I have written several times that the adverse effects of prohibitions and related enforcement are as much as 20 times worse than the problem itself. Today, we'll examine one of those adverse effects, the impact of the Price Cap on oil prices.
The bottom line for my busy readers is this: The Urals and ESPO discounts have motivated non-OECD buyers, notably the Chinese and Indians, to hoard as much Russian oil as possible. As a result, excess inventories -- those above routine daily needs -- are about 1 billion barrels in the non-OECD. As long as a discount remains, Asian buyers will continue to hoard cheap Russian oil. If the discount disappears, that oil will return to the market, likely capping Brent around $85 through 2024, and potentially driving it down as low as $65 / barrel at times.
One might be tempted to conclude that the Price Cap should be abandoned. This is the wrong read. The Price Cap needs to be restructured to fix the hoarding problem, while at the same time ensuring funds for Ukraine's war effort and reconstruction.
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Excess crude oil and refined product inventories are those above the quantity needed by the industry to ensure uninterrupted, regular business. The OECD countries ordinarily carry about 60 days of crude and refined product inventory as a share of consumption. For example, US oil consumption is about 20 mbpd (million barrels per day), and normal inventory is about 60 days of consumption, or 1.2 billion barrels. If we had 66 days of inventory, then we could say that 6 days, or 120 mb (million barrels) of that inventory is excess. If refiners and distributors are holding excess inventory, they will be motivated to liquidate such excess, typically by lowering prices -- the same as any other industry.
In the OECD, we know both the actual level of inventories and the volume to be expected based on normal turnover of 60 days. Excess inventory (or the deficit of inventory) is the difference between the reported inventories and the expected level assuming 60 days. Therefore, if the EIA reports 1.3 billion barrels of US inventory and we would anticipate 1.2 billion barrels based on 60 days of turnover, then we can say that the US has 100 mb of excess crude and product inventories.
The matter in the non-OECD is not quite as straight-forward, as non-OECD countries often report their inventory levels late, unreliably, or not at all. Therefore, we have to impute non-OECD inventory levels. During 2018-2019, oil markets were largely in balance and inventories were at historical averages in the OECD. We can assume that inventories were similarly balanced during this stretch in the non-OECD and use this as a baseline for subsequent changes. We can then adjust for subsequent builds or draws using EIA supply and demand data, deducting reported OECD inventories. The result can be seen on the graph below.
As the graph above shows, excess inventories soared with the start of the pandemic. Readers will recall that the world closed down and oil started piling up around the globe, with fears that available storage capacity would be swamped. As it turned out, oil companies rapidly began to reduce their production, but excess inventories still crested over 2 billion barrels in the spring of 2020. Thereafter, excess inventories were slowly worked off as operators withheld production and the global economy gradually recovered. By late 2021, excess OECD inventories had all but disappeared and excess non-OECD inventories were gradually declining. Had the war not occurred, excess non-OECD inventories would likely have dissipated by now.
However, with the start of the war, a huge discount opened up between Brent and the various Russian oil prices, incentivizing countries like India and China to load up on Russian oil. As a result, excess inventories started to balloon again, visible in the darker red color on the graph above. This was not the result of a mismatch between supply and demand fundamentals, but rather due to hoarding by purchasers of Russian crude. As long as the discount persists, purchasers of Russian crude will have an incentive to load up as much inventory as they can handle. In other words, the Price Cap is preventing excess inventories from returning to the market on a net basis. Previously purchased cheap Russian crude is processed to make gasoline and diesel, but inventories are immediately replenished with new, discounted Russian crude. The result is about 1 billion barrels of excess crude and refined products stored in non-OECD countries.
If the Urals and ESPO discount disappeared, holders of cheap Russian crude would have an incentive to run their inventories back to normal levels. That is, about 1 billion barrels of excess inventory would find its way back to the market over a period of 2-3 years. This implies a draw of 1-1.5 mbpd of crude and products from inventory, which is a lot. This would depress oil prices.
Moreover, excess inventories exert strict discipline on the market. Such inventories will be stored, ready for use, in tanks conveniently located near ports and rail terminals. They can be dumped quickly on markets in almost unlimited quantities if the price is right. Therefore, as long as such inventories last, they would cap oil prices, likely limiting Brent to around $85 / barrel through 2024, with the potential to push it all the way down to $65 at times.
Today, oil demand is running well ahead of supply, pushing oil prices up and putting sufficient pressure on the Biden administration to prompt the U.S. Department of Energy, as Reuters notes, to approach oil producers and refiners to ensure stable fuel supplies at a time of rising gasoline prices. Notwithstanding, the non-OECD has an absolute ocean of excess inventory, available if the Urals and ESPO discounts dissipate, or more precisely, are properly restructured.
As I have noted before, we need to reform the Price Cap to bring it into conformity with both theory and historically successful practice. One benefit will be lower pump prices to US and European consumers.