It was a good day for oil bulls with the commodity finally catching some upside after a few months of weakened prices. As seen in the following chart of this week’s trading action, most of the gains seen in crude occurred on Friday and appear to have been in conjunction with an overall rally in the equity markets.
It is my belief that crude oil is going to trade higher over the next few months…a lot higher. As you will see in the following analysis, I believe that there is a strong possibility that crude oil will rally by over 50% in the next year.
When discussing crude oil, I always like to start with a five-year range chart of crude oil inventories. The reason why I start here is that this chart captures the summary of the balance between supply and demand and at a single glance tells us the trajectory of market inventories (which directly impact price).
As you can see in the above chart, 2019 has been a year marked by inventories continuing to weaken against the levels seen in 2018. This weakness has been evidenced throughout the entire year with last week’s EIA inventory figures bringing the difference to within a few million barrels.
As we will discuss later, there is a statistically strong correlation between this difference narrowing and increases in crude price – in other words, the ongoing tightness seen in crude inventories is almost certainly going to fuel further upside as long as this trend continues.
In the following sections, I will step through the four main components which constitute supply and demand. It is my belief that the market is currently making an error in its assessment of both supply and demand variables in crude oil and that in the coming weeks, the balance is going to strongly shift into bullishness.
Let’s start our discussion with demand. In my recent headline browsing, demand seems to be getting the most attention due to the general concerns of an economic slowdown.
The first and largest piece of demand is refining utilization and this has undoubtedly been a weak spot in the balance in 2019.
As you can see in the above chart, refining utilization has largely been below the five-year average for most of the year. The financial media has correctly honed in on the fact that demand has been unusually poor this year due to a general slowdown in the economy as well as potential retooling to prepare for the upcoming marine fuel specification change in 2020. However, as witnessed by the surge in refining demand over the last two weeks, I believe we are poised for a bullish uptick in demand.
To understand why demand is going to uptick, we really don’t have to look any further than product stocks. While refining demand has been low in October due to a heavy turnaround season, the economy has continued to operate, which means that demand for petroleum products has remained. This underlying demand has led to a collapse in the inventories of gasoline and distillate as seen in the following charts.
This collapse in inventories has caused the gasoline and distillate cracks to rally across the major market regions in North America.
The cracks are calculated as the difference between the price of gasoline or distillate and crude oil and provide a rough benchmark as to the profitability of refining. When the cracks increase, refineries are economically incentivized to run more crude to sell more barrels of products.
At present, the cracks are giving a strong signal for refining demand to increase and I believe the recent uptick in demand we have seen over the last two weeks is almost certainly going to continue to accelerate to capture these excellent margins. Given this economic incentive coupled with refineries increasing runs, I believe that refining demand has now become a bullish factor in the balance.
The other item which constitutes demand is crude exports and crude exports are strong.
It is extremely difficult to look at a chart like this and argue that exports are anything but bullish for the crude balance. Exports have continued to grow and shatter new highs in most of the quarters over the last few years since legalization in early 2016. Given the fact that the U.S. has demonstrated both a willingness and ability to expand export capacity, I believe that crude exports will continue to grow which will be bullish the balance because more barrels will be taken from the United States for other waters.
In a nutshell, demand is currently being incorrectly reported by the media in my opinion. A simple Google search will show that “demand fears” are weighing on crude prices, but as we’ve just discussed, I believe this is incorrect when the actual data is examined. Refining runs have been weak, but are poised to surge and crude exports have continued to grow. I believe that once prices see more upside, the reporters will catch on, but this decoupling between reporting and developing reality represents an opportunity for investors and traders to exploit.
On the supply side of the balance, the picture is quite bullish as well. The most popular bearish argument on the supply side of the equation currently revolves around production and typically involves a chart like this.
Yes, crude production is growing – but that’s not the full story. If you look at the growth rate in production, we’ve actually been seeing a slowdown for nearly a year.
If you look closely at the chart above, what you’ll see is that we are actually in one of the largest prolonged contractions in production growth rate in at least 20 years. The last time we saw growth rate decay at this clip, crude markets were in freefall and bottomed within a handful of months.
When examining production growth, it’s important to keep in mind that to keep crude markets balanced in a typical year, you need production to be growing because population and overall economic activity increase which directly impacts demand. This tangibly means that any slowdown in production growth is actually bullish the balance of inventories because less supply will be available for demand.
The current trajectory of declining production is almost certainly going to continue due to bankruptcies in the Permian taking out a number of producers. Given this current trend, supply is rapidly becoming very bullish at this time and likely to remain so for over a year as producers reorganize and consolidate.
The final piece of the balance on the supply side is imports. And imports are strongly bullish.
To understand why imports have come in below the five-year range in most of 2019, we have to rewind to the market action of late 2018.
In the face of falling prices, OPEC met in late 2018 and decided to cut production in January. This decision led to an immediate rally in the price of crude oil and was the primary driver of the price rally for the next five months. In the middle of 2019, OPEC decided to extend these cuts through March of 2020. This course of OPEC cuts has resulted in the least amount of barrels imported into the United States on a year-to-date basis in decades.
As long as this trend continues, imports are a very bullish component of the balance. And this bullishness is slated to continue through March of 2020. Given the large amount of barrels removed from the market (1 to 2 million barrels per day to the United States alone this year), the balance is quite vulnerable to upside price shocks at this point.
Supply is a bullish component of the balance and will be so for some time. Production growth is slowing and a number of bankruptcies suggest that it will likely take some time for growth to recover. Imports are very weak and will remain so through at least March of 2020.
Putting it all together
At present, I believe the market is seriously underestimating the possibility of an upside price shock in crude oil. The market believes that demand is weak, but refining margins and collapsing product inventories means that demand is poised to soar in the immediate future. The ongoing growth in exports has demonstrated no max capacity at this point, which means that we are almost certainly going to continue exporting. When these variables are combined with the fact that crude oil production growth is slowing and OPEC has removed around 500 million barrels from the United States, we’ve got a recipe for a strong rally in the price of crude oil as inventories fall.
To understand just how vulnerable the market is, take a look at the year-over-year change in crude inventories.
As you can tell, fundamentals are trending towards bullishness with the 52-week change in stocks falling by over 10% in the last five months. The reason why this matters is that there is a direct correlation between the year-over-year change in inventories and the price of crude oil.
As you can see in the above chart, when crude stocks fall, the price of crude rises in proportion to the decline in inventories. This dataset encompasses the last 25 years of market data and has proven resilient through the days of “peak oil” fears all the way through the shale boom.
Based on the current trajectory in the supply and demand balance, over the next year, we will see crude inventories fall by over 20%. Historically speaking, the average price change seen in crude oil for a drop of this magnitude is 51%. In other words, on average, when crude inventories decline by 20% on a year-over-year basis, the price of crude rallies in tandem by 51%. And the current trend in place will see us there in one year.
This simple analysis makes one key assumption: the trend continues. As we just discussed, I firmly believe that the trend in falling stocks is actually going to accelerate. By way of recap, here’s why I believe that we will see crude inventories decline strongly in the coming months.
- Production – Becoming bullish as growth rate slows
- Imports – Strongly bullish due to ongoing OPEC cuts
- Refining runs – Immediately shifting to bullish due to strong margins
- Exports – Remains bullish due to continued growth rate
In light of the above fundamentals, I strongly believe that not only has crude bottomed, but that we could also see a rally of 50% or more over the next year. It is definitely time to buy crude oil.