There was not much to cheer about after the latest stats on US oil stocks were released but the one part, crude oil, that was bullish was relevant enough to support the whole oil complex. Production fell another 100,000 bpd to 11.50 mbpd and crude oil inventories drew for the second consecutive week. This depletion was almost exclusively thanks to the 5.8 million bbls fall in PADD2 inventories, 96% of which took place at the NYMEX delivery point. The pressure on bulging inventories has been relieved for the second week running and consequently NYMEX WTI gained $1.53/bbl yesterday to close at $33.49/bbl. The front-month spread also strengthened and settled 6 cents/bbl higher. The latest set of data does not provide an answer as why inventories dropped 5.5 million bbls at this critical hub. Refiners upped their runs by 3% in the Midwest, but crude imports rose week-on-week by 200,000 bpd and Canadian exports into the US also increased.

The rest was gloom. Gasoline defied expectations and rose by 2.8 million bbls. Distillate inventories jumped by 3.8 million bbls, much more than the forecast although less than the API estimate. Commercial oil inventories built just over 5 million bbls and they are at 1.4 billion bbls. The increase in refined product stocks is attributed to three developments. Firstly, nationwide refinery utilization was up 1.5%. Secondly, net product exports fell to 1.57 mbpd last week, the lowest since the hurricane season of 2017. Thirdly, after taking four steps forward US demand recovery took a step back and fell by 200,000 bpd on the week led by the 600,000 bpd decline in gasoline. Although confinement is being gradually lifted in the US this latest report suggests that the escape route from the corona virus is paved with economic hurdles, one of which is high unemployment impacting domestic demand.

The price rally was further aided by a jump in stock markets. The message from Wall Street is that any excuse will do. Two days ago an allegedly successful vaccine trial pushed equities higher. When it turned out to be not much more than hot air attention turned to the forward guidance released by the Fed. Minutes of the latest meeting showed that although the central bank left interest rates unchanged at the end of April it vowed not to be faint-hearted to provide further stimulus to the economy. In other words, cheap money will be available as long as necessary, hence yesterday’s move up inequities. The underlying bullish sentiment survived one more day.

Tight supply is foreshadowed by CAPEX cuts

The current impressive oil price recovery was as much triggered and supported by supply considerations as by rising demand. Oil producers all over the world, national or international oil companies, shale producers, have been forced to meaningfully reduce output levels, either voluntarily or forcibly in the face of plunging prices. The health pandemic significantly curtailed global oil production. In January the EIA predicted 2H 2020 non-OPEC supply to be at 68.61 mbpd. This month it is forecast to be 62.17 mbpd. US domestic production estimates for the same period have been cut from 13.35 mbpd to 11.08 mbpd. Shale oil output is expected to fall from over 9 mbpd in March close to 7 mbpd in June. OPEC and its ten allies have started to reduce their output level by 9.7 mbpd, which is likely to climb to nearly 11 mbpd and could last all through the year. This is an unrivalled producer response to an unprecedented global crisis, which set off an impressive price reaction. Brent have risen from the low of $16/bbl to $36/bbl in the space of a month. As discussed on the pages of this report the current curtailment is not expected to last. As oil price rises so will output effectively capping any price rally that might be anticipated or hoped for during the remainder of the year. Taps can be re-opened in a relatively short period of time when circumstances are favourable.

There is, however, an ostensibly bullish output picture in the making that could possibly emerge in the second half of 2021. The price crash we witnessed in March and April did not only force global oil producers to restrain production but also rein in spending. In the time of uncertainty cash is king. These savings come in a lot of shapes or forms: freezing dividend pay-out, laying-off work force, reducing operating costs or cutting capital expenditure spending. It is the latter that is potentially setting the scene for a tighter oil balance further out. CAPEX is an excellent barometer for futures supply, not just in oil, but basically in every walks of the economy. The less the investment, the shorter the supply. In their effort to preserve cash oil producers have significantly reduced their spending in the light of the recent downturn. During the previous output war back in 2014 expectations were the same. The fall from $115/bbl to $36/bbl led to notable reduction in spending and the consensus was that it would lead to future supply shortages. The oil industry in general and shale in particular, however, proved remarkably flexible and innovative back then. The break-even price in US shale quickly plummeted from $80/bbl to $30/bbl and apart from a short-lived drop in output in the second half of 2016 the industry accepted the challenge and adapted exceptionally well to the new environment.

This time it appears different. From oil majors, including Exxon, Total and Shell, through Saudi Aramco to LTO producers, the name of the game is cut. Major producers have reduced their CAPEX by nearly 30% or $62.5 billion this year, Reuters calculates. Rystad Energy puts the budget cuts in exploration and production at $100 billion this year. ExxonMobil, for example, reduced its CAPEX by 30% and its OPEX by 15% due to the coronavirus. Most of this production constraint will impact its Permian operation, more so in 2021 than this year. Elsewhere, spending cuts will also lead to lack of investment in mature oil fields. Replacing these aging fields would be a necessity as global oil demand recovers from the current shock.

When trading conditions are as volatile and violent as today 18 months is a long time in the oil market. Readily available data and information, however, imply that lack of investments in E&P could lead to supply shortages. It is not a far-fetched thought that the structure of the two main crude oil futures contracts will flip into a prolonged backwardation from 2H 2021, especially if the OPEC+ producer group remains disciplined throughout next year. Keeping this in mind it is worth noting that both WTI and Brent displays a monthly contango of anywhere between 17 cents/bbl to 25 cents/bbl from the end of next year. If one buys into the “tighter production” theory, then crude oil spreads from December 2021 out look good value.