In hindsight, it is shocking how easily almost everyone forgot the laws of supply and demand when it came to the world’s most important commodity. A half century ago, oil was so plentiful that prices fell to their lowest-ever levels (adjusted for inflation). A complacent West was exposed to the unsheathing of the ‘energy weapon’ a few years later.
By 1999, with the crisis a distant memory, complacency returned. Cyber-technology attracted copious capital while investing in dowdy extractive industries had become unattractive after 20 years of falling prices. The Economist magazine nearly called the bottom with its bold prediction of $5 oil.
By the second oil price shock 30 years ago, prices had risen tenfold in just a decade, and politicians were warning that we would ‘run out’ in a generation. But this weapon badly backfired for producers, spurring conservation and the development of areas such as the North Sea that cut the Middle East’s share of world production by nearly half.
Within nine years though, hydrocarbons prices had once again surged tenfold and talking heads fretted that demand would soon exceed supply. Few realised how illogical such statements were. Prices peaked near $150 a barrel in mid-2008, but oil demand per unit of economic output, even having fallen by half in 30 years, could not bear such a price.
The ensuing decade has seen output rise modestly and oil prices break new records, but there is no sense of crisis. The marginal barrel is now expensive enough for the value of saving one to roughly equal the utility of extracting it from the ground.
Petroleum’s dominance is giving way to alternatives. It is unlikely that we will ever bother to extract that last barrel.
Politicians seeking out villains in the oil market tend to fixate on stereotypes of heartless US speculators, mercenary Middle Eastern petrocrats and greedy Chinese industrialists. Rarely do they think of the Belgian dentist driving his Volkswagen hatchback or of an Indian worker driving a Tata Nano.
The Opec oil cartel has repeated through the year that as a contribution to global economy recovery, it was supporting moderate oil prices. Saudi Arabia put numbers on the cartel’s words, describing the $70-80 a barrel range as ‘excellent’. For sure, Opec’s aim of $70-80 a barrel—the group avoids stalking about a target—has helped the global economy, particularly of poor oil importing countries.
But there are signs that the oil cartel is not as altruistic at it appears at first glance. Opec appears to be as concerned about the global economy as about driving consumers away from oil. This is the clearest recognition yet that high oil prices could damage the cartel’s interest in the long term by reducing energy demand for ever.
The deliberation came to light as Opec—apparently in a mistake engendered by the chaos surrounding the meeting in Luanda, Angola—allowed reporters to remain in the plenary room while the group’s economists told ministers about their latest findings. “Crisis appears to have induced a permanent loss in oil demand in OECD and slower rate of growth in non-OECD, due to policy measures and changes in consumer behaviour,” the concluding remarks of the presentation read.
Crude oil comes in many varieties and demand patterns for the different products derived from it differ markedly. This is important because it means refining capacity, not just oilfield output, affects the crude price. When demand for a particular product rises quickly, refiners will bid up the price of their main raw material—crude oil—because they can still earn a bigger margin as the price of the end product will rise.
So called middle distillates (diesel, jet fuel and gas oil) comprise the single most popular segment of the oil barrel and enjoy a faster growth in demand. A big reason for this is Europe’s gradual switch to more efficient diesel vehicles. This year, the old world should burn 6.3m barrels per day of diesel and gas oil compared with 5.2m in North America and 2.8m in China.
Europe’s thirst for middle distillates—particularly those low in sulphur—strains a global refining system largely built to produce gasoline. Light, sweet (low-sulphur) crudes are best suited to producing middle distillates but comprise only about one-fifth of global output. What’s more, Nigeria is a leading exporter of these grades, so trouble there moves the oil price. Opec, meanwhile, complains that the extra oil it is pumping (mainly heavy, sour crude) struggles to attract buyers.
Faltering American demand for gasoline is already weighing on the oil price. Europe’s weakening economy will dampen demand for middle distillates. Easing of the refining bottleneck could be the next shoe to drop on the oil market—long before China’s thirst for oil diminishes.
A global surplus of diesel, heating oil and other distillates is creating opportunities for deep-pocketed traders and a big question mark for the Opec oil cartel. Distillates are the lifeblood of the industrial economy, powering trucks, trains and firing furnaces in winter. Among the rich nations where they are best measured, stockpiles are a stubborn 13% higher than a year ago, according to the International Energy Agency, the oil watchdog of the Western world.
The inventories’ spike has helped spur investment in tank capacity and led traders to charter ships to hold what does not fit on land. But it is also a big concern for Opec.
Distillates’ stocks are one reason why Opec decided to leave quotas alone, even after oil prices gained 65% in 2009. “Stocks of distillates are high,” said a senior Opec official in Luanda. “That is a strong sign that global industrial activity is still weak.”
The oversupplied distillate market has prompted oil majors, commodity trading houses and even banks to chase the so-called ‘floating storage’ trade, filling tankers and mooring them outside ports in the UK, the Netherlands and Singapore. Opec estimates that about 100m barrels of distillates were stashed in tankers last month, equal to two weeks of European demand.
On land, tank farms are brimming. Royal Vopak, the world’s largest independent operator of oil storage terminals, says its facilities are 93% full. It is building new capacity from Sweden to Singapore. Kinder Morgan, the largest US independent terminal operator, is also increasing capacity in response, in part, to traders’ demand.
