Oil Demand vs. Refiner Demand
Oil is in Hot Demand but Where are Refiners?
Author: Brynne Kelly 11/14/2021
There is no denying the bullish sentiment underlying energy prices these days. Production is front and center as the villain. But, is that really where the buck stops?? Is oil output really the issue here? As a whole, the US petroleum complex has adapted to significant changes in demand over the last 2 years.
As background, from 2014 to 2020, US domestic crude oil production increased by over 150% (#1 below) while at the same time, total US supply of crude oil (production plus net imports, #2 below) was largely unchanged.
This trajectory of US production growth displacing the need for imported supply came to an abrupt halt in 2020 with the onset of the Coronavirus pandemic.
A 2020 New York Times article highlights how quickly that landscape changed:
Oh how times have changed! A mere 18 months later and the headline call for oil couldn't be more different. Calls for the Biden administration to "do something" about high energy prices have reached a crescendo:
*SCHUMER URGES BIDEN ADMINISTRATION TO TAP PETROLEUM RESERVE TO LOWER GASOLINE PRICES
Yet, none of the actions from the White House have altered the trajectory of US crude supply in the 10 months since Biden took office. “If the Biden administration was waiting for the EIA to give them a good reason to tap the SPR this week, they did not get one,” said Ed Moya, analyst at online trading platform OANDA.
Today, we review a little history in order to give you something to ground yourself to as we head towards, what in all expectations, looks to be a frantic holiday season marked by supply chain issues.
Production, Inventory and Operations
We know that US crude oil production growth relieved the global supply/demand picture. The US became less of a price taker and more of a price maker on the global stage. It now had the flexibility to be a selective buyer and seller of crude oil on the global stage. Now the US could optimize its operations, moving crude oil to the highest bidder.
This rapid production increase from the US also led to a step-change higher in US petroleum inventories in 2015 as it prepared for an environment that would require higher operating inventories to function. As an exporter of crude oil, the US needed to increase inventory levels across the system to accommodate the logistical needs of being a global supplier.
Initially, this growth in production went straight to US inventory (red box below, combined US crude oil, gasoline and distillate inventory). This deposit into inventory continued well into 2017 before the US mastered the art of managing their new-found supply.
While much of the increase in US inventories could be attributed to new system operating requirements (new pipelines needed initial line fill, export terminals needed storage tanks for staging tank loading, etc.), it was also a burden on the system.
Bottom line, oil supply got ahead of refined product demand. Breaking down the increase in US petroleum inventories, we note that it is attributed solely to increased crude oil inventory (left chart, below).
During the same time period (2015) that US production was growing along with US crude oil inventories, demand for crude oil by US refiners was largely unchanged. This points out the obvious: US production growth was not a necessity of US refiner demand for oil. In fact, since 2020, US refiner demand for crude oil had plummeted.
The 'system' has evolved. The US now manages domestic supply via its import/export balance.
Inventory vs Operations
Calls on US inventory can now be managed by matching the call on crude oil from refiners with US production and net imports. Note below that the initial surge in US crude oil inventories in 2015 was not met with an increase in US refiner demand for oil (right chart below - weekly supply less refiner demand for crude oil).
Fast forward to current times - when refined product prices are soaring - and the only idea the US administration seems capable of white-boarding is that of releasing oil from it's Strategic Petroleum Reserves or placing a temporary ban on US exports. Both are absurd solutions. The most obvious reason being that as noted above, US refiners are not demanding more crude oil. This is also evident from another angle: US crude oil versus US crude oil input to refiners.
We are no where near the refiner demand seen from 2015 - 2020. It seems as if an immediate increase in US supply (either from the SPR or reducing exports) would simply end up in commercial US inventories. Sure, growing inventories are worrisome and could lead to a temporary decrease in oil prices. But, what about refined product prices? Is it rational to imply that creating excess oil supply leads to higher refined product supply? Are refiners simply not processing more oil into products because the price of the raw material (crude oil) is too high?
It's no secret that energy prices have staged a rebound this year that almost puts the pandemic dip in prices to shame. In 2020, the selloff in the energy space was most notably played out in the front of the market. No need to revisit the newsworthy, yet short-lived dip to negative prices. What's more important is the recovery in prices across the curve. The dip in front month prices certainly were enough to drag down the back of the curve initially and send producer valuations into a tail spin. It's always notable when front-month fundamentals reverberate across the term structure of oil. We saw this last year - the weakness in spot-market fundamentals were enough to pull the term structure towards, or below, the $40 level. Equally so, the epic rally since then has lifted the entire curve (red line vs gold line below).
In fact, it's arguable that the strength in the 'back' of the market has been the catalyst supporting front-month futures.
The crux of this rally for the consumer has been that refined product prices have followed suit, closing near yearly highs last Friday along with WTI. Meaning that refined product futures are following oil futures.
Yet, with the data provided earlier about refiner demand for oil, one wonders what it would take to pop this bubble. They all go hand in hand and signs of weakness are hard to come by.
