HardAssetsInvestor

Written by Sumit Roy  |

August 15, 2012

Brent Surging Toward $120 As US Inventories Plunge, But WTI Will Outperform

Details

A big decline in U.S. oil inventories helps keep the oil rally alive.

The Department of Energy reported this morning that in the week ending Aug. 10, U.S. crude oil inventories decreased by 3.7 million barrels, gasoline inventories decreased by 2.4 million barrels, distillate inventories increased by 0.7 million barrels and total petroleum inventories decreased by 4.6 million barrels.

Crude oil prices surged after the latest inventory figures. Brent topped $116, while WTI rallied to just below $95.

BRENT

WTI

The spread between the two benchmarks is close to $22 amid concerns that the U.S. Midwest will face a glut of crude oil when refineries shut down for maintenance this fall. However, as we wrote last week, the spread is at the top end of the recent range and is more likely to decrease than increase over the medium term.

Inflection points are difficult to predict for such a volatile measure, but with takeaway capacity out of the Midwest growing through increased rail capacity and pipeline expansions, it’s a high probability that the spread will be much lower than current levels by the end of the year.

Taking a look at broader oil market fundamentals, the rally in Brent prices clearly indicates a tightening market, and U.S. inventory movements paint the same picture.

The market is dependent on extremely elevated levels of production from OPEC, a source of supply that can be manipulated easily by Gulf members such as Saudi Arabia. Moreover, elevated output has translated into depressed levels of OPEC spare capacity—the amount of crude oil that the cartel can put onto the market in the case of a disruption.

In the IEA’s latest oil market report, it said that OPEC’s effective spare capacity was 2.58 mmbbl/d.

The agency has a global demand growth forecast of 0.8 mmbbl/d for 2013, which may prove conservative if economic growth surprises to the upside, either organically or thanks to central bank stimulus.

Non-OPEC supply is expected to fall just short of overall demand growth. The IEA sees producers outside of the cartel growing their output by 0.7 mmbbl/d in 2013 after growth of 0.5 mmbbl/d this year. However, the agency has consistently overestimated non-OPEC supply growth and thus that figure is likely to be revised lower.The difference between demand growth and non-OPEC supply growth has to be made up by OPEC producers.

In our view, the oil market’s dependency on OPEC and the cartel’s low levels of spare capacity will keep oil prices elevated. Our next objective for Brent is $120, with a break exposing $127—which we see as the high end of the medium-term range.