Brent May15
Every oil trader has known the feeling.  You’ve done your sums, talked to everyone, and decided the market is going to be short of product.  So you start buying discreetly, building up inventory to sell in the future at higher prices.  But then the messages from other traders start coming: ‘”What would you bid for my volume?”.

And they keep coming.  Too late, you realise that your analysis was wrong.  The market clearly had much more product available than you thought.  Now you are caught.  You realise with a sinking feeling that you have become the market.  Even worse, there are very few people who want to buy the inventory you now own.

Being expensively wrong is not a pleasant feeling.  But it seems likely to be experienced by the oil market speculators who have been bidding up oil prices in recent weeks.  Because latest data shows they now own a record 510 mbbl of oil – equal to 5 days of world demand.   As the Financial Times notes:

This is equivalent to the combined monthly output of Saudi Arabia, Iraq and Iran, the biggest producers in OPEC“.

Even worse news for the speculators comes from the International Energy Agency in its latest Monthly report:

Global crude supply was up by a staggering 3.2 mb/d in April year-on-year, extending the first quarter’s massive gains” 

So the speculators have indeed been building inventory just as the market was moving even further into surplus.  Even worse, their buying has been a self-defeating trade.  Back in January. the IEA had suggested that H2 might see lower US production, as producers would have been unable to hedge their output at attractive prices:

  • But all the buying has enabled producers to hedge quite happily at prices around $60/bbl
  • In addition, it has given them precious time in which to start cutting costs dramatically
  • Cuts of 40% or more in operating costs have been quite common in recent months
  • So many more producers can now afford to continue at much lower prices than today

And in addition, events have been moving forward in the real world where the fundamentals of supply and demand matter.  Saudi Arabia’s oil exports hit a 10-year high in March.  It is also increasing its refining volumes by a further 1.2mbd by 2017, to become the world’s 2nd largest oil products’ exporter.

Saudi’s latest comments on its market share strategy have also confirmed my own analysis last year.  As it said last week:

“Saudi Arabia wants to extend the age of oil. We want oil to continue to be used as a major source of energy and we want to be the major producer of that energy.

Plus, of course, talks to end the Iran oil embargo continue to progress, raising the chances that it will be able to return to world markets and also invest in updating its production facilities.

In the end, reversion to the mean has always been a very profitable investment strategy.  In the case of oil, as the chart shows, this would mean prices falling back to their long-term average around $33/bbl in $2015.

Time will tell, as markets will soon see the end of the peak period for US refineries, as next week sees the Memorial Day holiday.