Supply-Side Crudenomics

With front-month WTI futures suffering their worst 2 days since 2016 into the start of the US long weekend Friday and a sudden proliferation of "lower for longer is dead" analyses, crude has justifiably loomed large in the eyes of professionals the world over, even with lots of light and some heat in Turkey (reforms to the CBRT's rate transmission mechanism), Italy (a technocratic PM choice from Mattarella that will most likely wind up with new elections), and Spain (Rajoy faces a no-confidence vote which may result in elections though that's TBD). As a side note, the Cackalack BTP view most recently published has been positively roasted by the market, though nothing that's happened since it was posted has fundamentally changed our perspective...that may shift if Lega election rhetoric shifts more aggressively anti-euro.

Your humble correspondent doesn't have very many consistent views on commodities, but one of them is that speculation rules in the asset class. With roughly $190bn worth of crude represented in the open interest for NYMEX WTI futures alone, it's frankly quite difficult to have any other perspective.

But fundamentals are surely worth a look anyways, right? Sure, why not, and as this outlet's excellent tagline always reminds us, TMM always offers a money back guarantee, so time spent reading is all you risk.

As shown below, Q4 of last year saw global crude markets in a 37 bps deficit as a percentage of global crude supply, the third successive quarter where demand outstripped supply for the commodity following a grim run of excess supply dating to mid-2014.

It's an awful pain to be working with numbers that aren't just backward looking but released at an interminable lag so in the second chart below we show the QoQ change in US inventories (aggregated from the almost-real-time weeklies released by the EIA). As shown, you can miss some big swings in global supply/demand of crude by going with the US weeklies but at the end of the day they've been reasonably accurate over the last several years. Q1 and Q2 to date are tracking enormous sequential declines of ~3%, suggesting similar supply-demand imbalances and higher prices yet to come.

The crude curve basically concurs. With the 1st and 7th month Brent futures contracts (for delivery in July and January, respectively) logging a ~$2 backwardation, the curve is consistent with supply-demand imbalance of at least 1-2% of production, albeit less reliably than our estimates based on US inventory tracking.

So for now, it looks like it's reasonable to assume demand continues to outstrip supply in crude markets. Will that continue forever? Of course not, but one point we did find interesting in the course of knocking these charts together is illustrated below. From 2000 to 2011, over 5 year periods the elasticity of crude to supply and demand was almost always above zero. That is, demand and supply both tended to rise in the face of higher prices and fall in the face of lower prices. That changed a bit in the 5 years ending 2012, when the opposite prevailed for a short period of time, but since 2014 both supply and demand changes relative to price have been negative. 

Now, calculating these elasticities is of course a tricky business and we'd be the first to say this is a very simplisitic approach. [By the way, if you have a better one, we'd love to hear about it in the comments!] But the fact remains something has definitely changed in the crude markets post-2011, and we're not so sure the "shale swing producer" thesis is the one reflected in the chart above. Theories are of course welcomed, but taken at face value the regime change suggested in the chart below leads us to believe that high prices won't necessarily curtail demand much, and that in turn suggests more (or exclusive) focus should be on the supply-side of the crude markets. If that's correct, it's going to be a very good summer for oil bulls, recent wobbles aside.