Oil Prices Don’t Make Any Sense – The SPR Hit a 40-Year Low

US strategic oil reserves have fallen to the lowest level since 1983. If the recent pace of drawdowns continues unchanged, the reserve would hit its “emergency floor” in about two to three months. The pace of drawdowns may be expected to slow, but it does indicate the unusual situation.

How did this happen and what happens if it keeps draining? Just last week with a ceasefire in place, we explained why why oil prices are falling from $120 to $70. But, since then hostilities have resumed, traffic from Hormuz has ground to a halt again, and yet oil prices remain stubbornly low at $71.

You might think this doesn’t make sense. Well, let us look at oil prices compared to diesel prices. The crack spread is the difference between oil prices and the price of petrol/diesel. As a consumer, petrol and diesel is what you buy, not crude oil. And this highlight the current conflict in oil markets, oil prices have fallen, but diesel crack spreads are rising.

Oil traders are pricing in the end of supply disruption and lower oil prices, oil refineries are saying, actually we do have shortages and if you want to buy diesel, you have to pay higher prices. Basically, something will have to give. So the question is – will it be oil prices will have to rise, or diesel prices will fall?

If the conflict was genuinely over and there would be no more disruption in Hormuz, there is a case to say, that the past issues of over-supply will come to the fore and oil prices will remain low, but the Iran crisis drags on, it creates a huge amount of uncertainty, with predictions of oil futures ranging from $50 to $200. One thing is certain the volatility of oil prices has increased in recent months.

And as the economist reports someone is making a fortune from this chaos, and it’s not who you’d think. BP, Shell and Total’s trading arms are on track for $15 to 20 billion in pre-tax profit this year.. These desks trade 40 to 50 million barrels a day — five to ten times what the majors actually produce — and the profits are so opaque they’re deliberately buried inside other divisions’ results.

Now, Using IEA data we can see Hormuz lost 13 million barrels per day, the adjustment came from increased production elsewhere, and a 2 million surplus before the war. But interestingly 6 million came from lower consumption. This is primarily China drawing down its inventories . But the interesting thing is that despite oil prices falling dramatically to $70, China still isn’t going back to refill its inventories and buying extra oil. Oil imports have recovered but are still 25% less than before the war.

You might think kind of doesn’t make sense, if you use your oil inventories when the price sky-rockets, this saves China import costs. But, although Chinese inventories are large, it becomes a gamble to keep using inventories.  Oil expert Javier Blas argues that China may be waiting for oil prices to fall to $60 before going back to large scale buying. It’s not that the Chinese economy has stopped using oil, but they have become less dependent than in the past. The rise of renewables, electric and also coal for chemical industry. But here is the thing, it’s not just that China may start rebuying oil imports like before the war, they will also buy surplus to refill its inventories. You can’t rely on this 6 million reduction in demand as a permanent situation.

Supply – Demand of oil

But going back to the equation of oil demand and supply, the other reasons for low oil prices is drawing down inventories. This has involved using oil on the sea, but also US inventories were falling to a very low level. The US administration were very keen to keep gas and oil prices low, because of the political cost. So they encouraged a big draw down of inventories and encouraged other countries to do the same.

It is also worth pointing out than in 2022 and the Ukraine War, President Biden used up inventories when oil prices soared, but the US was slow to restock inventories, when prices were low. The problem is that with gas prices still relatively high, there is a reluctance to go back to refill inventories creating extra demand. It is worth noting the SPR is stored in huge underground salt caverns relying on water injection to push oil through the wells. This is why you can’t go below a physical floor, pumping rates and pressure drop. But, when you have very thin reserves, it means another shock could cause a much bigger price rise

So the US really wants a resolution to Iran War. The problem is that Iran want to charge tolls that Washington refuses to pay. And this week there has been tit for tat missile strikes, leading to Hormuz effectively grinding to a halt again. UAE and Saudi Arabia have been pumping more oil, but that isn’t an oil glut if Hormuz is still a chokepoint. As we mentioned last week, the gulf states are looking at on land work arounds, but this is only a fraction of sea-based oil traffic.

So  the big question is someone must be wrong. Wall Street are convinced the crisis is over and a glut is coming, but is this a case of wishful thinking? Certainly, Wall Street would love the crisis to be over. It means lower inflation, lower interest rates and higher growth. But Wall Street can easily fall into wishful thinking – anyone seen earnings growth recently. But also the complication is that there are signs of a world getting used to less oil. The US has missed a beat, slowing down the transition to renewable energy and electric cars.

Upward pressures in the short-term

So in the short-term, the continued closure of Hormuz will put upward pressure on oil prices, the US SPR is getting critically low. In the autumn, you will no longer be able to rely on using inventories, in fact, if China starts to restock, that could create a bounce in oil prices. In the long-term, the future of oil prices is different. I like this graph which shows actual oil demand compared to forecasts. Basically, there was expectation of rising demand, which didn’t materialise. The electric revolution does place a gap on demand, yet global supply has proved to be very elastic, responding to this crisis with increased production in Brazil, Canada and the US. The long-term future of oil prices may be benign, but the decline of inventories is a potential major shock for the rest of this year.

It’s such a fascinating question because there is so much uncertainty and the stakes are very high. Given a slowdown in growth, even a mild inflation shock creates a real headache for any government.

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