Released on October 2, 2002
(Next Release on October 9, 2002)

To Be, Or Not To Be
Despite OPEC’s self-proclaimed role as a reliable supplier of reasonably priced oil, commercial crude oil inventories continue to plummet towards new startling lows in the world's largest oil market, and the U.S. marker crude oil, West Texas Intermediate (WTI), remains over $30 per barrel and is threatening to climb higher, causing concern in some quarters over the global supply of crude oil. Even as producing and consuming country officials met recently in Osaka, Japan to communicate policies, an apparent split in perspectives seemed to deepen as OPEC talked about stabilizing over-supplied markets haunted by war fears, while consuming country officials argued that seasonally higher demand levels this winter would require much more OPEC supply than likely forthcoming without a quota increase, especially if global inventories are to avoid falling further below already alarmingly low levels.

While oil markets are fraught with uncertainty, imbedded on both sides of the global supply/demand balance, one point seems clear. Oil markets are not over-supplied. For this to be the case, inventories would have to be high and/or rising at a more rapid than normal pace. Yet, preliminary data suggest that OECD crude and product stock totals fell below year-ago levels in August, continuing contra-seasonal movements begun as early as the second quarter of this year. Weak builds then have been followed by outright drawdowns in the third quarter, based on both available supply and demand data and reported inventory levels.

In the U.S., the pattern is even more striking, which is to be expected, since the U.S. was the repository of most of the world's surplus inventory last year, as well as the first half of 2002. Deep OPEC production cuts relative to last year, ranging from 2 to 3 million barrels per day for the first 6 months of 2002, and depressed Iraqi oil exports, averaging 1 million barrels per day to date less than last year, have combined with economic recovery (albeit at a slower pace than some expected) and firming underlying oil demand to elevate crude oil prices. Consequently, refiner margins have been depressed, thereby generating more than ample incentive for refiners, especially in the United States, to reduce oil purchases, imports, and refinery operations, while meeting firming customer requirements by drawing down crude oil inventories. Even ignoring last week's sharp added downward pull from Tropical Storm Isidore, U.S. crude oil inventories were already 24 million barrels below last year and well below the normal range as of September 20. But, more than anything, it is the trend that belies OPEC rhetoric, with U.S. crude oil inventories plunging from high levels at the end of February 2002, some 44 million barrels over year-ago levels, to current levels of 275 million barrels, a decline of 52 million barrels in just seven months, a near record drop. (The only two periods with a sharper drop over a seven month period were in December 1990/January 1991 following Iraq’s invasion of Kuwait and December 1999, when similarly deep OPEC production cuts combined with preparations for Y2K to sharply draw down primary inventories.)

Just as worrisome is the third quarter turn in U.S. distillate fuel inventories. As discussed here in the September 25 issue (see TWIP, 9/25/2002), distillate stocks have dropped from still high levels at the end of June, a 17 million barrel surplus over June 2001, to 130 million barrels, now only 5 million barrels from the lower limit of the normal range for the end of September. Low refinery margins and continuing strong gasoline demand this fall suggest that the relatively low distillate production levels seen in July and August that were partly behind the distillate turn downward, may not catch up with seasonally rising deliveries, especially if more normal weather combines with structural improvement in the fourth quarter.

Speaking of structural improvement, what about supposedly weak demand prospects? EIA is still forecasting a global rebound this winter, primarily driven by an assumed return to normal weather, continuing recovery in air travel, and rising U.S. and worldwide economic activity levels, including improvement in the manufacturing sector. Of the average growth globally expected this winter of about 1.5 million barrels per day, 0.6 million barrels per day of this is anticipated in the United States. So, at least according to our forecasts, oil demand is not expected to be “weak” this winter.

