OECD industry stocks fell by 1.5 mbpd between the end of October 2002 and the end of January 2003, leaving forward stock cover at just 51 days, equal to the record low reached at the end of 1999. Crude markets have been in almost continuous backwardation since June last year and wide prompt premiums have been signalling a serious shortage of oil during the first quarter. The current low level of inventories is due to a series of events -some foreseen, some unforeseen - which have cut supply and boosted demand within a short time span. Opec production ceilings, hurricanes in the US Gulf coast,a strike in Venezuela and an unusually cold winter in the US all contributed to the run-down in stocks. Additionally, the expectation of military action in Iraq must have prompted some precautionary downstream stockbuilding.
Companies hold oil for logistical reasons and as a buffer against seasonal fluctuations in demand,as well as more severe disruptions to supply. Even when supply appears plentiful stocks can quickly be depleted by an unexpected stoppage. Refiners cannot draw down stocks indefinitely, for a minimum volume of oil is needed to allow them to operate efficiently and to meet contractual obligations for delivery. Once this minimum operating level is breached, the industry risks suffering considerably from local supply disruptions and shortages. US crude inventories were very close to this minimum level for most of the first quarter of 2003.
Desired stock levels change over time as refiners’ perceptions of the oil market and the risks they face change. Over the last 20 years there has been a continuous decline in both inventory volumes and the level of forward cover they represent. The increasing role of futures markets, a build in government strategic stocks, rationalisation of refineries, and more efficient operational systems have all allowed refiners to hold lower inventories without significantly increasing their risks. Rising availabilities of short-haul crude have further encouraged US refiners to reduce their crude stockcover. However, Asian refiners have also cut their stockcover substantially, despite the widely-held belief that they tend to hold higher stocks than their Western counterparts because of their high dependence on Middle Eastern oil. In Europe, refiners have much less flexibility to reduce stocks due to the high proportion of the IEA and EU compulsory inventory requirement held in industry storage. Two-thirds of compulsory stocks are delegated to companies in Europe compared with one third in the US and Japan.
Futures and forward markets provide a useful insight into the role of stocks in the oil industry. There is an obvious inverse relationship between forward cover and the differential between first and second month futures prices, which allows us to identify the level of cover at which each market switches between backwardation and contango.The existence of these cut-off levels, which trigger reversals in the forward price spread,is important for two reasons. First, it shows the need for stocks to be maintained at a minimum level and that this level has changed over time. Secondly, it shows why futures markets can spend long periods in backwardation or contango that are unrelated to seasonal stock changes. A desired stock curve for the US heating oil market illustrates a clear shift into contango whenever forward cover moves above 40 days. The same curve also shows that while the level of contango is limited by the costs of storage, there is apparently no such restriction on the level of backwardation, which rises sharply once the minimum operating level is breached.