Massive Inventory Decline

Jim Brown
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WTI prices soared to more than $100 on Wednesday as a result of a massive decline in crude inventories and the impending military takeover in Egypt. For a low volume trading week the news flow was huge.

Crude inventories declined -10.3 million barrels last week to 383.8 million barrels. The massive decline was caused by two factors. The first was a jump of +2% in refinery utilization to 92.2%. This compares to just 86% utilization just six weeks ago. Refiners shifted into high gear ahead of the July 4th holiday period in order to fill the sales channel with enough gasoline and diesel to accommodate the increase in holiday driving.

Gasoline inventories fell by -2.4 million barrels and distillates declined b -1.7 million. The decline in refined products when the refiners are sharply increasing production suggests retailers were drawing down supplies in anticipation of the holiday.

In the greater scheme of things the oil inventories are held at the refiners and in the pipelines of producers, storage companies, oil depots, etc. Gasoline and diesel are held either at the refinery, in the pipelines or at wholesale distribution centers. The gasoline in tanks at your service station is not counted in the weekly inventories.

In advance of a big driving holiday the retailers order more gasoline to top off their tanks. This gasoline is delivered by a tanker truck from a wholesaler storage tank. The tank is refilled from the pipeline from the refiner. When all the retailers suddenly order a couple thousand extra gallons of fuel it ripples all the way up the system to the refiners.

The refiners are pushing refined fuels into the storage and pipeline system as fast as they can but that system is gushing fuel at the distributor end.

The sudden surge in demand and refinery utilization will only last another week. Once past the holiday everything will return to normal and utilization decline back to the 90% range or less.

The second factor impacting the big decline in crude inventories was a sharp drop in imports. Crude oil imports declined by -891,000 bpd or 6.237 million barrels for the week. Apparently several VLCC tankers were delayed at some point in the transportation and delivery process. We import on average about 7.85 mbpd. Over the prior two weeks that spiked to 8.37 mbpd. Last week imports declined to 7.41 mbpd. The sharp decline in imports coupled with the sharp increase in refinery utilization were to blame for the unexpected decline in inventories.

The restart of the 413,000 bpd BP refinery in Whiting, Indiana also helped to boost the refinery utilization rate and demand for crude oil. The refinery has been offline for weeks as the coking and hydro-treating units were upgraded.

Gasoline demand surged to 9.29 mbpd from 8.89. Diesel demand rose to 4.45 mbpd from 3.89. Both of those numbers are strictly related to anticipation orders ahead of the holiday. Those numbers were also multi-month highs.

(Inventory Snapshot guide: Green squares are multiyear highs. Yellow is multiyear low. Orange is multi month high. Pink is multi-week highs. The number of active gas rigs at 350 is an 18 year low. Oil rigs at 1,412 is an eight-month high. Crude oil at 397.6 mb is the highest since 1931.)

Inventory Snapshot

Note that the decline in crude inventories corresponded exactly to the normal historical trend.

Crude Oil Inventory Chart

Gasoline Inventory Chart

Distillate Inventory Chart

The hurricane map is starting to show some activity. The yellow circle is a storm front that has only about a 10% chance of turning into a tropical storm. It should remain a localized area of heavy rain and moderate winds as it progresses towards Louisiana over the next 48 hours.

The red circle is a rapidly organizing front that has slightly better than a 30% chance of generating cyclonic activity over the next 48 hours. It is currently moving west at 20-25 mph. We will know by Wednesday if it turns cyclonic and increases in intensity as it approaches the Caribbean.

The National Weather Service is expecting a 70% probability of 13-20 named storms with 7-11 developing into hurricanes. There have been two named storms in the Atlantic so far this season and neither caused any trouble. (Andrea and Barry)

We have not had an active summer hurricane season in the Gulf of Mexico since Katrina and Rita in 2005. There have been storms but none that were nearly as strong or damaging. Sandy in 2012 was severe but hit in the Northeast and not in the Gulf oil patch. Most storms in 2012 went to the Northeast and stayed offshore in the Atlantic.

Needless to say we are due for another powerful Gulf storm.

Hurricane Outlook Map

The Gulf of Mexico is important to our growing supply of oil. Baker Hughes reported last week the rig count in the Gulf hit 57 active rigs and a four-year high. The last time there were 57 rigs in the gulf in February 2009, 54 were drilling for gas. Last week only 14 Gulf rigs were looking for gas. The 43 rigs looking for oil is the highest oil count since March 2001.

