Oil prices set another record last week, closing above $145 per barrel for the first time, on the strength of heightened fears of an attack by Israel or the US on Iran, combined with a dip in US commercial oil inventories below 300 million barrels, their lowest level since the end of January and at the bottom of their seasonal historical average range. But although lower inventories are generally a bullish signal for the market, we shouldn't forget that the relationship between prices and inventories runs in both directions. Current and expected future prices, along with actual supply and demand, play a significant role in guiding companies in setting their desired inventory levels. Determining whether a drop in inventories reflects tight supplies or expected future weakness depends on a broader array of indicators, including how seriously the oil industry takes forecasts of oil prices reaching $170-200 per barrel later this year.
The Department of Energy defines "crude oil stocks" as including "domestic and Customs-cleared foreign crude oil stocks held at refineries, in pipelines, in lease tanks, and in transit to refineries" and excludes the oil held in the nation's Strategic Petroleum Reserve (SPR). Some of this oil is required to ensure the uninterrupted operation of US refineries and pipelines, while the rest ebbs and flows with shifts in supply and demand and changing expectations for future prices. Although last week's figure looks low compared to average US commercial oil inventories since 2005 of 323 million barrels (MB), it is still 15 MB higher than the average during 2003-2004, and well above the 264 MB seen in January 2004. If nothing else, that suggests that current inventories remain safely above the minimum level required to keep the US pipeline and refinery network operating smoothly. That is consistent with the calculated 19.5 equivalent days of refinery supply at current consumption, compared to a low of about 17 days in September 2004.
There are two reasons why higher prices might lead companies to hold lower inventories. The most basic has to do with the carrying cost of owning high-priced oil. If a 200,000 barrel per day refinery had 4.4 MB of oil on hand when the price of West Texas Intermediate crude oil was $100/bbl, then the spike to $140 has increased its carrying cost for that inventory by the equivalent of $0.19 per barrel of output, assuming a corporate cost of capital of 8%. At $140/bbl, reducing plant inventory by 10% would cut the total carrying cost by 6 cents per barrel. While that might appear trivial on the scale of the profits oil companies are making, it would look very significant indeed to refineries that have experienced a gross margin between gasoline and crude oil of only about $8.00 per barrel so far this year. For a refinery manager seeking to contain costs, running a bit closer to minimum operating inventories looks like a good option, particularly when gasoline demand is dropping.
The other reason to reduce inventories has to do with expectations of future prices. While the market seems to be locked into a "shortage psychology", bolstered by pessimistic production estimates and forecasts of ever higher demand in Asia, the industry itself seems skeptical that current prices will last, despite futures markets trading at $142/bbl all the way out to 2016. If companies were planning their investments based on a return to $100/bbl or less, it would be hard for refinery managers to justify deliberately adding to inventory at today's price. And although the risk of a new war in the Middle East might alter that calculation, it must contend with the near-certainty that the government would release oil from the SPR to counter any actual disruption of supplies that would follow such an event. Moreover, rumblings in the Congress to release SPR oil to deflate a perceived speculative bubble in oil act as an additional deterrent to holding any more inventory than absolutely necessary.
For the present, then, falling crude oil inventories constitute another ambiguous component of the mixed bag of fundamental signals the market must interpret, including comfortably stable US gasoline stocks and falling gasoline demand, recovering diesel and heating oil stocks, weak refining margins and rising biofuels production. In the absence of a clear indication that supply will soon exceed demand, every mildly bullish indicator will push the market toward fulfilling the views of the growing cadre of analysts engaged in an apparent arms race of escalating forecasts, egged on by the media attention this attracts. But despite scare stories of $7 gasoline--which at current refining margins would require light sweet crude oil to reach at least $250/bbl--no one knows where oil prices will be in six months. Six months ago, crude oil was trading under $90. Can anyone look at the fundamentals and determine conclusively that it couldn't be back there this winter, rather than continuing on to $200? This reality makes even tactical planning for companies that are big energy consumers an extremely challenging undertaking.