Crude prices rallied 33% in the first half of this year, leading some to believe that crude price weakness is a thing of the past. Many experts continue to emphasize supply related disruptions, particularly in Nigeria and Canada, as the main driver of crude’s price strength. Sensationalist headlines diverted attention away from the true driver of price appreciation… unexpected Chinese demand. China’s 原油之渴 – crude oil thirst, was so great that the nation stealthily amassed a plethora of crude over the last six months, beating even the most bullish oil analyst’s expectations.
The latest U.S. Energy Information Administration’s (EIA) 2016 demand figures published in their July 2016 Short Term Energy Outlook confirmed that the surprise did not come from supply constraints, as many articles suggested, but rather from demand. The EIA revised upwards its 1H16 realized global oil demand by almost 400kb/d from their forecast published in December 2015, versus only a 5kb/d revision in realized global oil supply for that same period. It is important to note that these realized supply figures included all the unanticipated supply disruptions from earlier in the year. With China constructing the second phase of its Strategic Petroleum Reserves (SPR), market expectations were for the nation to buy 80-120 million barrels of crude, at a measured pace, over the course of the year. However, China took advantage of severely depressed oil prices at the beginning of the year to front load their buying program. By my calculations, China has already stored over 135 million barrels of crude this year, 30 million barrels more than they stored over all of last year. In February and April their import volumes caused net global crude oil draws where most analysts expected builds. This was evidenced by sudden backwardation in Brent spreads during the month of April. This rate of buying is unsustainable and it brings to question how much crude oil storage capacity is truly left in China.
As bulls cheer the flat price rally, they may be overlooking the fact that refined product storage globally is being called into question. Refiners have turned excess crude into a product glut. Blockbuster gasoline demand in the United States and modest diesel demand globally have done little to put a dent into global inventories. Now at seven year highs, global product inventories stand at a staggering 1.06 billion barrels (+6% yoy) across the US, ARA, Japan, and Singapore. In my earlier blog post Refined, not Crude, I discussed the poor economic state of the refining sector and how overcapacity would cause a race to maximize refined products, thus destroying margins. Since the winter of 2015, we have witnessed this exact scenario play out. In an effort to maintain healthy refinery margins amidst poor distillate cracks, refineries maxed out gasoline production. Over the last three months refiners produced two times more gasoline than distillate, which is a ratio not seen since 2012. Modest to stagnant global diesel demand has also led to ample distillate inventories. Will there be room for added barrels as we approach fall, when products are expected to seasonally build?
Along with Europe and Asia, US petroleum product production has continuously outpaced demand this year. In New York Harbor, gasoline supply is so ample that we are witnessing ships being turned away whilst others are converted to floating storage. In Europe, there are reports of full product storage in Germany and lines of product tankers in Antwerp and Rotterdam. China, whose gasoline exports are up almost 37% this year, exported excess gasoline into the U.S. Gulf Coast with the hopes of alleviating their swelling inventory. Lastly, Singapore light distillate stocks hit a 20 year high at the end of 2Q16, with a barrage of refined product vessels sitting off its coasts. It is no wonder that Asian naphtha cracks (differential to Brent price) and other gasoline blendstocks are at an 18 month low. Summer gasoline, in the midst of peak driving season, is now trading at a discount to diesel which is a market condition not seen since 2013. This troubling picture forces me to believe that refinery margins will continue to suffer and cause refineries to impose economic run cuts. This would be detrimental to crude price appreciation.
The backlogs of crude tankers off the coast of Qingdao, China are finally diminishing; barrels have been heading inland to fill storage sites like the 9.5 million barrel Hainan facility which has been operational since July 2nd. However, China’s June net oil imports fell 5.5% from the previous month to 7.48MB/d which are the lowest levels since January 2016. This is likely the beginning of a slowdown in crude purchases. Interestingly freight rates have plunged to multi year lows despite a record number of vessels being used for oil storage. For example, Nigeria to China and Saudi Arabia to Singapore shipping routes are now trading $1.75 and $0.66 per barrel respectively (down 57% and 64% from December 2015 highs).
Potentially lower Chinese demand and refinery run cuts, should they materialize, would put significant pressure on crude prices. China’s 原油之渴 thus far has masked the world’s refined product glut. Oil bulls will need to be patient as a pullback in prices could be imminent.