate a supply shortage.  Exports had actually risen to around 500,000 Bbls/d from minimal levels during 2014 and 2015, and have shot up by over 5 times this amount to around 2,750,000 Bbls/d since passage of the bill that removed the export ban. 

Removal of the export ban has opened a release valve for domestic production that has prevented almost 3,000,000 Bbls/d from being added to inventory levels.  Comparative inventories would be at significantly positive levels if exports were added to domestic storage.

Conclusion

Adding exports to currently high inventory levels shows that pricing volatility should have downside price risk if current production levels are maintained or increased.  Saudi Arabia has lowered the curve by decreasing production since 2015, but if U.S production continues to increase and take export market share, it seems likely that Saudi Arabia will eventually quite putting wrong answers in the box and absolute performance will achieve relevancy once again.