Global petroleum stocks have fallen by almost 600 million barrels since May 2020, after rising by over 1.2 billion barrels in the previous five months as a result of the epidemic and lockdowns.
Stocks are expected to decline by a further 140 million barrels over the rest of the year, according to estimates prepared last month by the U.S. Energy Information Administration (“Short-term energy outlook”, EIA, Jan. 12).
Inventories are likely to end 2021 several hundred million barrels above the level at the end of 2019, before coronavirus struck, but that was a relatively tight baseline against which to measure stock levels.
The expected production shortfall in the rest of this year, and inventory draw down, has already been reflected in the sharp rise in front-month futures prices and the shift in calendar spreads into a significant backwardation.
Brent prices have climbed by almost $20 barrel (50%) since the announcement of the first successful coronavirus vaccine trial at the start of November, to the highest level for almost a year.
And Brent’s six-month calendar spread has swung into a backwardation of more than $2.20 per barrel (the 80th percentile for all trading days since 1990) from a contango of $2.50 (which was only the 18th percentile).
The spread is at its tightest since January 2020, before the epidemic and the Saudi-Russian volume war sent the oil industry into a slump.
The rapid escalation in spot prices and tightening in spreads is consistent with a market climbing towards a cyclical peak, and signalling the need for more output to relieve expected future shortfalls.
PRODUCTION RAMP UP
Oil producers have already started to respond to the rise in prices, albeit it cautiously and from a low base, by increasing exploration expenditure and drilling programmes, especially in the United States.
The number of rigs drilling for oil in the United States has increased by 123 (72%) in a little over five months, according to oilfield services firm Baker Hughes.
The rig count is still down by around 380 compared with the same period last year, but it is trending steadily upwards, with increases in 18 out of the last 19 weeks.
Experience suggests the rig count responds to price changes with an average lag of 4-6 months, which allows for delays in decision-making, contracting and moving equipment to the well site and setting it up.
The rise in the rig count so far mostly reflects rising prices during the second and third quarters of 2020, as they bounced back from lows in April and May 2020.
The more recent price surge since November is expected to keep the rig count climbing throughout the first and second quarters of 2021.
There is normally an additional delay of six to nine months from the moment when rigs start to drill to the point where new wells begin to flow commercially, so output is likely to increase through the rest of the year.
U.S. oil production is expected to hit a cyclical low this month, stabilise, and then increase gradually in the second half of 2021 and throughout 2022.
Last month, the EIA forecast U.S. domestic production would increase by nearly 800,000 barrels per day (bpd) between February 2021 and December 2022.
But the continued upward pressure on prices and calendar spreads implies traders do not think the anticipated increase in U.S. production will be enough to meet increased consumption and inventories.
SPOTLIGHT ON OPEC+
Escalating prices signal the need for a significantly faster ramp-up in U.S. production, or an increase in output from OPEC members and their partners in the expanded OPEC+ group.
In the last decade, whenever real Brent prices have been at $60 or higher, shale producers have increased their output to fill the production-consumption gap, capturing market share from OPEC.
Last year, when prices and spreads were close to current levels, Russia and Saudi Arabia fell out over production policy, triggering an ill-timed volume war in March and April, just as the epidemic reached its first peak.
Russia pushed for output increases to protect market share, while Saudia Arabia pressed to continue restricting output in the hope of pushing prices higher.
The market is now back to the same critical price and spread threshold where divisions over strategy are likely to re-emerge.
