Prepare for the Great Inventory Liquidation

Oil prices are on a one-way escalator up according to most pundits surveyed during International Energy Week in London. Surging demand in China will lift demand while sanctions imposed on Russian exports will be ineffective. Optimism prevails, but inventories are ignored in the hoopla. Yet more than one commodity price bubble has been broken by inventory liquidation. Today, rising interest rates, structural change in the oil market and the willingness of consuming nations to intervene in oil markets will likely cause a significant liquidation of stocks over the next year. In the past, such liquidations have been followed by large price declines. 

At the beginning of IE Week, Bloomberg’s Alex Longley and Grant Smith suggested that the hottest topic would be whether oil prices are gearing up for a major rally. Vitol’s CEO also told Bloomberg TV that “the prospect of higher prices in the second half of the year, in the sort of $90-$100 range, is a real possibility” on the first day of IE Week.

Missing from all the talks and presentations, however, was any discussion of the coming inventory liquidation. Major stock reductions are in the offing, but they are not anticipated by the industry or its followers. The causes — including the psychological effect of market interventions by International Energy Agency countries, higher interest rates, and the new dominance of independent refiners with no affiliation to crude producers, as well as the G7 price cap on Russian oil — have been ignored. Thus many will be shocked as commercial firms make radical inventory cuts. These cuts could depress prices by 20%-40% from current levels unless Opec reacts by decreasing its production substantially.

Inventory Economics

The looming liquidation will come as a shock because most who trade oil, manage oil companies, lead trading companies, or write on the subject, have probably not studied the economics of inventory behavior or read Storage and Commodity Markets by Professors Jeffrey C. Williams and Brian D. Wright.

Using extensive data and complicated mathematics, Williams and Wright show that the existence of strategic commodity inventories can cause private companies to reduce stocks. The book is important, but out of reach for anyone not familiar with advanced mathematics. In an early paper I commissioned while teaching at Yale in 1980 they showed that private oil inventories might decline by a third of a barrel for every barrel added to strategic reserves.

Williams-Wright completed their study in 1990. Little has been written since. Over time, the “displacement” impact of strategic stocks withered because governments refused to dip into them when prices rose following crises such as Libya’s 2011 collapse. In the past, most traders and oil companies likely determined the amounts of oil they would hold based on their internal needs. At times, the presence of low interest rates would encourage firms to boost stocks if supplies were in question.

Williams-Wright also emphasize the cost of storage in their research. Discretionary stocks decline when storage costs rise. Interest rates, which measure the cost of money, are a clear determinant of storage costs.

Money-Market Amnesia

Both the psychological impact of strategic stocks on levels of private stocks as well the cost of money have been ignored in most recent analyses of oil market trends. The failure of governments to use strategic stocks caused forecasters to forget about possible impacts, while the prolonged period of very low interest rates lead to what might be termed money-market amnesia.

The 2022 decision to release substantial volumes from strategic oil stocks, combined with the central banks’ aggressive interest rate hikes, has altered how firms view and manage inventories. A year ago, a trader or oil company would calculate the incremental cost of storing an additional barrel for three months to be less than 10¢ per barrel. Banks were also eager to lend. Today, the per-barrel storage cost exceeds $1 thanks to the Federal Reserve and European Central Bank, and lenders are scrutinizing credit requests. Soon, the storage cost could exceed $1.50/bbl. Both factors discourage stock accumulations.

In addition, before 2022, most firms believed they were on their own and would need to pay the piper for oil supplies in a disruption. Today, these firms understand that government stocks are available to moderate supply interruptions and so will cut discretionary stocks. Traders at these firms as well as at companies such as Vitol are also now keenly aware that interest rates are rising.

Structural Change

The sales and divestitures of refining assets by the integrated companies will probably lead to an even larger inventory liquidation than would have been observed during the last period of high interest rates, 40 years ago. Williams and Wright wrote about the behavior of an integrated industry in 1980. At that time, the oil inventories held by most companies came from their own wells. Little cash passed from buyers to sellers as the crude moved into tanks. Things are much different today. Most refineries are not owned by crude producers and must pay cash for oil added to stocks. These firms will limit their crude purchases.

Marketers who buy products from the refiners will also limit purchases as interest rates rise. Reductions in their purchases will depress product inventories and crude runs.

The G7 cap on Russian oil prices will also discourage stock holdings. Refiners and marketers in Europe, North America and OECD Asian nations will worry that their competitors in India and China will take advantage of lower priced crude and products from Russia to boost production and dump products into their markets. Caution due to this threat will discourage stockbuilding.

Energy Intelligence's Dinakar Sethuraman made this point on Mar. 1 when he wrote that Indian refiners are boosting runs using discounted Russian crude. He noted that “private-sector refiners have been buying cheap Russian crude and converting it into high-value diesel, before exporting it to Europe.”

Given the change in industry structure and the willingness of governments to step in to meet shortages, we must expect to see commercial stocks decline sharply. The great inventory liquidation has begun. Do not be surprised if global commercial stocks are down by 400 million barrels by the end of 2023.

Many will doubt such a large reduction in stocks could be feasible. However, Energy Intelligence data on global commercial stocks and projected levels of consumption make clear such a reduction is both possible and in line with historical trends. The chart below shows data on global commercial inventories and days of supply calculated from this data on total product demand. Energy Intelligence’s forecast of global total product demand for the remainder of 2023 is then used to calculate days of supply assuming a 400 million bbl stock liquidation.

This calculation exercise demonstrates that such a reduction in stocks is possible. Indeed, a stock drawdown of 400 million bbl would not even return days of supply of commercial stocks to the 2012 or 2008 lows. The data make clear markets must prepare for a large liquidation of stocks.

Philip Verleger is an economist who has written about energy markets for over 40 years. A graduate of MIT, he has served two presidents, taught at Yale and helped develop energy commodity markets since 1980. Kim Pederson is editorial director of PKVerleger LLC. The views expressed in this article are those of the author.