Oil's Cold Shoulder For Canada

It'll take more than wildfires to dent the glut and drive prices higher.

The scenes from Alberta's raging wildfires are apocalyptic. Yet one constituency seems strangely unmoved: the oil market.

Roughly 1 million barrels a day of supply are estimated to be offline due to the fires around Fort McMurray in Alberta. And yet this looks set to be the first week in more than a month where crude oil actually closes lower than the previous Friday.

Strangely Weak

Weekly WTI crude oil price

Source: Bloomberg

The market hasn't been wholly unperturbed. The discount at which Western Canada Select crude oil is priced below benchmark West Texas Intermediate has narrowed. Still, it doesn't look like the extreme move you might expect with more than a fifth of Canada's production capacity suddenly out of commission.

Slow Reaction

Western Canada Select crude oil's discount to WTI has come in, but not by much

Source: Bloomberg

And you can see here that, so far, the market's concerns about disruption to supply are confined to the next few months.

Summer Anxiety

Futures prices for Western Canada Select crude oil have moved up, but only through August

Source: Bloomberg

Note: WCS futures quoted as a discount to the corresponding WTI crude oil futures price.

The market's sanguine take may reflect an expectation that the wildfires, while terrible, may not last and will not spread further north toward core oil-sands operations, meaning disruption will be temporary.

Still, Canada's disaster has happened in a week where the traders also had to digest news of an attack on a Chevron installation in Nigeria, continued escalation between factions in Libya, and a report that oil production fell in the first quarter across all regions of a seriously-stressed Venezuela for the first time since 2008. With U.S. output also continuing to decline in response to low prices, oil should be entering this weekend looking more nervous than the last, not less.

Two things are suppressing the anxiety.

One is that the market had already raised price expectations. Oil's rally this spring has been fueled in part by speculators re-entering the market or unwinding short positions in oil, as this chart shows.

Back in the Game

Net non-commercial length in WTI crude oil futures and options

Source: Bloomberg

That shift in sentiment has been driven by a mixture of things, ranging from the (busted) Doha supply-freeze talks to indications of strong demand for gasoline in the U.S. Taking sentiment even higher likely needs another definitive catalyst, and Canada's disruption doesn't yet seem to be definitive enough.

The culprit in that regard is the other burden weighing on the market: high inventories.

As I wrote about here, rebalancing oil supply and demand isn't just about removing excess production -- we also have to drain the build-up in storage tanks that has happened already. This is a slow process, barring a significant uptick in demand or a sudden shock to supply. What the market's reaction to Canada's disaster is showing us is that the shock would have to be way bigger.

In the chart below, I lay out three scenarios for OECD oil inventories, assuming future global excess oil supply flows into them, and vice versa. The first is based on the Energy Information Administration's short-term projections, which imply inventories don't start to level off until late 2017. The EIA assumes Iranian production expands by around 600,000 barrels a day this year and that OPEC proves ineffectual -- both of which look like sound positions. The second scenario assumes a million barrels a day of Canadian production stays offline through the end of this year. The third adds in a further, more extreme shock: a total collapse of oil production and consumption in the third quarter in Venezuela, which looks like the shakiest domino among the petro-states today.

Here's how these scenarios stack up.

Shock Wave

Projected OECD commercial oil inventories under three scenarios

Source: Energy Information Administration, BP, Bloomberg Gadfly analysis

Note: Assumptions as per detailed in accompanying column.

Two things leap out from this chart. First, Canada's disruption, even if it lasts through December, doesn't prevent inventories ending 2016 higher than they were at the end of 2015.

Second, Venezuelan collapse would have a dramatic impact. Inventories would end this year slightly lower; and by the end of 2017, the amount drawn down relative to where we ended 2015 would be almost 500 million barrels -- equivalent to almost all of the crude oil stored commercially in the U.S. today. Little wonder energy economist Phil Verleger wrote recently that "the oil market story for 2016 is Venezuela."

The market isn't spooked yet, though. And if oil should rise back above $50 a barrel due to disruptions, the message coming out of many U.S. E&P companies' first-quarter earnings calls is that they would then start to put idled rigs back to work. Meanwhile, on the demand side, Friday's relatively weak payrolls number runs counter to the bull case for U.S. gasoline, while China's growth prospects are a riddle, wrapped in a mystery, stuffed inside a big old pile of debt.

Even as Canada's fires rage in the real world, the oil market's multiple crosswinds keep them in check for now.

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

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