London, 24 January 2011

No question in the oil market is more important than what happened to all the barrels of crude turned away from the U.S. Gulf Coast during November and December 2010 for tax reasons. Some were simply deferred until after year-end. Others may have been diverted to the fast-growing but underreported economies of China and the rest of Asia.

If they were simply added to unrecorded stocks then the supply-demand balance remains comfortable. But if they were consumed, the market is tightening with alarming speed and prices will surge unless Saudi Arabia boosts output.

PADD III MISPLACES 18 MILLION BARRELS

Commercial crude stocks held in Texas, Louisiana and the other states along the Gulf Coast in PADD III fell by a massive 30.7 million barrels in November and December, according to weekly estimates published by the Energy Information Administration ( EIA), the statistical arm of the U.S. Department of Energy.

Only a small fraction of the draw was due to higher consumption at refineries. Net crude inputs into PADD III refineries were just 140,000 barrels per day (bpd) higher in Nov-Dec than they had been in Sep-Oct. Most of the draw was due to a fall in imports. Crude imports into PADD III were 300,000 bpd lower in Nov-Dec than in the two previous months.

Of 30 million barrels of PADD III crude that disappeared in the final two months of 2010, about 8.5 million was processed into products and 18.3 million represented imports that did not arrive and were diverted elsewhere.

While 18.3 million barrels may not seem much, it represents around 2 days of Saudi exports or U.S. imports. It is a very large component of recorded stock changes globally.

OECD FORWARD COVER FALLS

OECD crude stocks fell by 0.9 million barrels in November, according to the International Energy Agency (IEA), as draws in North America (-10.5 barrels, that fall in PADD III) were offset by a build in reported crude inventories in the Pacific (+11.0 million barrels).

There was a much larger draw down in refined products especially fuel oil in Europe (-1.8 million barrels) and "other products" in North America (-9.2 million barrels). Combined with the small draw in crude, the result was a further tightening of total OECD stocks by 8.3 million barrels, and decline in forward demand cover from 59.1 days in October to 58.7 days in November.

Draws in OECD stocks seem likely to have continued, even accelerated, in December. Falling OECD stocks in November and (probably) December helped reverse the big build in stocks and forward cover reported in the summer, according to the IEA.

Crucially, stocks draws and falls in forward cover supplied the fundamental underpinning for the big rally in oil prices at the end of the year and into the start of 2011. The drawdown in PADD III is therefore central to the oil bulls' case about a rapidly tightening supply-demand balance, need for more output, and gradual absorption of Saudi Arabia's spare production capacity in 2011 and 2012. But what really happened to the 18 million barrels that failed to arrive in PADD III in the last months of 2010?

END-YEAR TAX EFFECTS

Some arrivals have been deferred until after the end of the year to avoid sales, use and excise tax liabilities in Texas and Louisiana. In the week ending Jan 14, PADD III saw a massive stock build of 6.9 million barrels, according to the EIA. Crude arrivals accelerated by 576,000 bpd (12 percent) to 5.4 million bpd, the fastest rate of unloading since late October. Imports picked up even as refinery consumption started to slow.

PADD III stocks normally rise during January and February, and carry on building in March and April. But last week's reported build was an outlier. The 6.9 million barrel stock increase in one week was almost as much as the region normally sees in the whole Jan-Feb period on average (7.4 million barrels) and is almost half the biggest total build (11.3 million barrels) ever recorded since 1981.

The one-week PADD III build was the fastest start to the year since 2007 and before that at least 2003. In 2007, stock increases quickly tapered off after that initial week; the year saw one of the smallest overall increases between January and April in recent years.

The market is still guessing whether the huge rise last week is a one-off or the start of a large seasonal build but crude futures prices for both WTI and Brent have backed off recent highs as the market digests the increase. Market participants are waiting to see if the unusually big drawdown before the end of 2010 is followed by an equally large build at the start of 2011.

UNRECORDED MARKETS

In addition to deferred arrivals, some of the missing barrels that failed to arrive in PADD III may have been diverted to other markets. That could account for some of the big reported build in oil inventories in OECD Pacific (Japan, South Korea, Australia and New Zealand). Or the barrels may have been diverted to China, India and other emerging markets in Asia, where stocks are largely invisible.

If the missing PADD III barrels have been diverted to unreported markets outside the OECD it is vital to know if they have been consumed (implying the market is very tight) or added to unrecorded stocks (implying the market remains comfortable).

During the recent rally, oil bulls and most market participants seem to have assumed the barrels had been consumed -- probably in Asia. But it is not certain. The arrival of some after year-end has acted as a reality check on surging prices.

In contrast, Saudi Arabia and other leading oil producers evidently do not believe the draw is all due to consumption rather than diversion and stock building in Asia, and insist supply remains adequate.

The destination of those missing barrels is the difference between a balanced oil market and a tightening one -- prices capped below $100 for the time being and a demand-destroying surge towards $120.

Ends --