We find ourselves under increasingly constructive circumstances within the oil cycle underpinned by: crude tightness, refined product tightness, escalated geopolitical tensions and rising inflation. Below we will deconstruct the inventory, supply, and demand equation to illustrate why we remain bullish on oil (CL1:COM). Over the past year, several underlying catalysts have acted as a one-way ratchet increasingly tightening the oil market. The past year has been spent de-risking the supply side by lowering product inventory, drawing down OPEC spare capacity and calling on US shale. All signals of supply scarcity. The only means to rectify a commodity market as tight as this one is by demand destruction or gross supply expansion, neither of which are credible scenarios in the near future as explained below.
The US Energy Information Administration provides a weekly update on domestic inventories. An inventory build indicates that more oil is being supplied than can be transported away for refining; conversely, a drawdown means that the market absorption of refined products is outpacing crude supply. Inventory levels act as absorbers to supply and demand shocks. The lower inventory levels, the more visceral demand shocks (and correspondingly price volatility) are going to be. Inventory levels across a range of products are trending at or below their 4-year lows, as illustrated below, indicating that product demand is outpacing incoming supply.
The markets quickly dismissed Biden’s announcement of a release from the Strategic Petroleum Reserve (SPR) of 1 mb/d over the course of six months. Spot prices dropped $4.25/bbl, but 12 month strip pricing remained predominantly unchanged. Although the SPR release will cause some mild near-term downward pressure, the current absorption rates are simply too strong.
Over the past several months there has been a cumulative release or announcement of release totaling 260 million barrels (50mb in Nov 2021, 30mb in Mar 1, 2022, 180mb in Mar 31, 2022) from the SPR. Although this will cause some short term downward pressure, this is simply an immaterial supply shock and we believe markets have correctly responded to the release announcement by continuing to sustain high pricing ($100+/bbl WTI). Furthermore, EIA members are required to hold 90 days of net imports to cover strategic reserves. The US imports ~6.5mb/d and exports ~3mb/d yielding a difference of ~3.5mb/d. This implies a theoretical SPR minimum storage of 315mb. As illustrated below, SPR levels are aggressively below their 4-year lows and steadily trending toward their theoretical minimum levels. These reserves have historically been used during times of environmental disaster (such as Hurricane Katrina in 2005) or times of geopolitical tensions. Meaning that using SPR releases as a market stabilizer is a predominantly unproven strategy.
Although the headlines of the SPR release are heard around the globe, the underlying effects are largely regional. Four SPR facilities are in Louisiana and Texas. The current refinery run rates are ~9.5 mb/d in PADD3 with a maximum operable limit of ~10.2 mb/d (based on the maximum monthly utilization). Refiners in the area can absorb up to a maximum of roughly ~700 kb/d, while the remaining 300 kb/d will likely go into commercial storage or be staged for export. The problem is the lack of capacity to move released crude supply to the US northeast. Below is an illustrative summary of current refining capacity, utilization by PADD and the corresponding SPR facilities.
- Low inventories across product classes support a bullish price outlook as demand is healthily outpacing incoming supply.
- Once the SPR release has been implemented the government will have no more levers to pull to appease supply shortfalls, and the bulls can sleep peacefully buying into this market knowing that there are no more SPR releases.
- The US may start buying back barrels to refill reserves (at current elevated prices) of course.
Jet fuel demand continues to remain impaired compared to pre-COVID levels with January demand at 1.45 mb/d, or 10% below pre-COVID levels. Inventories are low, namely due to reduced jet fuel refinery throughput and lower yields. Pre-COVID, for every 100 bbl of crude into a refinery, roughly 10.5 bbl were processed into jet fuel, that number is now closer to 8.7 bbl. This is because refiners have shifted towards economically favorable products, namely gasoline.
As COVID approaches the endemic stage and air travel picks up over the coming months, aviation storage may fall extremely low spiking jet fuel margins, and subsequently signaling refiners to shift yields to jet fuel. This trend has already begun, as illustrated by the plot below indicating the shift towards jet fuel and away from gasoline. Furthermore, refiners can only directionally shift yields so far, especially given increased gasoline demand leading into the spring and summer months.
Let’s consider some factors to get a sense of implied travel demand. Namely: The Transportation Security Association checkpoint throughput, the Official Aviation Guide seat capacity tracker and the Bureau of Transportation Statistics consumer report.
The TSA checkpoint counts the number of travelers going through the United States (including both inbound and transfer flights) this serves a good proxy for implied flight demand in North America. The OAG monitors the historical seat capacity for global, domestic and international flights. It also provides a summary of the confirmed booked seats for the next three months. Finally, the BTS consumer reports summarizes the number of US operated flights (calculated as Scheduled flights less Cancelled flights). The figures illustrate a clear trend of growing demand, supporting a bullish outlook for kerosene and jet fuel demand.
