Energy Prospectus

Comments below are from Jon Costello, an energy sector analyst at HFI Research. My comments in blue.

I’ve been investing in the energy sector since 2009, and I’ve never witnessed the kind of divergence that exists in today’s market. In short, the historical relationship between oil prices and global inventory levels has broken down to an extent I’ve never seen.

Oil prices have always exhibited a strong inverse correlation with oil inventory levels. Steadily growing inventories indicate that oil supply outstrips demand. Higher inventories imply more slack in the market. The converse is also true. Inventory declines indicate that supply is lower than demand.

Charts that plot oil prices versus inventory levels over time show a price line and an inventory line that are essentially mirror images of one another. Today, the mirror image has disappeared as both inventories and prices head lower. We're now at the point where global inventories are far too low for current oil prices.

What Is WTI’s “Fair Value” Today? < I call it the "Right Price"

Today’s divergence is far greater, longer lasting, and more persistent than anything I’ve experienced. < I think there is a False Paradigm in the market that the U.S. and/or OPEC+ can ramp up supply to meet demand quickly. The global oil market is NOT a "Just in Time" supply chain. U.S. oil production is flat and "Drill Baby Drill" cannot ramp up production quickly. OPEC+ may have more supply available, but even they would need several months to increase exports by more than a million bpd.

To determine its magnitude, we can reference the work of various analysts who have developed regression models to estimate the current “fair value” of WTI or Brent. Michael Rothman at Cornerstone Analytics, for instance, has a particularly good one.

On X, the account handle @UndervaluedOnG publishes the results of a similar regression analysis after weekly U.S. inventory reports. The price-to-inventory data has an 87% fit. The theoretical maximum 100%, so this model does a good job correlating the two variables. Its output is typically in the ballpark with other models I’ve seen.

Now, there’s a lot going on in the currnet chart, but suffice it to say that it estimates WTI’s “fair value” to be approximately $85 per barrel as of November 6. < This why I often say the "Right Price" for WTI is within the range of $75 to $85 and why I believe my 2025 forecasts are conservative by using $75/bbl for 2025.

Bottomline: WTI closed today’s trading session at $70.41 per barrel. Based on the modeled “fair value” estimate, WTI has nearly 21% upside from its current price.

More from Jon Costello:

Implications for the Oil Market
Trying to tease out the reasons why prices are so disconnected from inventories is so complicated as to be an exercise in futility. But we know enough to be highly confident that prices are seriously out of whack with fundamentals.

There are several implications of this fact.

First, we can state with confidence that there is no geopolitical premium in the oil price. In fact, one can argue that there exists a massive geopolitical discount.” Of course, this makes no sense given the hostilities underway in the Middle East and the non-zero chance that a mistake made by, say, the Houthis or some other aggressor group disrupts supply.

Another implication is that the current pricing is acting as a de facto price control. It’s an established principle of economics that when prices are kept too low, shortages emerge. Severe shortages create the potential for a price spike. With regard to today’s oil market, we can infer that if prices remain too low, inventories will be drawn down to the minimum levels at which refineries can operate. At that point, prices will surge higher.

If oil prices are held down for too long, a price spike is only a matter of time, though the comeuppance could be a long time coming. However, we’re seeing a key step in the process, namely, surging refinery margins, which occurred again today despite the ugly price action.

Another implication is that the lack of price response to supply and demand developments creates havoc for fundamental-based traders. Consequently, many—if not most—of significant size have exited the oil market.

In their absence, momentum-based algorithmic programs now dominate oil futures trading. A market increasingly dominated by momentum traders distorts the price discovery process. A distorted price discovery process forces even more fundamental-based traders out of the market, which causes more severe distortions, and so on. Prices are left to drift higher or lower with little fundamental justification.

This is not how markets are “supposed” to work. In the end, it’s bad for capital allocation and the long-term health of the market.
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MY TAKE: The oil supply chain is one of the most important supply chains in the world; right up there with the food supply chain. September/October is the lowest demand period of the year for oil-based fuels. During the winter demand for heating oil ramps up and U.S. heating oil supplies are almost 10% below normal. In the spring demand for diesel ramps up, followed quickly by a spike in gasoline demand starting in May.
Our Sweet 16 companies are profitable at $70 WTI and $2.50 HH natural gas, but they will not ramp up drilling programs until oil & gas prices move back to the "Right Price" levels.
The "Paper Traders" can keep the oil price low for a while, but supply/demand fundamentals eventually determine where the oil price goes.