Commodity trading companies have also entered the storage game. Vitol, the world’s largest independent oil trader, recently bought storage facilities in the Dutch port of Antwerp and in Cushing, the delivery point for US crude futures. They have decided to have their own facilities at strategic locations in the world to secure their trading position. Oil majors such as BP are expanding storage, and banks are approaching the traders to finance storage deals in exchange for profit shares. With the price of heating oil, a distillate benchmark, for delivery a year from now 11% higher than January futures, it could make sense for financial traders to book storage.
While onshore and floating storage of distillates has been rising, the amount of crude oil stored offshore started declining earlier this year, as prices for future delivery fell closer in line with spot markets. Yet, at some point, an oversupply of distillates will clog up the market for crude refiners’ main raw material. “Given the overhang in middle distillate inventories and the slow recovery in products demand, product market circumstances are not expected to support crude fundamentals,” Opec said in its monthly market report.
While the economic recovery and winter heating demand could burn off some of the glut, it will take more of an Ice Age rather than just seasonal weather to correct this overhang.
Iraq has the potential to be a game-changer
One of Opec’s founding members, Iraq has invited foreign oil companies back into the country to develop its vast oil reserves. The auction promises to bring Iraq’s oil production up from 2.5m barrels a day to as much as 12m barrels a day within a decade, an increase equal to Saudi Arabia’s current output. A significant portion of the oil will arrive far sooner.
Iraqi officials are already arguing that the country has a special right to pump extra oil to make up for the decades during which it pumped very little because war and sanctions decimated its industry. The International Energy Agency, the Western countries’ watchdog, has based its long-term supply and demand scenarios on Iraq pumping 6.7m barrels a day by 2030, significantly lower than what the country now believes it will pump by 2020. If Baghdad ramps up its production and no other Opec country accommodates the surge by cutting their own output, prices could drop significantly.
However, Baghdad and the international oil companies face huge political difficulties in raising output. Second, Iraq’s new output could be needed to compensate for declines elsewhere, including the North Sea or Mexico, resolving Opec’s quandary.
If Iraq ramps up its output, analysts say the blow could be especially severe to big investors, particularly pension funds, which are now buying forward-dated oil contracts above $100 a barrel, in the belief that the oil market will remain tight. But any decision to withhold new Iraq oil from the market would also be deeply unpopular among big oil companies such as Royal Dutch Shell, BP, ExxonMobil and Lukoil, which have committed to rebuilding Iraq’s oil sector for low fees.
Mexican strategy matters
Mexico’s decision to spend more than $1bn to guarantee that it will earn a minimum of $57 a barrel on all its 2010 net oil exports appears to suggest that it is pessimistic about the outlook for prices and demand next year. After all, it hedged its 2009 output at $70 a barrel—a strategy that netted it a profit of more than $5bn. That deal, struck in mid-2008 as oil rocketed towards $150 a barrel, was bravely contrarian when forecasts for a price peak of $200 a barrel were widespread. So, should its view about 2010 set alarm bells ringing among oil market analysts?
After all, the consensus is for crude oil prices to rise next year as global economic recovery strengthens. US crude prices are expected to trade at $76.85 a barrel by the end of next year, according to the latest analysts’ poll published by Consensus Economics. In the futures market, the Nymex December 2010 contract was trading above $82 a barrel, whereas the January 2010 contract (the front-month) was trading at about $73 a barrel.
Agustin Carstens, Mexico’s finance minister, has almost certainly put his job on the line in taking a more conservative view than the market consensus. But Mexico probably started to plan the deal more than six months ago when there was more uncertainty about the outlook for the global economy. Securing a price that would fit a target for government revenues would have been more important than outright profit maximisation. This does not mean that Mexico believes that oil prices will fall as low as $57 a barrel—this is only an insurance policy and the deal is all about managing risk.
Choosing a strike price of $57 a barrel will have reduced the cost of the put options (rights to sell) for Mexico. The further away the strike price is from market expectations, the cheaper the option is to buy. Further hedging is likely to take place by producers keen to take advantage of the fact that forward oil prices are currently trading substantially higher than spot oil prices. Oil producers could implement the same strategy as Mexico at almost half the cost, as premiums for put options have fallen since September 2009.
The deal is also an opportunity for investment banks such as Barclays, which acted as counterparties to Mexico. The banks can offer over-the-counter calls (rights to buy) that can be customised for client needs rather than mere standardised contracts.
Options market positioning suggests Mexico’s strategy sits comfortably within the current range of expectations. For December 2010, put options are concentrated at $60 a barrel (numbering 40,634 lots) and $40 (36,398 lots) while the bulk of call options are about $100 a barrel (currently 60,661 lots).
An oil price at $80 a barrel is clearly inconsistent with supply and demand dynamics, inventory levels and the current macroeconomic environment. But I expect:
* Risk appetite and cheap liquidity will continue to support the market
* Dollar will remain weaker and EUR/USD could reach155 in three months time
* OECD forward-demand cover will drop to 54-56 days
* Opec will not slip further on compliance or hike production at its forthcoming meeting
The glut of liquidity flowing all over the world due to ultra-loose monetary policy followed by governments could lead to renewed speculative interest in oil until it reaches a level that may lead to demand-destruction. It’s deja-vu, all over again!
Source: Financial Express
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