Similar to the example for implied jet fuel demand, we can use several proxies to understand developing trends and baseline implied future demand for gasoline. For starters, let’s consider the average miles driven by region (Rural and Urban) in the United States, provided by the Federal Highway Administration. The plots below indicate the 2022 mileage is already trending at the upper end of the four-year range, a bullish indicator for motor vehicle (gasoline) demand on both rural and urban roads.
Secondly, consider the quarterly public transport ridership (going back thirty years) and test how it compares to current ridership during extremely elevated gasoline prices in the United States. A litmus test to understand if the average American is changing their consumer habits (due to rising gasoline prices) is to check if there has been a material increase in public transit ridership. As illustrated by the figure below, public transit ridership provided by the American Public Transportation Association has remained just below half of its pre-COVID (2019) average, with only a marginal increase from the COVID 2020 low. Public sentiment towards transit use has not changed since the onset of the pandemic, meaning that increasing gasoline prices have not been enough to dissuade consumers away from personal vehicle use and towards public transportation.
Lastly, lets analyze the relative percentage of restaurant seated guests from the 2019 pre-COVID baseline for 2020, 2021, and 2022. This can serve as a proxy for growing consumer demand (i.e. all product demand not just gasoline or kerosene) as we move past the pandemic and individuals continue to dine out more frequently. The data is provided by OpenTable and it clearly indicates that the average global restaurant demand is above 2019 pre-COVID levels for the same day during the year. Moreover, the United States has returned to pre-pandemic levels. These are all strong indicators of increasing consumer demand, and support the case for a constructive oil cycle.
- TSA throughput and flight seat bookings are trending upwards at an accelerated pace, indicating a strengthening kerosene demand both domestically and globally.
- Miles driven have returned to pre-pandemic levels, and consumers have resisted the shift towards public transit use albeit increased gasoline pricing. This is indicative of strengthening gasoline demand both in rural and urban centers.
Finally, let’s consider the last input to the oil and gas macroeconomic equation: supply. Production from the predominant US regions has largely returned to pre-pandemic levels as illustrated by the figure below. Note the orange tint for oil-weighted regions and the green tint for gas-weighted regions.
Furthermore, rig count by regions can be seen to be accelerating but at a relatively more modest pace than the other comparative “boom” cycles of the 2010 and 2016 eras. This is largely due to a change in priorities from the major public producers, where capital discipline and shareholder returns underpin management’s current priorities.
Lastly, consider the drilled but uncompleted (DUC) well count, which can be seen to be decreasing precipitously as per the figure below. This is an important trend to monitor as it illustrates how rigs are being utilized. Although there is an increase (albeit moderately paced) in rig count activity in the United States, these rigs are being used to complete already drilled wells. Meaning that new wells and discoveries are rare and far between as there has been a systemic shift away from new drilling activity and towards completion of already drilled wells. This serves to preserve capital as management focuses on shareholder returns instead.
- Albeit US production has largely returned to pre-pandemic levels, crude and product pricing continues to soar and inventories continue to lower as demand continues to outpace supply growth.
- Rig counts are increasing, but relatively modestly compared to other price boom cycles, furthermore rigs are being deployed to complete existing drills rather than to drill new locations and bring new production online.
The case for demand destruction
Let’s play devil’s advocate and discuss the case for demand destruction. Nationwide, retail gasoline prices have only surpassed $4/gal twice. The first time in the summer of 2008, the second time was last month. First, consider that the financial health of the average American leading into these higher prices is materially different than it was in 2008. Household savings rate for the 12-month period leading into March is averaging near 11% this year (the highest on record). Comparatively, in 2008 household saving was at 3.4% or a seven-decade low. The main point being: the average American is more financially able to absorb $4/gal price shock than they were in 2008.
The impact of sticker shock prices is overplayed, and US gasoline demand has nearly always proved to be less elastic to price than the headlines suggest. True prices have been volatile, but such surges rarely result in a protracted period of lower demand. This is because gasoline use is incredibly sticky. Transportation and highway use are the arteries of a developed economy such as the United States, and it will take some serious pain at the gas pump before habits are changed.
What would that “pain” price be? Adjusted for inflation the top price of $4.09/gal in June 2008 equates to $5.37/gal in today’s dollar terms. Furthermore, if we draw the parallel from gasoline prices to WTI pricing, then a $4/gal price equates to roughly $115/bbl WTI while a $5/gal equates to $150/bbl WTI. Implying there is still meaningful price upside if we stipulate that demand destruction occurs at $4/gal equivalent (or over $5/gal in today’s dollar terms). For this reason, we continue to maintain a bullish price outlook for oil as a constructive market cycle continues to develop.
All inputs to the crude oil commodity equation (inventories, supply and demand) point toward an increasingly tighter market and bullish price outlook. Inventories are below their pre-COVID lows, supply has been slow to react, governmental action via SPR releases will have negligible effects, and demand for products continues to remain strong. As a result of these circumstances we believe crude pricing will continue to increase.