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Market View: Tank Tops and Game Theory

Perhaps for the first time in its history, the oil market is about to test storage capacity limits

Perhaps for the first time in its history, the oil market is about to test storage capacity limits, when production must be shut in because operators have run out of tanks and underground facilities to stick the oil in.

This development is happening at record speed, due to the combination of two powerful forces: an unprecedented plunge in demand due to the coronavirus, and a formidable supply surge following the breakdown of the Saudi-Russian production deal that had kept the market in balance for the last three years.

Game theory modeling by Kayrros founding partners Jean-Michel Lasry and Antoine Rostand, Fields Medal laureate Pierre-Louis Lions and Columbia University economist Jose Scheinkman clearly shows the inevitability of such periodic market rebalancing. Old market hands recall other times when the largest, lowest-cost producers — the “dominant monopoly” in game theory parlance — let prices off a cliff to regain market share and undermine their “competing fringe” of smaller, higher-cost players. Kayrros’ model of the oil market had shown for some time that the market was waiting for just the right shock to go into “cliff” mode. The coronavirus has provided such a shock. This is why the unraveling of the OPEC+ agreement did not come as a surprise and why we had cautioned at the time about its likelihood.

While the cycle is familiar, the steepness of the cliff is unprecedented. Because the coronavirus pandemic is presumably of limited duration, the world’s top producers have a narrow window of opportunity to leverage the collapse in demand and test storage limits. Hence the steepness of the supply surge, with Saudi Arabia pledging to boost supply from an estimated 9.5 Mb/d-9.7 Mb/d level in February to a March target of 12.3 Mb/d, an unprecedented high.

Just days after the OPEC meeting of March 6 that saw the unraveling of the Russian-Saudi deal, signs of stress in inventory capacity are already cropping up. Satellite imaging processed by Kayrros shows global crude stocks jumped nearly 60 million barrels over the last month, with the builds accelerating to a record 3 million barrels/day in the week ended March 15. Average capacity utilization now exceeds 62%, with maximum operational capacity pegged around 80%, or even less in practice. In more than a few locations tanks are getting full and traders are reportedly struggling to find available storage capacity.

Crude oil stocks in China, which has been hardest hit by Covid-19, have reached an all-time high of nearly 750 million barrels, up more than 50 million barrels in three weeks. Storage terminals in Shandong province, home to the so-called ‘teapots,’ the independent refineries that led the growth in Chinese crude demand of the last few years, are near tank-tops. At the largest facility in Shandong, two thirds of the tanks are full. In Qingdao, the province’s largest oil port, some facilities are nearly 90% full.

Remarkably, the stock buildup is not limited to consumer countries. Middle Eastern inventories are also surging. This is counter-intuitive, since one would have expected Saudi Arabia to draw on its own stocks to fulfill its pledge to dramatically ramp up supply: after all, field production cannot be switched on or off on a dime but takes weeks if not months of advance planning. OPEC countries typically use their storage capacity as buffer to manage shifts in production targets, drawing down stocks in case of increases and building them up in the event of supply cuts. Given the magnitude of the supply hike announced by Saudi Arabia on March 7, one would have expected at least part of the increase to come from storage. But Saudi stocks jumped by 5.6 Mb in the week after the OPEC meeting, helping lift Middle East crude inventories by nearly 2 Mb/d. Stocks also jumped by 3.4 Mb in Egypt, a transit country used by the Kingdom to ship crude to Europe. This dramatic build would suggest that the Kingdom was fully prepared to ramp up production in a hurry at the time of the OPEC meeting. It would also seem to undermine the prevailing view that the end of the OPEC+ deal came as a surprise to protagonists and that the Kingdom’s decision to boost supply was spur-of-the-moment, tit-for-tat escalation after Russia refused to partake in
production cuts.

Not all stocks are available to the market. Iranian stocks also rose in the week to March 15, up 3.44 Mb to an alltime record of nearly 60 Mb, led by gains at the country’s main terminals at Kharg Island and Assalouyeh, as the sanctions-hit producer struggles to find a market outlet for its crude in an impossibly crowded market.

While the breakup of the Saudi-Russian alliance has all the external signs of a conflict between the world’s two largest exporters, Kayrros’ game-theory model of the oil market suggests that both countries stand to benefit from the price war and have a shared interest in waging it. Not only have the unraveling of their alliance and the resulting price collapse dramatically shifted market expectations and forced their “competing fringe” to reconsider spending plans and slash operations. The imminent testing of storage capacity limits, an unprecedented development, is set to soon push prices further down and trigger actual production shut-ins. Both Russia and Saudi Arabia may have to dip into their financial reserves in the short run but will come out stronger producers as a result.

The price war will cause many casualties, not least within OPEC’s own ranks. Whether US shale industry will be wiped out is highly doubtful, though. Tight oil producers already weathered the 2014–2016 price collapse relatively unscathed, adapting to a lower-price environment through brutal efficiency gains. This time may be more difficult. Whatever low-hanging fruits there were in 2014 have already been picked. But the sector will undoubtedly adjust again, likely by accelerating a wave of restructuring and consolidation that was already under way before the OPEC breakdown. When the dust settles, the US might also come out stronger and look in some ways like the other
leaders of the “dominant monopoly,” Saudi Arabia and Russia.