Goldman on who’s really wagging the oil market

If you’re wondering what Goldman Sach’s view on crude is — it can be summed up in one neat sentence from their latest research note:

The world crude oil market remains exceptionally tight.

The reasoning is pretty straightforward.

To sum up: Saudi production hit 9.8m barrels per day this summer. The oil market supply-demand balance has remained in a seasonally adjusted deficit despite the US Strategic Petroleum Reserve (SPR) releasing 30m barrels of oil into the market. Crude oil inventories outside of the United States have drawn to their lowest levels in nine years. OPEC effective spare production capacity is less than one million barrels per day.

As they conclude:

This leaves the oil market reliant on Non-OPEC production growth and a resumption of Libyan production to meet world oil demand growth. However, Non-OPEC production continues to disappoint, with the growth that is occurring being predominantly NGLs, and not crude oil, or being trapped behind logistical bottlenecks in the US Midwest and Midcontinent, unable to reach the world oil market.

Somewhat of a Greek tragedy to say the least.

But there is something even more interesting which they suggest might be supporting matters. The European debt crisis.

While we too would have thought the unravelling of the European economic system would be considered bearish for crude, in Goldman’s opinion it is actually exacerbating the tightness in the physical market.

Here’s how:

As the market “prices in” a higher probability of recession, it drives down futures prices below levels needed to balance supply and demand in the current market. This leads to further inventory draws, backwardation and a tighter physical market.

Dated Brent prices are trading $5/bbl over the front-month Brent contract, one of the strongest sustained spreads on record, illustrating the strength of the current physical market relative to expectations for the future. The fact that a second potential global financial crisis is so widely anticipated is a clear contrast to the financial crisis in the fall of 2008. In 2008, the oil market anticipated a much tighter oil market going forward. This was expressed in rising long-dated oil prices, which pushed forward curves into contango, and motivated the building of inventories. In 2011, in contrast, the oil market is anticipating a much weaker market going forward, with longdated oil prices falling, pushing forward curves into backwardation, and exacerbating a continued destocking of inventories (see Exhibits 3 and 4).

This is a very interesting point.

In a nutshell, it means that Goldman expressly believes futures are leading the physical market. That it is the selling-off of futures on the curve which is creating backwardation, which in turn is incentivising inventory drawdowns. (Because if you happen to have crude stocks at the moment it makes much more sense to sell now, and replace the crude with cheaper supply from the future.)

What’s more, they add, in 2008 it was the very opposite. Investors were buying futures on the curve — due to the belief that oil prices would inevitably rise — exacerbating the sell-off by encouraging contango and inventory building.

But if the current drawdowns are incentivising stock drawdowns — which are not based on real demand but the result of the curve’s structure — would that not mean there would be surplus product inventories building up instead?

Not necessarily so. As always it’s a matter of price. And as John Kemp at Reuters has been noting over the past few weeks, if anyone has been suffering on account of the crude price it’s been the western refineries… most of whom, he notes, have been struggling to cope with margin pressure as well as surplus refinery capacity in North American and Western Europe.

So yes, the market is tight, but western refiners (at least those not within the Cushing-related windfall zone) are unable to turn a profit because product prices are not strong enough to cover input costs. As a result refineries are being forced to keep production surpressed just to keep margins higher.

And yet, the structure of the curve is still incentivising inventory drawdowns…

It’s a funny situation. But in most analysts’ eyes, all of this is easily explained in three words: emerging market demand.

That is to say, the global price of crude nowadays is much more reflective of global market demand than western demand.

In Goldman’s opinion, in fact, it’s western oil economics which are currently preventing prices from reaching the equilibrium point (or choke price) which would restore things like Opec spare capacity and reduce market tightness:

However, this is resulting in a crude oil price too low relative to current market supply-demand balances, leading to a draw on inventories to exceptionally low levels. Should economic growth surprise to the upside, the market risks running into increasingly pressing supply constraints in 2012. Like Odysseus, the oil market is currently running on Scylla wishing avoid Charybdis.

Essentially, until prices rise, the rest of the world will keep lapping up oil which in their eyes is being produced at far too attractive a price to resist. Furthermore, until the curve returns to contango, crude oil producers will continue to willingly sell at what are clearly “below fair value” prices.

That said, Goldman doesn’t really mention what would happen if emerging market demand was to suddenly fall alongside western demand. The answer, however, is probably obvious.

For more of the note, check out the Long Room.

FT