Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

It is almost the first anniversary of that fateful OPEC meeting for which only oil bears give thanks. A year after Saudi Arabia upended expectations by refusing to prop up the oil market, speculation on when prices will recover is sure to be a hot topic around many a dining table on Thursday (or maybe just in my house).

Despite recent experience, high oil prices are still fresh in the collective memory. So it isn't hard to imagine a run back toward triple digits. After all, oil is hardly the picture of stability.

Volatile? Moi?
West Texas Intermediate crude oil spot price
Source: Bloomberg

Think a bit differently, though, and oil has a pretty big mountain to climb.

First, with West Texas Intermediate crude trading around $41 a barrel, seeing triple-digit prices again would involve a rally of about 150 percent. If you are banking on that happening by the time you sit down to 2016's turkey dinner, consider this: On a year-over-year basis, that sort of rebound has happened only once in the past three decades, between February 1999 and February 2000.

The Foot of the Mountain
Year-over-year change in the WTI crude oil price
Source: Bloomberg

Back then, oil rallied from what now seems like the ludicrously low level of $12 a barrel to a merely quaint $30. Saudi Arabia managed to coordinate supply cuts with a raft of other producers, causing global oil output to fall for the first time on an annual basis since 1990.

While oil prices haven't gone anywhere near $12 this time, the current crash is in some ways more violent than back then. Looking again at year-on-year moves, the price had collapsed by more than 50 percent by early 2015. In the past 30 years, that has only been seen twice before: the oil price crash of 1986 and the global financial crisis. The former bears some resemblances to today's situation. Saudi Arabia, unwilling anymore to shoulder the burden of supply cuts to prop up prices in the face of rising competing supplies, raised its output by 1.6 million barrels a day, or 45 percent, in 1986. This helped flush out the market, with annual non-OPEC supply growth averaging just 281,000 barrels a day between 1985 and 1987, compared with roughly 1 million barrels a day in the three years prior to that.

Today, excess supply as OPEC's own members and rival producers battle for market share is weighing on near-term prices for barrels. The futures curve, which shows the prices of oil for delivery in the months and years ahead, is drooping like it just had a double helping of turkey and the trimmings.

The Future Imperfect
WTI crude oil futures prices
Source: Bloomberg

 

With almost 3 billion barrels of oil held in commercial inventory in the OECD countries, it is little wonder that this isn't exactly a seller's market for crude oil dated for delivery soon. The International Energy Agency calls that buffer of inventory "unprecedented." That is somewhat debatable. Back in the mid 1980s, inventories might not have been as high, but spare production capacity equated to around 15 percent of global demand, according to the Rapidan Group, an energy consulting firm. That offered a different sort of cushion. Spare production capacity today is a few percentage points at best, so those billions of barrels in tanks serve a useful purpose against any potential disruptions.

They aren't so useful, though, if you're banking on a recovery in prices. For that to happen, inventories have to decline to a more normal level. Defining normal is, of course, the sort of debate usually best left until you're well into the digestifs. In this case, one way is to measure oil inventories versus consumption. OECD oil stocks spent most of the past six years covering less than 60 days of demand. Recently, they have spiked into the mid-60s for the first time since the financial crisis, hitting 64 days in the third quarter. So one definition of what's normal would be to get that back below 60 days of cover.

It won't be easy. Using IEA projections, and assuming OPEC maintains its output at third-quarter levels of 38.3 million barrels a day, another 375 million barrels of oil would flow into storage globally between the end of September and June next year. Assume this all flowed into tanks in OECD countries -- where much of the world's commercial oil storage resides -- and stocks would rise above 70. In reality, at that point there would likely be a run on bathtubs just to take the excess supply, and the doomsday scenario of oil crashing toward $20 a barrel, raised recently by both Goldman Sachs and Venezuela, would become a reality.

If OPEC were to cut supply by 500,000 barrels a day -- or by a whopping 1.5 million, equivalent to OPEC-member Angola shutting down and then some -- it wouldn't be a quick fix based on current projections. Even under the latter scenario, it would still likely take a year to get back below that magic 60-day level, as the chart below shows.

Leveling the Mountain
The number of days of OECD oil demand covered by commercial inventories has jumped--and could rise further still without action, potentially crashing prices
Source: International Energy Agency, Bloomberg
Note: Scenarios assume excess oil flows to OECD stockpiles

It is worth bearing in mind that these numbers don't include a big increase in Iranian output after the lifting of sanctions. The bigger point is that while the stockpile of oil will get worked off, it will take a while. It would make little sense for Saudi Arabia to suffer for the past year only to deliver a surprise Thanksgiving present to the likes of Russia, Canada and the U.S. oil industry by deciding to suddenly cut production at OPEC's upcoming meeting early next month.

So oil bulls banking on a rally sometime soon really need a deus ex machina in the form of Saudi Arabia repeating its late 1990s feat of securing global cutbacks or a wildcard like Syria's tensions escalating into a wider conflict. For the first time in many years, there is a genuine, competitive price war going on in the oil market. Getting out of those trenches will necessitate a steep and treacherous climb.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net