Baker Hughes also said the onshore rig count rose by +9 to 1,757. Active gas rigs rose by +2 to 355 and oil rigs rose by +5 to 1395. Two additional rigs were listed as miscellaneous.

Brent crude prices are not rising as fast as WTI because of more supply coming online in the Middle East and Northern Africa. South Sudan resumed crude exports in June after a 17-month halt as Sudan and South Sudan squabbled about borders, pipeline transit and rebel backing. The Dar Blend from South Sudan is a heavy sweet crude favored by Asian refiners for its ability to produce diesel and other products besides gasoline. The sulfur content is only .12% but the gravity is 26.42 making it one of the heavier crudes. Anything with a gravity under 30 is considered heavy.

Dar Blend exports from South Sudan are expected to double from June's rate of 2.2 mbpd to more than 4.0 mbpd as production ramps up. China and South Korea already committed to buy multiple cargoes from South Sudan. The pipeline restart and the addition of the heavy sweet crude into the market forced the similar crude from Australia to 18 month lows. The medium sweet crude market had been strong while Sudan's crude was off the market. Now the medium sweet products will have to be discounted significantly to compete with the heavy product. The Dar Blend sells at a $10 discount to Brent. The medium sweet products had been in use for power generation in Japan as a filler for the lack of nuclear power. Japan has been moving to burn more coal as a cheaper alternative and that is putting additional pressure on the medium grades of oil.

Australia's Vincent field will restart in September adding 1.5 mbpd to the global supply. This heavy sweet oil can also be used for power generation and that will further pressure Brent prices and the oil grades indexed to Brent. The Australian oil is currently trading at a $6 discount to Brent and that is the lowest in 18 months. In the past, when China and Europe were going strong the buyer of Australian crude paid as much as a $7 per barrel premium.

The shrinking spread between WTI and Brent is soon going to be causing problems for U.S. refiners. When the spread was high in the $15-$20 range over the past several years the coastal refiners began buying rail cars and committing to large amounts of crude from the various shale fields. They could buy the oil $15-$20 cheaper than Brent, spend $5 to ship it, convert it to gasoline and sell it at the Brent prices everyone else was getting. This was a bonanza for the enterprising refiners. As the spread shrinks it is becoming less of a bargain and more of a hassle. A train derailed this week and spilled a lot of oil creating fires and explosions.

If it costs them $5 a barrel to ship oil from the Bakken, Permian or similar fields then a WTI_Brent spread of $3 means they are losing money compared to buying a tanker of water borne crude. This means those rail cars could be sidelined and the railroads are going to take a significant hit from the lack of transportation. However, the oil producers in the shale fields don't have enough pipeline takeaway capacity to handle all the production so they have to ship most of it by rail. This means the refiners are going to force a steep discount on them to make up for the rail cost. Producers will have more options by the end of 2014 when several more pipelines are completed and they can ship to the Gulf. Refiners and producers will have to stay sharp to make sure they are on top of this ever changing game.

WTI crude prices rocketed to $103 on the Egyptian news. However, once those headlines begin to calm the price should tumble back to earth. As reported above there is about 5.7 mbpd of oil coming back online after being out of production for many months. This is going to produce a supply ripple as buyers drop the replacement grades and go back to their preferred suppliers. This should push Brent back close to $100 and WTI could drop back to the low $90s.

WTI Chart

Linn Energy (LINE) imploded last week after it disclosed the SEC had begun an investigation into its accounting practices. Linn is in the process of buying Berry Petroleum (BRY) for $2.5 billion in stock and the assumption of Berry's debt. Linn is organized as a MLP and paid a rich 6% dividend. Numerous questions had been raised in the past as Linn continued to add debt and issue shares to raise money while it kept its dividend payments high.

After the disclosure about the SEC the proverbial dam burst and armchair accountants all over the net are dissecting Linn financials and finding serious cause for concern in their accounting practices. The Berry acquisition could be in jeopardy and Linn's MLP status could also be at risk. Linn shares Linn Energy Chart


Historically the first week in July is typically bullish and that seasonal pattern played out as expected last week. Typically the markets ease higher into Q2 earnings and then fade into August and September where new lows are a routine event.

Crude prices typically decline in August-September and then rebound in the fall as winter heating oil demand increases. Investors should wait for the normal end of summer weakness to add long positions.

Jim Brown

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