Oil inventories provide insight into the balance of supply and demand in the oil market, and the balance of supply and demand influences oil prices. The relationship between supply and demand is one of the fundamental concepts of economics.
Supply and Demand Fundamentals
Supply refers to how much of a good the market is willing to offer, and demand refers to how much of the good the market demands. When a good is a particular price, there is a certain amount that sellers will supply and a certain amount that buyers will demand. When a market is in equilibrium, the amount of demand and the amount of supply are equal.
The oil market is unlikely to ever sit at equilibrium. Oil is a traded commodity, not just a good purchased for end use. Instead of reaching equilibrium, oil supply and demand change rapidly in unison with prices. An increase in supply suggests that sellers are willing to produce more oil at the current price than purchasers demand. In theory, to encourage demand, suppliers should reduce the price and see if more buyers come to market at the lower price point. When supply declines, it means there is ample interest from buyers at that price point. In this situation, there may be room for sellers to increase prices.
Oil Inventories and Prices
Crude oil prices are dynamic. While it may take time for prices of some products to balance as the market reacts to changes in supply and demand, in the case of oil, the price adjustments can be instantaneous. When oil inventories go up, traders may question the demand for oil at the current price and immediately sell their positions, causing a price retreat. When oil inventories decline, traders can take this as a signal that demand is increasing, and they may buy back into the oil market, bidding up prices. (For related reading, see: Oil & Gas Sector "How to Find Hidden Gems.")
The U.S. Energy Information Administration (EIA) provides a weekly update on domestic inventories. The weekly inventory report shows how U.S. oil stocks, other than those in the strategic petroleum reserve, have changed in the prior week. This is a major market-driving data piece. Ahead of the inventories report, analysts issue projections on inventory adjustments. If the EIA's reading differs from analysts' estimates, oil prices can react dramatically. The EIA's weekly inventory report also updates total stockpile levels that can be compared to average stockpile readings from prior years.
Another crucial component of the EIA's inventory data is the number of oil stocks at the Cushing, Oklahoma, delivery hub. Oil is delivered from production areas across the United States, stored in Cushing, then transported to end refining markets. Inventory levels at Cushing reflect the pace at which the U.S. oil supply is moving from inland production areas to end refining markets. An inventory build-up indicates that more oil is being supplied than can be transported away for refining. West Texas Intermediate (WTI) crude oil prices, the major North American benchmark, are set in Cushing.
Oil inventories provide a crucial observation into one of the fundamentals of the overall market: the level of supply. The level of supply influences prices. Oil prices can react immediately following the EIA's weekly inventory report if they differ greatly from analysts' expectations. Total stockpile levels are also crucial because weekly inventory adjustments are taken in the context of the overall stockpile level. If stockpiles are low and there is a huge weekly draw on inventories, prices could see a steep rise. If total stockpiles indicate a well-supplied market and weekly inventories continue to increase, oil prices could experience downside pressure.
(For related reading, see "EIA Versus API: Comparing Crude Inventories Announcements.")