(John Kemp is a Reuters market analyst. The views expressed are his own)
By John Kemp
LONDON, Sept 8 (Reuters) - U.S. oil markets have been transformed over the last decade by the emergence of oil trading and storage as a major business in its own right, separate from production and refinery operations.
At the end of 2014, there were more than 390 million barrels of crude stored at refineries and tank farms as well as in transit in pipelines and barges and in storage tanks at oilfields.
Commercial crude stockpiles had climbed by more than 100 million barrels since the end of 2004, almost 38 percent, according to annual data published by the U.S. Energy Information Administration (EIA).
By the end of April 2015, commercial stocks had climbed by another 105 million barrels to a record 491 million as the oversupply in the global oil market ended up at refineries and tank farms.
Even after a strong summer driving season, with U.S. refineries processing record amounts of crude into gasoline and other fuels, stockpiles remained at 455 million barrels at the end of August.
But the focus on rising inventories as a sign of the cyclical supply-demand imbalance has obscured deeper structural changes which have resulted in the industry holding higher stocks than a decade ago.
Some of the increase in stocks stems from operational requirements linked to the increase in domestic oil production, which means more crude stored in field tanks as well as in railroad tank cars and in pipelines on the way to refineries.
The amount of crude held at field facilities doubled from 16 million barrels at the end of 2004 to more than 32 million at the end of 2014, according to the EIA.
Most of the increase in lease stocks has occurred since 2009 and roughly corresponds to the 63 percent rise in domestic oil production over the same period.
Oil held in railroad tank cars, barges and transmission pipelines en route from field to refinery has also surged over the same period.
According to the EIA, the amount of oil in transit has risen by 22 million barrels, 30 percent, to 97 million since 2011, the earliest available records.
Unfortunately, there is no comparable data for earlier years, but the amount of oil in transit has almost certainly risen even more since 2004.
The futures markets are also providing incentives to store more crude in the form of a much wider and more consistent contango structure.
Before 2005, the U.S. oil futures market traded in backwardation about two-thirds of the time, and contango around one-third of the time.
From 2005 onwards, the position has reversed, with the market in contango almost 80 percent of the time and backwardated only 20 percent of the time.
Between 1984 and 2004, the average difference between first-month and third-month U.S. crude futures was 41 cents per barrel backwardation.
From 2005 to 2015, however, the average difference has swung to almost 99 cents contango (link.reuters.com/pyv55w).
Contango encourages marketers, traders and refiners to hold higher stocks since it helps cover the costs of storing and financing inventories through a “cash and carry” strategy.
There are various theories about why the term structure of the crude futures market appeared to change around 2005.
The structural break corresponds with increased interest in commodities as an asset class by pension funds and other institutional investors.
Greater participation by institutional investors and hedge funds resulted in crude oil futures becoming more “financialised”, according to some analysts.
The long-bias of financial participants has been blamed for pushing the market into a near-permanent contango.
Whatever the cause, the shift from backwardation to contango trading as the norm has coincided with a large increase in stockholding.
And the physical market has moved to accommodate an increased desire to hold stocks by building much more storage capacity.
The amount of on-site storage available at refineries has changed little and remains around 150 million barrels, compared with 156 million in 2004 and 164 million in 1994.
But the amount of storage available at tank farms, most of which is leased either long-term or short-term to traders, has surged.
Tank farm and underground storage capacity jumped to 391 million barrels in March 2015, from 307 million in March 2011, according to the EIA (“Working and net available shell storage capacity”, May 2015).
Unfortunately, 2011 is the earliest date for which comparable data is available, but it is likely tank farm capacity has grown even more substantially compared with 2004.
It is fruitless to speculate on which came first, higher stocks or the contango.
Did the operational need to hold higher levels of stocks at leases and in pipelines force the futures market into contango? Or did the emergence of a contango in the futures markets encourage more stockholding at tank farms? The answer is probably a combination of both operational requirements and financial factors.
Either way, the physical and financial markets have been transformed since around 2005, with higher physical stock levels and more contango trading.
The structural shift is clearly evident when stock levels are compared with the amount of crude processed by U.S. refineries every day.
Inventories are a cost for business because they tie up capital - unless they can be financed in a contango market through a cash and carry strategy.
Between 1985 and 2004, the amount of crude held in commercial stocks was reduced from about 26 days' worth of refinery consumption to just 18 days, as the industry embraced a lean inventories strategy (link.reuters.com/syv55w).
But from 2005 onwards, crude stockpiles have been steadily increasing and by the end of 2014 stood at 24 days, the highest level since 1992.
Extra inventories are being held at tank farms and on leases and in pipelines rather than at refineries. Some of the increase stems from operational requirements but some of it looks essentially financial in nature.
The structural shift to higher stockholding should prompt a reconsideration of what level of stocks the market considers “normal”.
Between July 2013 and August 2014, U.S. stocks ranged between 350 million and 400 million barrels. But the futures market mostly traded in a large and rare backwardation between the first month and the third month, implying that the level of inventories was uncomfortably low and there was demand to carry more.
Total stocks were near record highs in absolute terms. But once adjusted for increased lease stocks (16 million barrels), more oil in transit (at least 20 million barrels) and higher refining runs, they appear more moderate.
In simple terms, U.S. crude oil inventories were actually relatively low in the second half of 2013 and through the first half of 2014, and the first part of the stock build in 2015 restored them to more normal levels before overshooting (link.reuters.com/vyv55w).
If the physical U.S. oil market felt relatively tight in 2013 and 2014 when stocks were running at 350-400 million barrels, then the current stock level of 455 million barrels is not as excessive as some observers suggest.
There is no doubt that stockpiles were bloated when U.S. crude inventories hit 490 million barrels, but the market might feel balanced again with stocks well over 400 million.
Interestingly, the futures market is currently trading in a contango of around $1.18 between the first and third month, which is not much more than the 99 cents average since 2005.
The contango suggests the U.S. market is only moderately oversupplied and there is expected to be enough storage capacity available to accommodate inventories over the next few months.
More broadly, oil market observers need to update their assumptions about what constitutes “normal” stock levels to adjust for the operational and financial changes that have occurred since the onset of financialisation in 2005 and especially the rise in U.S. oil production since 2009. (Editing by Dale Hudson)