Two weeks ago aggregate U.S inventory levels increased by 0.23%, only to fall by 0.50% the following week to rest at 521.10 million barrels. During this time headlines asserted a bearish outlook on future prices, which within the week flipped into a bullish one. Placing the recent resurgence of prices with talk of a Russian-Saudi output freeze aside, this article focuses purely on the logic of price changes deriving from inventory storage counts. As part two of a series on volatility in the crude oil market, we will begin by attempting to explain why firms benefit from inventory and how inventory levels interact with prices within the industry.
The correct amount of crude oil that any given market may need is subject to immense uncertainty. Whether a competitor refinery goes offline, such as in the unplanned outage of Suncor’s Edmonton refinery in June, or a shipping company observing a strong futures price, inducing them to buy cheap crude now for sale later, the ability to store oil ensures stability for the oil and oil products supply chain.
To the refiner, the benefit in maintaining a smooth, consistent and predictable operations schedule is critical in reducing the depreciation of their capital. To the shipper, the possibility of super-contango offers a time arbitrage with good margins. Whether it is to hedge against uncertainty, or an opportunity to capitalize upon, the holding of inventory is critical in adapting to the volatile reality of crude oil prices.
As summarized by Robert Pindyck in the Energy Journal, inventory levels act as a buffer for when prices change. It enables consistent production, as refiners are able to draw upon it during periods of high demand. When a refiner or shipper changes their inventory level, the EIA observes the change and accounts for it in their weekly reports. Such information generates important guideposts for traders, who use the information to assess the state of the market, and make better decisions when buying and selling.
As the supply and demand for oil changes, which is partly signaled through inventory levels, traders decide whether to buy or sell at the resulting price level. Keep in mind, the formation of this price level is complex and is summarized, at least in part, here. Outlined in an RBC Capital Markets report, a market in equilibrium cannot be a market with excess supply. To the oil trader, daily excesses of production, (typically blamed on Saudi Arabia) are not the only source of excess supply. Deviations from seasonal trends, or historically high inventory levels count as well. When inventory levels increase, especially if they increase over last years data, prices go down. And when inventory levels decrease, especially under the seasonal trend, prices increase.
Oil prices are constantly going up and down. Oil traders, responsible for the decision to buy or sell at any given time, ensure a more efficient market. They use inventory as a signal of market fundamentals. If crude oil wasn’t a storable commodity, like electricity, the production of oil derived goods would be considerably riskier. As such, it is important to note that inventory is not the cause of systemic low prices, but rather a diagnostic of the industry’s point of market equilibrium.