Crude oil prices retraced modestly in recent days from record-high nominal levels reached last week as more weak housing data and negative earnings surprises that resulted in a sharp equity market sell-off reignited concerns over economic growth and, in turn, oil demand growth.

Exacerbating these concerns has been a recent substantial weakening in refinery margins as petroleum product prices have underperformed crude oil prices.

Upon that backdrop, Goldman Sachs said it its Energy Weekly report that "Although this underperformance has generated concerns about end-user demand for oil, it is important to emphasize that the decline in refinery margins has been in large part seasonal and the extent to which weakness has exceeded seasonal norms has resulted from exceptional tightness in crude oil fundamentals rather than softness in product fundamentals. In other words, the market has shifted into a “crude-driven” environment from a “product-driven” environment of recent years."

Recent data releases that provide more evidence of tightening crude fundamentals underscore this shift.

“On net, we believe that crude oil prices remain consistent with current supportive fundamentals, but vulnerable to the downside in the near term as weaker refinery margins potentially motivate refiners to reduce their demand for crude,” Goldman Sachs said, adding “However, downward price pressure on crude oil prices will likely prove temporary as the relatively low level of product inventories suggest sustained refinery run cuts are unlikely and as crude oil fundamentals remain tight. Further, it is important to note that the concentration of call options at $90/bbl and $100/bbl suggest the potential for a “negative gamma” effect to push prices sharply and rapidly higher should these key thresholds be reached.”

More evidence of tightening oil fundamentals

Goldman Sachs once again noted that a large 33 million barrel counter- seasonal draw in OECD total oil inventories during 3Q2007 versus a seasonal 25 million barrel build indicates a very strong seasonally-adjusted market deficit of over 600 thousand b/d.

Further, the inventory decline accelerated in August and September, underscoring the risk of a continued seasonal acceleration of the market deficit in 4Q2007). “As we have long emphasized, the current sustained market deficit is the result of a decline in global production against relatively stable demand. During 3Q2007, total global supply was 400 thousand b/d below the same period last year,” said Goldman Sachs.

In September, crude oil production was 680 thousand b/d below year-ago levels. Only the expansion of NGL production has prevented total supply from falling and explains the modest 140 thousand b/d year-over-year increase.

According to Goldman Sachs, it should be emphasized that while the NGL supply expansion is typically used to meet increasing demand from the petrochemical industry, its use is very limited to meet the bulk of the oil demand for transportation fuels.

As global inventories decline at a sustained pace and approach critically low levels, it is not surprising that price volatility increases and that the upside price swings tend to be much stronger. In every commodity, low levels of inventories typically create a “spikeprone” environment where the upward price movements can be particularly violent and the level of backwardation potentially extreme.

“This dynamic is typically more extreme to the upside with low inventories than to the downside with high inventories since timespreads have no theoretical upper bound, while in a contango they have a lower bound in the cost of carry,” Goldman Sachs said.