Inventory Revisited

As crude oil prices fell, so did investment, rig counts, and production. Now production and consumption are approaching equilibrium, but prices remain stubbornly low.  This is because the perception is that the oil glut will persist as inventories remain high.  In the developed world, above ground crude oil and product storage remains about 400 million barrels above historical levels.  Admittedly, this is a great deal of inventory.  In fact, if these were drawn down at the rate of 1.1 million barrels per day (bpd), it would take a year to work off the surplus.  However, a recent article by ARC Financial points out that  true storage consists of two components:  the above ground supplies that are traditionally cited in the industry press, and “spare capacity”.

Spare capacity is the oil supply that is below ground and can be quickly tapped via wells that are either shut in or choked back from their maximum potential production rates. Almost all the world’s spare capacity is in Saudi Arabia, and for decades the Desert Kingdom acted as the swing producer to offset short-term supply shortfalls.  Recent examples are the Libyan Civil War in 2011, and the reduction in Iranian production due to international sanctions in 2012.

Above ground storage and spare capacity need to be considered together to have an accurate estimate of total inventory. If above ground inventory falls, but there is still abundant spare capacity, then there will not be a shortage.  The reverse is true as well.

The article uses the example of early pioneers and modern urbanites. The pioneer stored enough food to get through the entire winter.  Currently, city dwellers keep relatively small amounts of food on hand as they can always go to the local grocery store when necessary.

As Saudi Arabia flooded the market with oil in an effort to preserve market share, their production reached an all-time high. In so doing they reduced their spare capacity by a million bpd.  The rest of OPEC cannot be relied on to take up the slack.  Nigeria, Libya and Iraq are plagued with warfare and terrorism, and others, such as Venezuela, are economic basket cases.

The International Energy Agency (IEA) has optimistically estimated OPEC’s spare capacity at 1.9 million bpd. While that might sound like a great deal of oil, it is 1.4 million bpd lower than a few years ago.  “This lost spare capacity is greater than the surplus oil in storage, if it were to be liquidated over one year.”

OPEC’s spare capacity will drop even more in 2017 as the cartel produces even more oil to offset declines in other countries and satisfy increasing demand.

ARC concludes that the market is currently biased toward viewing inventory solely in terms of above ground storage, and ignoring diminishing spare capacity, especially as far as OPEC is concerned. This, in turn, would seem to indicate oil market fundamentals are stronger than perceived.

To read the article in its entirety, please go to .