Winter Distillate Inventory Patterns
It goes without saying that the common narrative in the energy patch for the upcoming winter is one of fear. The fear that production growth has been hindered, indefinitely, by the pandemic. But, we have also shown that the 'system', for now, has enough operating capacity to meet present day-to-day demand.
This brings us to winter heating oil inventories. Technically, storage of oil and oil products help to smooth out supply and demand discrepancies. But, we are now in a situation where production is lagging and inventories are low. The market is pricing in the incremental unit of production as a result. It makes sense that this incremental unit of production is costly. It also makes sense that the world is concerned about governments dropping excess supply on the market in the form of releasing reserves, reducing demand or forcing supply to stay local.
This is evident in distillate markets. The winter holiday season brings in competition for distillate (aka heating oil, distillate, diesel) markets. A double whammy is longhaul trucking demand to deliver holiday supplies and winter heating demand, where appropriate. This heating demand in the US comes from the US east coast where many homes and businesses still use conventional heating oil as their primary source of heating. The US east coast inventory is defined in US EIA inventory reports as PADD 1 inventory. This inventory is something that traditionally hits it's peak just ahead of the winter season (purple line below). Which is why we usually see PADD 1 inventories greater than US Gulf Coast inventories (PADD 3) at the start of the winter heating season (green circles below).
This is where things get dicey. Can we effectively operate the energy system this winter with, what appears like, lower than normal inventory levels in the face of lower than normal production?
Strategic Petroleum Reserves
The Strategic Petroleum Reserve (SPR), administered by the Department of Energy (DOE), has been a part of U.S. oil security policy for over 40 years. Originally intended as a reserve to replace oil that might be withdrawn from the world market to forward political purposes and objectives, its rationale has evolved with the changing world oil market and the role of the United States in the market. In addition to replacing oil lost to political turmoil, as in Libya in 2011, in recent years it has been more commonly used to replace oil supplies curtailed due to natural disasters, mainly hurricanes. The effects of hurricanes, especially those of the magnitude of Katrina, Rita, and others, has threatened to disrupt oil production, refining, and distribution, creating potential economic dislocation. Use of oil from the SPR has helped to minimize the economic effect of those events.
The most recent emergency release of SPR oil was in 2011 due to the Libyan export curtailment. At that time, the United States and other members of the IEA decided to release 60 million barrels of oil onto the world market. The U.S. obligation was set at 30 million barrels. In June 2011, competitive offers were solicited for the purchase of selling oil to be delivered by the end of August 2011.
Beginning in 2015, the debate over whether the SPR storage balance was too large given the evolving nature of U.S. oil production, consumption, and net imports resulted in Congress mandating the sale of SPR oil. The sales revenue accrued through SPR sales was allocated to a variety of uses; however, energy policy, or security, was not among them. The legislation that mandated SPR oil sales includes the Bipartisan Budget Act of 2015 (P.L. 114- 74), the FAST Act of 2015 (P.L. 114-94), the 21st Century Cures Act of 2016 (114-255), the 2017 Tax Revision (P.L. 115-97), the Bipartisan Budget Act of 2018 (P.L. 115-123), the Consolidated Appropriations Act of 2018 (P.L. 115-141) and the America’s Water infrastructure Act of 2018 (P.L. 115-270). Broadly considered, this legislation requires oil to be sold from the reserve over the period FY2017 through FY2027.
The 2021 mandated SPR sales noted in the table above, require the sale of 10 million barrels. So far in 2021 the US has seen a drawdown of 28.60 million barrels from the US SPR.
The most recent draws have been against Fiscal Year 2022 mandates. How much more can we pull forward?
Globally, oil output is increasing. Clearly not at the same pace as demand. US SPR reserves as a savior are highly overrated. The overall 'system' is showing signs of anemic supply on all fronts. Although suggestions of additional supply are looming, that supply would be in the form of raw material (aka, crude oil). Are the raw materials enough, or is the market really clamoring for more ready-to-use goods like gasoline and distillate?
With each passing day, the Inflation Bomb is ticking.
Of Note Over the Weekend:
A fire that broke out at a storage tank at Indonesian state-owned Pertamina's 348,000 b/d Cilacap plant in central Java on 13 November left no lasting impact on operations, the company said today after the fire was extinguished.
Countries came to an agreement at the 26th Conference of the Parties (COP26) in Glasgow, Scotland on Saturday. The final text included language to reduce the use of fossil fuels, phase out subsidies for fossil fuels and transitioning countries to using more renewable energy sources like solar and wind, Reuters reports. The Glasgow Climate Pact is the first agreement in COP history to include the term "fossil fuels," Axios reports. However, the pact does not hold wealthy countries to specific financial commitments to help poorer countries, which have been and are the most devastated by climate change.
EIA Inventory Recap
The EIA reported a total petroleum inventory DRAW of 6.30 for the week ending November 5, 2021 (vs a net BUILD of 2.30 last week).
Year-to-date cumulative changes in inventory for 2021 are DOWN by 141.30 million barrels (vs down 135.0 million last week).
Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years are have gone from way above historical levels to surprisingly below historical levels and should continue to draw as long as backwardation in the market persists.