Revisiting Oil Prices As “Surprise” Inventory Build Sends Crude Tumbling

We’ve talked quite a bit in these pages about what drives oil prices.

Our argument, generally speaking, is part common sense and part geopolitics. On the common sense side of things, there’s a supply glut. Plain and simple.

You can of course parse the API and EIA data which sometimes agrees and sometimes doesn’t, but the bottom line is there’s too much oil. Incidentally, yesterday’s API report did actually look something like today’s EIA data with both reports showing a build in crude inventories. That was apparently enough to offset the drawdown in gasoline stocks which, in a vacuum, would be bullish. Crude was of course off pretty sharply today:

Have a look at this from Goldman which shows inventory days of demand versus the five-year average:

(Chart: Goldman)

See there? Simple: supply versus demand.

But as we’ve argued on too many occasions to count, it’s critical that you understand why this is happening, because there’s this tendency to parrot the whole Saudi Arabia wanted to get rid of US shale production meme ad nauseam.

Was rising US production a factor in the Saudi’s move to pull the rug out from under prices in late 2014? Well, yes. But there’s more to it than that. At the time, the Sunni world was getting desperate to convince the Kremlin to abandon its support for the Bashar al-Assad regime in Syria and Riyadh figured one way to put the squeeze on would be to push the Russian economy even further into the doldrums by killing crude prices.

That plan obviously didn’t work. In fact, it backfired completely. Russia just ramped up its own production and then invaded Syria - literally.

But the even larger geopolitical undercurrent is of course the rivalry between the Saudis and the Iranians who are fighting on opposite sides in the region’s two proxy wars (Yemen and Syria). The sectarian tension boiled over in January when the Saudis executed a prominent Shiite cleric and political dissident. Since then, the two bitter rivals are simply pumping as much oil as they possibly can. Iran’s goal: restore its presanction market position. The Saudi goal: pump so much oil that prices stay low so Iran’s windfall profits are limited.

Here’s what Bloomberg had to say earlier today:

“Saudi Arabia and Iran are giving no ground in their market share war, just days after OPEC announced an informal meeting to discuss ways to stabilize falling prices.”

“The actions of some of the group’s biggest producers, however, were distinctly bearish. Saudi Arabia, the world’s largest crude exporter, boosted oil output to a record 10.67 million barrels a day in July, according to OPEC data published Wednesday. In Iran, production has risen to 3.85 million barrels a day -- the highest since 2008 -- according to comments from Oil Minister Bijan Namdar Zanganeh reported by the Fars news agency.”

“‘It only gives one signal to the markets, that the Saudis are not here to scale back, especially in the face of Iranians bringing more oil to the market,’ Abhishek Deshpande, an analyst at Natixis SA in London, said in a Bloomberg television interview.”

(Chart: Bloomberg)

And here’s a bit of color from Goldman on Saudi and Russian production:

“As shown in Exhibit 26, we forecast Saudi production growing from 10.3 mn bpd in 2016 to 11.3 mn bpd in 2020. We estimate Saudi Arabia’s productive capacity is approximately 12 mn bpd before incorporating the Neutral Zone. The recent decision by Saudi Arabia to reduce official selling prices into Asia may be further evidence that the country is looking to maintain market share against international competitors such as Iran. Similarly, in Russia, while the IEA is calling from flat-to-declining production, our analysts believe Russian oil production can increase from 11.2 mn bpd in 2016 to 11.9 mn bpd by the end of the decade, driven by favorable currency, brownfield projects and pipeline infrastructure debottlenecking.”

(Table: Goldman)

This is why we think the debate around where oil prices are headed is to a certain extent silly. There’s nothing bullish about any of this. And remember, if the Fed hikes, the outlook for prices darkens materially on a rising dollar.

So once again, common sense and a holistic approach that incorporates geopolitical realities is really all you need to make sense of markets. Crude is the quintessential example.

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