Why Oil Prices Are Plunging Despite Falling Inventories

Crude oil inventories have fallen below the five-year average for the first time this year.

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- Normally, U.S. inventories and oil prices have a strong inverse relationship.

- Currently, crude inventories are drawing, but oil futures seeing little support.

- Standard Chartered OPEC+ cuts will eventually eliminate the surplus that had built up in the global oil markets.

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Oil prices have lately lost their forward momentum, with both Brent and WTI crude plunging this week. A rather puzzling trend is being observed in the oil markets: there’s a big disconnect between inventory data and oil prices.

Crude oil inventories have fallen below the five-year average for the first time this year. Last week, implied gasoline demand rose by 992 thousand barrels per day (kb/d) w/w to a 15-month high of 9.511mb/d, taking the month-to-date y/y increase. Despite this positive inventory data, WTI prices have declined from $83.26 per barrel on April 12 to $68.85 on May 3 while Brent prices have declined from $87.33 to $72.54 per barrel over the timeframe.

Normally, U.S. inventories and oil prices have a strong inverse relationship, with falling inventories pushing prices higher while rising inventories have the opposite effect. However, large inventory draws over the past couple of weeks have failed to prevent significant price falls. As commodity analysts at Standard Chartered have noted, these dislocations tend to be temporary and come at times when prices are moved primarily by other oil market fundamentals, expectations, broader asset markets and financial flows. In this case, recent optimism regarding OPEC+ production cuts has failed to counter worries about demand linked to a weakening economic backdrop and a hawkish Federal Reserve leading to oil prices remaining range-bound. Further, there are reports that Russian crude shipments remain strong despite sanctions and embargoes: Reuters reported April oil loadings from Russia's western ports are on track to reach their highest since 2019 at more than 2.4M bbl/day.

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Source: Standard Chartered Research

Thankfully, a cross-section of Wall Street still thinks the energy sector remains good for the long haul.

Goldman Sachs has advised investors to buy energy and mining stocks, saying the two sectors are positioned to benefit from economic growth in China. GS’ commodities strategist has forecast that Brent and WTI crude oil will climb 23% and trade near $100 and $95 per barrel over the next 12 trading months, an outlook that supports their upside view for profits in the energy sector.

"Energy trades at a discounted valuation and remains our preferred cyclical overweight.We also recommend investors own mining stocks, which are levered to China growth through rising metals prices," the investment bank stated in a note to clients.

Indeed, energy stocks remain real cheap, both by absolute and historical standards.

The energy sector is the cheapest of all 11 U.S. market sectors, with a current PE ratio of 6.7. In comparison, the next cheapest sector is Basic Materials with a PE valuation of 10.6 while Financials is third cheapest at a PE value of 14.1 . For some perspective, the S&P 500 average PE ratio currently sits at 22.2. So, we can see that oil and gas stocks remain dirt cheap even after last year’s massive runup, thanks in large part to years of underperformance.

Rosenberg has analyzed PE ratios by energy stocks by looking at historical data since 1990 and found that, on average, the sector ranks in just its 27th percentile historically. In contrast, the S&P 500 sits in its 71st percentile despite last year’s deep selloff.

Even better, the outlook for the energy sector remains bright. According to a Moody's research report, industry earnings will stabilize overall in 2023, though they will come in slightly below levels reached in 2022.

The analysts note that commodity prices have declined from very high levels earlier in 2022, but have predicted that prices are likely to remain cyclically strong through 2023. This, combined with modest growth in volumes, will support strong cash flow generation for oil and gas producers. Moody’s estimates that the U.S. energy sector’s EBITDA for 2022 will clock in at $$623B but fall to $585B in 2023.

The analysts say that low capex, rising uncertainty about the expansion of future supplies and high geopolitical risk premium will, however, continue to support cyclically high oil prices.

In other words, there simply aren’t better places for people investing in the U.S. stock market to park their money if they are looking for serious earnings growth.

Market Deficit

But the biggest reason to be bullish about the sector is that the current oil surplus is likely to morph into a deficit as the quarters roll on.

Oil prices have only been treading water since the big initial gains from the shock announcement, with concerns regarding global demand and recession risks continuing to weigh down the oil markets. Indeed, oil prices have barely budged even after EIA data has shown that U.S. crude stockpiles have been falling while Saudi Arabia will hike its official selling prices for all oil sales to Asian customers starting May.

But StanChart has predicted that the OPEC+ cuts will eventually eliminate the surplus that had built up in the global oil markets. According to the analysts, a large oil surplus started building in late 2022 and spilled over into the first quarter of the current year. The analysts estimate that current oil inventories are 200 million barrels higher than at the start of 2022 and a good 268 million barrels higher than the June 2022 minimum.

However, they are now optimistic that the build over the past two quarters will be gone by November if cuts are maintained all year. In a slightly less bullish scenario, the same will be achieved by the end of the year if the current cuts are reversed around October.

By Alex Kimani for Oilprice.com - May 03, 2023