Global Crude Oil Prices: Why Volatility Is Likely to Endure

Crude oil, albeit in decreasing proportions, will likely remain significant in the global energy utilization mix for the next few years. The impact of the commodity’s price on the global economy is therefore palpable. The issue of peak oil is resurgent and  there are current concerns — even if somewhat mitigated — about an oil price shock.

Speculations were also rife in 2009 — amid the global economic decline — about an imminent crude oil price shock. The argument then was that the extant, low-price regimes constituted a disincentive to upstream capital expenditure (capex) and that when the global economy began to rebound, oil demand growth would vastly outstrip supply capacity. The International Energy Agency, IEA, even boldly projected a price shock by the year 2012, to wit this year.

Four points then are noteworthy:

Fundamentals

 First, current crude oil prices though high, do not derive from such fundamental imbalance. In a 2009 post, Oil Price Shocks and Market Fundamentals, l argued that even if there were an oil price shock in 2012, it would most likely hold no fundamental support. The IEA reports that oil stocks rose by about 1.2 million barrels per day, bpd, through 1Q 2012 even as supply by Organization of the Petroleum Exporting Countries, OPEC, went ahead of demand. Oil consumption by member-countries of the Organization for Economic Cooperation and Development, OECD, has been declining since 2005 (Figure 1) and growth is projected to remain largely flat through 2030.

In the United States, the world’s top oil consumer, Department of Energy data show that crude oil stocks have been on an upward trend and for the week of 13 April 2012 stood at a 35-week high, while consumption has been declining. Even in China, a major driver-country for global oil demand, Financial Times reports that consumption for December rose by only about 1% year-on-year, compared with the year-ago level of about 10%. The country’s demand growth for diesel for example has slowed and is projected to remain weak through 2Q as its construction, transportation and manufacturing industries pull back a bit. In addition, recent increases in official diesel prices have not helped demand. The Center for Global Energy Studies, CGES, has reported an increase in the country’s February 2012 oil imports to 5.9 million bpd, from 5.3 million bpd for year-ago levels; however such increase may well reflect a strategic inventory build-up in the light of declining supply from troubled and sanctions-buffeted Iran.

Both the United States and Russia have accounted for a significant proportion of the non-OPEC oil production. Between 2008 and 2011, U.S. total domestic oil production rose by about 19% to about 10.1 million bpd according to data from the country’s Department of Energy. CGES reports show aggregate Russian production at about 160,000 bpd above year-ago levels; the country which has become the world’s largest producer has been upping production levels.

Fiscal Breakeven Levels

Driven largely  by higher oil prices, oil-exporting countries in both the Middle East and North Africa (MENA) as well Sub-Saharan Africa regions are projected by the International Monetary Fund (IMF) to grow by 4.8% and 7.3% respectively in 2012. These countries accounted for nearly 60% of global oil exports in 2010. However, such growth has meant increased fiscal expenditure, requiring even higher crude oil prices for fiscal breakeven (Figure 2). Some of these countries for example put out billions of dollars as palliatives during the wave of regional unrest that led to the ouster of leaders such as Muammar Gaddafi of Libya.

High fiscal breakeven prices make major exporters reluctant to boost supply save for a spike in demand. While acknowledging the deleterious effects of, and the necessity for ameliorating very high oil prices, many of these exporters have also emplaced sliding tax scales which provide for higher effective rates at higher oil prices, a plausible disincentive for lowering of prices. However, oil production companies operating in such countries do not seem to do very badly: when oil prices are high, such companies often declare substantial profits even with high tax rates or reduced output. When opprobrium has been raised over oil price volatility, many of these countries have therefore received a significant share.

Spare production Capacity

The issue of spare production capacity has been of greater concern. Saudi Arabia is believed to hold about two-thirds of global, spare oil production capacity and its oil minister has boasted of the country’s capacity to pump an extra 2.5 million bpd into the market within four or so weeks. Over the past few years however, growth rate for global oil production has been largely flat  even as many analysts still question that Saudi claim especially in the event of any major supply disruption such as in the Strait of Hormuz; and with Saudi Arabia’s projected rise in domestic oil consumption as well as a reported pull back on the country’s plans for capacity expansion, such sentiments will likely sustain oil price volatility.

Speculative Trading

Analysts hold different views on the impact of the U.S. quantitative easing on dollar-denominated assets such as crude oil; or the effect of speculative trading on crude oil prices. However, it can be safely said that weaker dollar  values can translate to higher oil prices and large market influx of speculative investment can drive up prices. For example, during the oil price shock of 2008, oil prices were spiraling higher even when the market was well-supplied, an argument OPEC adduced in laying the blame for the shock on weak dollar values, rising inflation and a massive influx of speculative investment into the commodities market. 

According to Bloomberg Businessweek, speculative trading helped lift crude oil prices 30% in the last six months. It adds:

The amount of speculative money in the oil market hit a record high in mid-March, when money managers held a net long exposure to oil through 642,724 futures contracts. At 1,000 barrels per contract, that’s roughly equivalent to 643 million barrels of oil — more than the entire world uses in a week

Concerns about a major supply disruption — due for example to an armed Israel-Iran conflict or even a unilateral Iranian action in the Strait of Hormuz — may have added to unease in the oil market. Today it is Iran but tomorrow it could be Bahrain or Nigeria or even more nightmarishly, Saudi Arabia. The recent-weeks spikes in premiums for front-month gasoline contracts may well reflect that sentiment; and in the light of current geo-political or other considerations, such sentiments are unlikely to disappear any time soon.

 

 

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