Oil is Going Down Again

After a rough first quarter for oil in 2016, spot price trading has shown reduced volatility compared to the past year and a half. Supply movements have been relatively unsurprising in North America and other oil exporting nations. After the failure of the output freeze, OPEC's role changed from market leader to a market reactor waiting on true supply data to affect commodity traders. For the WTI spot price, a range of $40 to $50 developed with hopes of an upward breakthrough during the bullish summer months. June and July have passed and a different trend has set in. In its July meeting, the Federal Reserve was faced, once again, with tanking crude oil spot prices weighing on inflation. Now, August has come and oil is looking to break through a floor of $40. The EIA has revised their WTI projections from $48 a barrel by the end of 2016 to $44 a barrel. So why has this summer been so tame?

Based on data from the past five years, crude oil prices tend to peak in the first two months of the summer with refineries operating at full capacity. In 2015 and 2016, we're seeing deviations from this trend. Last year, volatile pricing was caused by a trend of climbing domestic production which overcame refinery inputs. This year, domestic production is stabilizing if not falling, so increased refinery utilization should help demand and reduce supply, but the WTI spot price hasn't responded accordingly. The average difference between the price of the first and eighth week during the summer over the past five years was +$0.53, in 2016 it was -$4.56. This deviation has troubled analysts who expected more bullish sentiment to be coupled with shrinking output.

Falling input prices have translated to even lower regular and diesel gasoline prices during the
summer months. The 2016 trend deviates from the usual pattern of high gas prices due to more demand from the summer driving season. In fact, the 1st to 8th-week difference in 2016 is larger than the past five years. Why is that? There are two sides of the coin to consider, the supply and demand side of the pump. On the demand side, 2016 transportation consumption remains strong and is already outperforming the previous two years according to the EIA's Monthly Energy Review. Compared to the first four months of 2015, petroleum consumption this year is up over 200 billion Btu. Therefore, supply-side factors can be assumed to have made the biggest impact.

Record high crude oil stocks have been the most bearish factor weighing on the price of oil. Initially, firms hoped that inventories would start to recede with less domestic output in the beginning of the year, but that wasn't the case. As soon as analysts started to see a reversal in upward crude oil stockpile trends, domestic production stopped falling. Going into the summer months, oil companies were faced with a rebound in spot prices, but inventories that have never been seen before. Typically, investors can expect a strong draw on stockpiles over the summer months with refinery inputs at their highest, but this year may be different (as it was last year). In fact, supply estimates for the last week of July reported an increase in crude oil stockpiles, weighing on the bulls.

The truth is, downstream trends could be having a larger effect on supply issues than producers. In 2015, we saw crude inputs rise well above 2014 levels as crude stocks grew with the oil glut, but that phenomenon did not carry over to this year. Crude oil estimates for this year have been in line with last year's even though stockpile estimates were much higher. What does this mean? For the first time in years, the U.S. upstream sector is outrunning its downstream sector which, previously, required imports to satisfy the refinery input demand. This summer, fully utilized refining operations are over-supplied and this is causing prices to fall on the producers' side. A bearish summer will force price expectations for the winter even lower as the maintenance season reduces weekly crude oil inputs.

The flood on the input side of the refinery is causing drivers to be flooded with cheap gas. Weekly motor gas production estimates have reached five-year highs. U.S. firms have maxed out downstream operations because it has become significantly cheaper to operate with growing from the transportation sector. As a result, gas prices dropped the faster this summer than the all of the past five summers. After growing to about $2.30 per gallon, prices at the pump plummeted back towards $2.00 a gallon with the EIA only projecting a rebound to $2.16 by the end of the year. The Short Term Energy Outlook forecasted summer prices to average $2.25 a gallon. The maintenance season should help stabilize prices around $2.15, but high finished motor gasoline production will persist to the end of the year.

After a seasonality analysis of the first two months of the 2016 summer, here's what we can expect:

  • By the end of the summer, a smaller draw on inventories or possibly a surplus if production increases.
  • Crude oil inputs to remain in line with last year's summer peaks
  • Motor gasoline production to peak higher than last year or follow in line with transportation consumption to show modest growth
For energy traders following WTI and regular gas prices, these three points will prove to be bearish factors in August and the fall. Rotary rig counts for June show that U.S. producers are beginning to increase their drilling activities after adding 10 active rigs in that month. If you think that the supply picture is continuing to improve, that is not the case. In fact, firms who have cut unconventional costs will find it profitable to produce at prices as low as $40 a barrel. When the industry finds this is possible, the glut will reemerge and weigh on prices more permenantly.


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