In my February 2016 article Saudi Arabia having a change of heart?, I concluded that “the possibility of a supply cut during OPEC’s June meeting (was) on the table.” Though the timing was three months shy, the market finally saw confirmation on September 28, 2016. OPEC affirmed my base case of a deal being struck at the 170th (Extraordinary) meeting in Algiers; in the official press release, OPEC stated the OPEC-14 will “target (a) range between 32.5 and 33.0 mb/d, in order to accelerate the ongoing drawdown of the stock overhang and bring the rebalancing forward.” It is my expectation that with the support of numerous non-OPEC nations, OPEC will finalize the details of implementing these production cuts with accommodation for Iran, Libya and Nigeria.
This is a significant change in OPEC/Saudi policy, which might as well be appropriately named “mission accomplished”. The Saudi policy of the last two years has effectively eradicated shale exuberance and reigned in competition from conventional and alternative sources. It would take at least six months of sustained prices above $55 a barrel to encourage redeployment of capital and even longer to source a sufficient amount of skilled labor to bring a significant amount of shale barrels back online. Conservatively modeling global inventories with a 33mb/d OPEC production shows a swing of 700kb/d, flipping the market into a substantial deficit starting in February 2017 (see Demand and Supply Outlook chart below). If OPEC follows through, the market will eliminate the entire inventory build of 2016 by the fourth quarter of next year.
With all focus on the OPEC deal/no deal, market participants seem distracted from changes in demand that seem to be materializing. Total oil and product stocks in the four major storage centers (USA, Europe, Japan and Singapore) have been rapidly drawing since OPEC, in mid-August, announced their intention to hold their extraordinary meeting in Algiers. In the last six weeks these centers have seen an astonishing 60 million barrels of crude and petroleum products, counter seasonally, drawn from inventory. This is the first period of sustained draws in almost two years, shrinking the year on year surplus from 12% in mid-August to only 5.42% today. A large amount of this demand is coming from China’s renewed increase in crude oil purchases after a two-month pause. By my calculations, China has stored 230 million barrels of crude this year, about 100 million barrels more than they stored all of last year. Last month a geospatial analytics company released satellite images showing that China has about 900 million barrels of petroleum tankage available, three to four times more than market analyst expectations. Furthermore, shipping activity in the dirty tanker market is at a 10 year high; traders have been scrambling to book cargoes heading east. Nigeria to China and Saudi Arabia to Singapore shipping routes are now trading $2.48 and $0.99 per barrel respectively (up 42% and 50% from July). Expectations of higher crude oil prices in 2017 due to OPEC intervention could have spurred China’s aggressive purchase of barrels, which is likely to continue for the rest of the year.
Four months ago the world was awash with gasoline. In the New York harbor, ships were being turned away whilst others converted to floating storage. There were reports of full product storage in Germany and lines of product tankers in Antwerp and Rotterdam; at the same time China exported excess gasoline into the U.S. Gulf Coast with the hopes of alleviating their swelling inventory. As such, it is astonishing to see the pace of inventory draws even more severe in the gasoline market. The year on year surplus has all but disappeared, falling from 10.15% in mid-July to just 0.65%. It is evident that demand has picked up, and is arguably higher than most market participants realized. Most of this additional demand seems to be coming from emerging markets as realized gasoline demand in developed markets have held steady. These developments lead me to believe that the 2016 global oil demand is likely to be north of 1.4mb/d year on year which is 200kb/d higher than market consensus.
In conclusion, there are two sides to a balance sheet. The combination of product demand and the implementation of OPEC production cuts could flip the curve from contango to backwardation and send oil prices towards $70 a barrel by the end of next year.