If production does begin to taper over summer, it should be supportive for oil prices and could help deplete inventory levels.The spectacular rise in U.S. crude oil production and OPEC’s market-share response led to a collapse in oil prices (Figure 1). As crude oil inventories rose (Figure 2), market participants grabbed oil at lower prices and stored it in the hope of selling at higher prices in the future in a contango market. In addition, there has been strong demand for crude as refiners take advantage of high crack spreads and ramp up gasoline production ahead of the summer driving season (Figure 3). In response, the price of West Texas Intermediate (WTI) Crude is 30% above its lows in January and March. Given the soaring inventories, will oil prices collapse again after the peak summer demand? The answer may be in the hands of American drivers and their counterparts around the world.
Extremely high inventories are not a problem if they are to be consumed in fairly short order. Refinery demand for crude oil is rising due in part to the strong gasoline crack spread – the difference in price between gasoline and crude oil (Figure 3 shows gasoline prices relative to crude oil in dollars per barrel). Many of the holders of crude oil inventories may be hoping that the crack spread remains wide so that they can sell their oil to refineries at a decent price in the future. The evolution of the crack spread will depend, in part, on how much gasoline demand there is in the U.S. this summer.
Indeed, Americans have so far responded to the lower gasoline prices by driving more. According to the Federal Highway Administration, the number of miles driven has risen by about 2.3% year on year (Figure 4). That might not sound like much but it’s the fastest pace of increase since 2005. Moreover, the number of miles driven declined from 2007-2011 and is just now returning to peak levels (Figure 5).
Miles driven, of course, is just part of the story. Another major factor is the efficiency of vehicles. Gasoline consumption should be equal to the number of miles driven multiplied by the number of gallons used per mile. According to estimates from the Environmental Protection Agency based on a combination of city and highway driving, 2014 model year cars use 17% less fuel than their 2007 equivalents. 2014 model year trucks use 14.6% less fuel than their 2007 equivalents (Figure 6). If such efficiency gains continue, miles driven will have to rise by about 2.5% per year to offset the gains in efficiency and keep demand for gasoline stable.
After oil prices collapsed in 1985-1986, the efficiency gains made in the late 1970s and early 1980s came to an end as Americans increasingly opted for gas guzzlers in the late 1980s and 1990s. The same could happen again if gasoline prices remain low for an extended period of time, but this is unlikely to have much impact in the short term as vehicle fleets take a long time to turn over. That said, the efficiency gains in automobiles tapered off noticeably in 2013 and 2014.
As such, in order to support the price of oil in the face of such high levels of inventories, the number of miles driven may have to increase by about 4-5% year on year. One sign that the number of miles driven may continue to grow is the surging level of vehicle sales, which have returned to levels common from 1999 to 2007 (Figure 7). In the past twelve months some sixteen million Americans have invested in a new car or truck. Some of them might be more inclined to go on a road trip in their new vehicle this summer due to lower gasoline prices, which benefit owners of both new and old vehicles.
While we don’t know what will happen to the price of crude oil between now and year’s end, we know that oil inventories and miles driven will be key factors to watch. Energy markets pay close attention to the Department of Energy’s weekly inventory and production numbers but appear to focus less on data from the Federal Highway Administration, which might warrant more attention in the future.
Another factor to note is oil production. So far, despite plunging prices and drilling rig counts (Figure 8), the level of U.S. production continues to grow (Figure 9) and the year-on-year growth rate is only tapering off modestly (Figure 10). If production does begin to taper over summer, it should be supportive for oil prices and could help deplete inventory levels. But if production continues to surge, it will make it harder for the market to bear such high prices unless drivers really step up and drive further and faster than before. Either way, fasten your seatbelts as the oil markets might be in for another wild ride.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
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Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
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