Demand Rising, Inventories Dropping

Jim Brown
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Unfortunately it is not just demand that is pushing inventories lower. There is a far more mundane reason at work here.

China reported on Friday that oil demand in October rose by +11.8% from year ago levels. That equates to 8.95 million barrels per day and well over the average for the first ten months of the year at 8.57 mbpd. That average is also up +10.4% over 2009 levels.

Chinese refiners processed 8.76 mbpd on average in October. This is a historic high and +11.3% higher than 2009. During September China added five million barrels to storage but according to Platts they should have used three million of those barrels in the October period. Refiners produced at an all time high in October and imports spiked a whopping 36% from the prior month.

It is clear that China's demand is growing rapidly but they are still faced with severe shortages because of government controls on prices. Sinopec and Petrochina, the biggest refiners in China produced diesel at breakneck speed in October but it was not enough. Both companies ordered imports of 200,000 tonnes of diesel to offset shortages.

The diesel shortage was blamed on hoarding, seasonal factors, transportation delays and energy-saving measures. Tens of thousands of Chinese businesses have backup diesel generators to cope with the continual brownouts in China's energy grid. Secondly China is on this insane push to save electricity by simply turning it off during high usage periods. Companies that want to continue in operation have to rely on backup generators powered by diesel. The power saving program is a five-year program that is set to end this year. In theory China will return to whatever they consider normal in 2011. Meanwhile companies have been stocking up on diesel to keep their generators fueled as cold weather descends on the country.

I reported last week about the severe shortage of diesel for drivers and lines 8 hours long at service stations. I can't imagine how much faster the Chinese economy would grow without all this useless hardship levied on their citizens by their communist leaders.

The first major winter cold front hit China this weekend with temperature drops of as much as 14 degrees Celsius. (25 F) Snow and sleet fell for the first time this year in the northern regions.

In the U.S. crude oil production averaged 5.5 mbpd in October and a record for the month. The growth in production has come mainly from the Bakken shale and the Eagle Ford shale. The U.S. rig count rose to 1,668 and +13 more than September. October 2009 only had 1,044 rigs in operation. That 1,668 number if 65% higher than in 2009.

The API report showed diesel fuel demand in the U.S. increased by 8.4% over October 2009. Average diesel demand was 3.19 mbpd in October. The first ten-month average was 2.97 mbpd so demand is definitely improving. Distillate demand rose +4% in October. That includes jet fuel and heating oil. Demand for jet fuel alone rose +17% to 1.6 mbpd, up from 1.45 mbpd. Deliveries of all refined products rose +1.3% to 19.0 mbpd. As you know crude supplies declined sharply over the last two weeks by as much as 14 million barrels according to the API and 10 million according to the EIA. What could have caused this drop?

Actually we know what caused the drop. Year-end tax season is coming. Refiners want to get rid of as much oil as possible so they don't have to pay year-end taxes on the high priced black gold. Having an extra five million barrels of $82 crude in inventory could cost you a fortune. That much oil is worth just slightly over $400 million and the property taxes on that much crude is not cheap. It makes more sense to let your inventory levels drop ahead of that December 31st deadline and then take delivery of replacement barrels in January.

This happens every year at this time and suggests we will probably see further declines in inventory levels in the weeks ahead.

Refiners use LIFO accounting. That stands for Last In, First Out. If they start the year with five million barrels of oil and a cost of $40 a barrel and add two million barrels throughout the year at say $80 a barrel then that extra 2MB is valued at the Dec 31st price. If however, they let the inventories decline to the same level that started the year then the existing oil is considered the old oil and still valued at $40 per barrel. The last barrels added to inventory are considered the first barrels used. In theory if you inventoried plywood in 4x8 sheets and you started the pile with $10 per sheet wood and then added $12 a sheet and $15 a sheet as times passed and prices increased you could end up with the sheets on the top costing $20. When you sold wood you are not going to unload the entire stack just to get the $10 sheets on the bottom. Last on the pile, first off the pile. LIFO accounting.

So, refiners will try to reduce inventory to exactly where they started the year in order to avoid any higher taxes. That would require a decline of another 31 million barrels by December 31st according to the EIA. Refiners ended 2009 with 326 million barrels in storage and the EIA reported last Wednesday a total of 357 million barrels. Let's see how close they can get.

Jim Brown

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