Somewhere, over the rainbow

Presenting BP’s Statistical Review of 2016 today, chief executive Bob Dudley said: “The oil market returned broadly back into balance by mid-year, but prices continued to be depressed by the large overhang of built-up inventories.”

Dudley’s definition of balance here is a straightforward matching of production and demand. Opec and its partners in output cuts prefer to factor in the inventories that are weighing on prices. And weighing they are. Brent has failed to break above the mid-$50s/bl, despite a disciplined cuts programme that has been in place since the start of this year, and has found itself most comfortable at well below $50/bl — below year-earlier levels — since last month’s agreement to extend the cuts.

Saudi oil minister and current Opec president Khalid al-Falih insists that everything is on track, that prices will recover as fundamentals exert themselves. “The result of this agreement will materialise over weeks and months,” al-Falih said in the Kazakh capital Astana. His companion on the trip was Alexander Novak, oil minister of Russia, by far the biggest non-Opec participant in the output agreement. He zeroed in on the stocks issue: “It is a question of returning to normal stock [levels],” Novak said, namely bringing them in line with the five-year average.  This will happen in the first quarter of 2018, he said.

In the wake of the extension deal, al-Falih too had focused not just on the need to get OECD commercial stocks reduced if prices are to rise, but on that specific aim of getting back to the five-year average. He said: “All the simulations… have demonstrated that we will be within the five-year average from the first quarter of next year.” He added: “We have seen a substantial drawdown of inventories … In the second quarter it is going to be accelerated… the fourth quarter will get us to where we want, and [for] the first quarter of next year we just want to maintain the levels and avoid a seasonal build next year by lifting the cap.”

Today’s Opec Monthly Oil Market Report returned to the theme of the five-year average, saying: “The decline seen in the overhang in OECD commercial oil inventories in the first four months of the year – from 339mn bl to 251mn bl compared to the five-year average – is expected to continue in the second half, supported by production adjustments by Opec and participating non-Opec producers.”

Let’s leave aside the obvious fact that the five-year average is a moving target. There’s a fundamental question being begged here — who cares what the five-year average is, apart from those producers battling to restore it?

Why not a four-year average, or a six -year average? After all, commercial stocks are held in part opportunistically — buy cheap — and in part on an assessment of requirements. But that assessment of requirements, surely, is a variable determined by expected demand and expected supply. In OECD Europe, the prognosis is for falling demand, a factor that is likely to erode perceived inventory needs over time. Stocks in OECD Americas have fallen somewhat this year, but in terms of days of forward cover they remain higher than for OECD Europe or OECD Asia-Pacific. And with US tight oil’s increasingly evident ability to swing in and out of production at current prices with great rapidity, the question arises as to whether it can substitute for some part of the inventory cover.

It is obvious when the market is out of kilter, but finding a definition of balance may be a hunt for fool’s gold. If prices do not begin to pick up in the next quarter, it may be an omen that Opec and friends will be disappointed when they get to the end of the rainbow.

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