And what is the evidence supporting this? For starters, U.S. gasoline demand growth in September averaged 150,000 barrels per day, based on the four weeks ending September 27, continuing the strong pattern seen all year with an average growth rate to date of 2.6 percent. Even factoring out 0.5 percent or so for air travel substitution, underlying gasoline demand growth of about 2 percent appears to reflect an economy in recovery mode. While others have recited the lengthy list of recent indicators of renewed sluggishness, including equity value declines, drooping consumer confidence, and re-flattening in manufacturing, other factors, including the lowest interest rates in 40 years, rising personal income, and low inflation continue to provide consumers with the means to increase spending. Sour mood swings aside, it is not surprising then that consumer spending remains buoyant, led by strong housing and auto markets. As such, numerous forecasts (including EIA’s) still call for a sharp pick-up in third quarter GDP and an average U.S. growth rate of about 2-3 percent for the year as a whole. Since gasoline demand is very closely correlated with GDP and real income, even air travel substitution rates of as high as 1 percent are consistent with average GDP growth this year, both observed through the second quarter, and expected for the balance of the year. Put differently, if gasoline demand continues to grow at anything close to rates seen so far, it would be highly unusual for GDP to sink below the 2-3 percent growth rates EIA and others assume going forward, which bodes well for oil demand growth in general.

What, then, are the signs here? Recall, first, that in previous issues of This Week In Petroleum, we have documented that much of the U.S. sag in oil demand last winter can be attributed to one-time factors, e.g. very warm weather, low natural gas prices, and the September 11 impacts on jet consumption. This suggests that with economic growth resurfacing, oil demand should be growing as these factors dissipate with the end of winter. And, indeed naysayers not withstanding, this is exactly what U.S. data show. U.S. total petroleum demand began its recovery in May by climbing slightly (0.9 percent) over year-ago levels, and growth has strengthened steadily since, with September data to date showing 1.2 percent growth over September 2001 demand.

But, since skeptics may argue that growth relative to the weak levels seen last year following September 11th is a hollow victory, let's look at light product demand, (i.e. gasoline, distillate, and jet fuel) thereby factoring out distortions stemming from structural decline in heavy fuel oil consumption and other one-time anomalies, largely associated with volatile natural gas prices. And, let’s look at the May through July period, well before any September 11-related distortions, and for which the latest final U.S. monthly data exist. Comparing May - July light product consumption this year with last, we see growth of about 180,000 barrels per day, or 1.3 percent; furthermore, while May - July 2002 demand falls below recent trend levels, the gap is a mere 30,000 barrels per day, only slightly more than the below-trend dip seen in 2000 when the U.S. economy was still growing at a robust pace. Hence, we can dismiss this as white noise.

Herein, then, lies the disconnect. U.S. crude oil inventories are very low and sinking fast, while distillate fuel inventories, even total commercial petroleum inventories, are dropping toward the low end of the normal range. Indeed, U.S. total commercial petroleum inventories have dropped in the third quarter only three times since 1986, one of them in 1999, a troubling reminder of the apparent retracing of the 1999/2000 cycle evident in U.S. and global markets movements since the end of last winter. With recent solid U.S. demand growth poised to jump sharply this winter, U.S. and global market fundamentals are firming rapidly and oil prices at $30 are merely reflecting this. Indeed, with crude stocks in the Midwest at record lows, and closely correlated with WTI prices, further upward pressure should not be unexpected.

And yet OPEC fiddles. How can oil markets be characterized as "fundamentally weak"? It would seem that such bearishness stems from a one-sided perspective or looking glass. If one focuses only on current global or OECD inventory levels and only on apparent global demand growth to date this year, one "sees" weak consumption and still adequate stock levels. But, of course, what is unseen in this is the essence of imbalance, a harbinger of forthcoming volatility, namely the steep downward trend in inventories at a time when stocks should be building for winter use. Even ignoring the clear signs of structural demand improvement noted above, the real blindness is on the supply side. Oil prices depend on both sides of the global balance, and deep OPEC cuts have more than offset non-OPEC supply additions and any weakness to date in global demand. Thus, it seems the growing divide between producers and consumers is less due to market uncertainties and more the direct result of opposite perspectives. And whether OPEC is seen as a stabilizing force or as an organization in which increasing volatility is rooted may also be a matter of perspective.