Crude oil stockpiles are expected to empty significantly during the third quarter as continued production restraint from OPEC interacts with the seasonal increase in consumption.
OPEC and non-OPEC countries are committed to reducing production by an average of nearly 1.8 million barrels per day in the first six months of 2017, with an option to extend cuts for a further six months.
Production assessments by independent agencies suggest compliance with the agreement has so far been high from OPEC especially from Saudi Arabia and its allies.
Further reductions from non-OPEC could be phased in over the next few months, with Russia in particular committed to increase its production cuts progressively during the compliance period.
Set against this is the risk of “compliance fatigue” if OPEC and non-OPEC countries become complacent and allow production to rise toward the end of the period.
Past experience suggests compliance tends to weaken over time as prices rise and the panic which made an agreement possible in the first place fades.
To preserve their flexibility, OPEC and non-OPEC countries have declined to commit themselves on whether the agreements will be extended.
But the consensus within the crude market seems to be that the cuts will be continued for a further six months, at least in modified form.
The alternative would be to flood the market with more 1 million barrels of extra crude from the start of July which would likely increase stockpiles again.
Assuming production cuts are extended in some form, the biggest impact is likely to come during the three months from July to September.
U.S. refineries normally increase their crude consumption sharply during the third quarter to meet strong demand from motorists during the summer driving season.
Over the last decade, net crude inputs into U.S. refineries have risen by an average of 840,000 barrels per day in the third quarter compared with the first.
The third quarter is also when Saudi Arabia and Iraq increase their own internal consumption of crude to meet air-conditioning demand.
Direct crude combustion in power plants will cut the amount of crude available for export by several hundred thousand barrels per day from both countries.
Finally, the third quarter is when most North Sea producers undertake maintenance, which cuts output of Brent and other grades during the summer.
In sum, the seasonal increase in consumption and reduction in output could combine to produce a particularly sharp draw down in crude stocks over the three months from July to September.
Traders are currently betting storage tanks will empty significantly during the third quarter based on the structure of Brent calendar spreads.
The Brent spread for April-May is currently trading around 35 cents per barrel contango, which makes storage on land profitable under most assumptions.
But the spread for June-July is only 19 cents per barrel contango, which makes storage only marginally profitable, depending on assumptions about the cost of financing and leasing tank space.
And the contango for September-October is currently just 2 cents per barrel which would make storage unprofitable under all assumptions.
While the June-July spread has not changed much for the last 12 months the spread for September-October has tightened significantly.
The scenario encapsulated in futures prices is that the market will move into a significant supply deficit over the third quarter.
Physical traders will gradually lift their inventory hedges and sell stocks to refiners to help meet the shortfall in supplies from producing nations.
This scenario is only one possible outcome and there are a number of risks to the expected rate of market rebalancing.
Stocks could draw down faster than currently expected, in which case the supply-demand situation would become very tight in the third quarter. OPEC might respond by allowing production to rise.
On the other hand, growing U.S. shale output, weakening compliance from OPEC and non-OPEC, and any slowdown in consumption growth could all push back the draw down in stocks and cause spreads to weaken.
The movement of the Brent spreads for June-July, September-October and December-January should therefore provide a real-time indicator of whether traders think rebalancing is still on track or slipping.