Inventory, Demand And The Enigma Of The Missing Barrels Of Oil

By Chris Ross, Executive Professor, C.T. Bauer College of Business

The Yom Kippur War, Ramadan War, or October War, also known as the 1973 Arab–Israeli War, was fought by a coalition of Arab states led by Egypt and Syria against Israel from October 6-25, 1973. The fighting mostly took place in the Sinai and the Golan Heights, territories that had been occupied by Israel since the Six Day War of 1967.

In retaliation against Israel’s perceived allies, Arab OPEC members cut production and embargoed the U.S., Netherlands and a few other countries, causing spot oil prices to rapidly increase; OPEC solidified the increase into its Saudi Arabian Light “marker” crude oil reference price.

The consequences of the price increase and embargo were compounded by ill-advised price controls installed by the Nixon administration and caused lengthy gas lines in the U.S. The global economy contracted. Oil consumption declined in 1974 after a decade of 7 percent growth per year, during which demand for light, lowsulfur crude oil had been particularly strong as utilities responded to the 1970 Clean Air Act by switching from high sulfur coal and No. 6 Fuel Oil to low sulfur fuel refined mainly from North African crude oils.

The sudden escalation of crude oil prices led to the nationalization of major oil companies’ oil production in most OPEC countries, and the new national oil companies had to face the reality that oil consumption was not inelastic. They could control production volume or price, but not both.

This lesson was relearned most severely in 1980 and again in 2009 (Figure 1).

Oil Price and Consumption

But back to the 1970s and the disruption of the Arab oil embargo. My colleagues and I had been consultants for several years for the Algerian national oil company Sonatrach, and for the first time we and our client were facing a weak crude oil market. The question was raised: how long will this trough last? We created a methodology to track and develop an outlook for future oil supply and demand on a quarterly basis, which helped our client understand how prices responded to the fundamentals of supply and demand.

The methodology migrated out to Petroleum Intelligence Weekly and on to the International Energy Agency(IEA), where it is the basis for its monthly Oil Market Report (OMR), which is closely studied by oil companies and traders. A critical element in the methodology has always been a reconciliation of observed imbalances between oil supply and demand, from which apparent inventory changes can be calculated, with observed actual changes in global inventories.

The problem has always been the integrity of the data: Most countries in the Organization for Economic Co-operation and Development – an international group promoting economic and social well-being – publish reliable data on oil production and consumption, but data outside the developed world are less reliable. Similarly, inventory data for the developed countries is well documented. Indeed, the IEA’s initial mandate was to propose minimum strategic oil storage levels to be adopted by members as a buffer against possible future oil supply interruptions. In addition, there are large quantities of oil stored temporally in transit on tankers, which the OMR estimates, and there are unpublished quantities in countries such as China stored as strategic oil reserves and elsewhere as a bet on future price increases.

So the data integrity is fragile, and analysts expend considerable energy tracking tanker movements and picking up clues and anecdotes that can illuminate the overall situation. Despite its best efforts, the OMR retains a line item called “Miscellaneous to Balance (MTB)” as an admission that the difference between supply and demand does not match observed changes in inventories. That line item exposes a serious gap in our understanding.

Moreover, it has been getting worse.

From the first quarter of 2009 through the fourth quarter of 2011, quarterly changes in the calculated MTB varied seasonally, and the cumulative change was slightly negative (Figure 2), suggesting that either demand was a little higher than assumed, that supply might have been a little lower, or that there had been a small withdrawal from inventories outside those reported. However, the differences were small, and the OMR presented a reasonable picture of the overall market situation.

That changed in the first quarter of 2012, and cumulative MTB increased to 700 million barrels by the beginning of 2016. This means either demand is higher than reported, production is lower than reported, or there is a massive overhang of oil in storage in addition to the observed 400 million barrels increase in reported OECD inventories.

If these missing barrels are, as in the U.S., in excess of the amounts required to support the oil supply chain, they could act as a serious drag on the market and slow the process of rebalancing of the market.

Missing Barrels since 1Q09

A lot depends on which is the correct interpretation of where these barrels are held. Let’s try this one:

  • OECD inventories held by industry in the first quarter of 2011, when inventories were thought to be “normal”, amounted to 2,562 million barrels, which represented 57.1 days of average yearly demand. Non-OECD oil demand grew from 43.1 million barrels per day in 2011 to an expected (by OMR) 49.7 million barrels per day in 2016. If industry holds similar inventories in non-OECD countries as in the developed world, this would require an increase in working inventory from 2,460 to 2,836 million barrels, an increase of 376 million barrels.
  • The U.S. holds approximately 700 million barrels in its Strategic Petroleum Reserve. China has reportedly been building and filling its own strategic oil reserve, which is aimed at being sufficient to cover 90 days of net imports. Chinese oil demand in 2016 is expected to be 13.1 million barrels per day; with production expected to be 4.1 million barrels per day that would require a reserve of 810 million barrels. It seems quite credible that China may have added at least 300 million barrels since the beginning of 2012.

This interpretation seems plausible: if correct, the missing barrels are safely tucked away in inventory required to meet growing demand in non-OECD countries and in the Chinese strategic petroleum reserve. History suggests that governments are very reluctant to deplete their strategic reserves except in moments of extreme supply insecurity. So there may in fact not be a substantial inventory overhang outside the OECD that could amplify the known overhang of about 400 million barrels within the OECD.

The Oil Market Report is projecting global demand growth of 1.4 million barrels per day in 2016 and 1.3 million barrels per day in 2017, along with declining non-OPEC supplies in 2016, then flat in 2017.

If they are right and OPEC producers maintain current production levels, excess inventories should start being depleted fairly soon. Then prices and rig activity should strengthen further. We shall see.

As a consultant, Professor and Energy Fellow Chris Ross works with senior oil and gas executives to develop and implement value creating strategies. His work has covered all stages in the oil and gas value chain.

UH Energy is the University of Houston’s hub for energy education, research and technology incubation, working to shape the energy future and forge new business approaches in the energy industry.

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