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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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Oil and Gas Investment: Three Noteworthy Issues

The European sovereign debt and currency crises as well as a very sluggish global economy led many analysts last year to project lower crude oil prices for the year 2012. However, in a seemingly counter-intuitive measure, oil and gas companies substantially increased capital expenditure (capex) provisions for the year (See Figure 1 below).

With increasing geopolitical tensions — especially in the critical Middle East region — and concerns over a precarious global economy, investment prospects in the oil and gas sector have come under greater scrutiny. Three issues then, are noteworthy:

Oil Price levels

High oil prices most often conduce to higher returns for operating companies (and good news for investors). Even when these companies have recorded production declines (as has sometimes been the case with some of the majors), high oil prices have boosted profits.

 Oil prices have been on the increase. The price for the global benchmark, Brent for example, has risen by about 15% since the beginning of the year, and just a few days ago reached its highest level since 2008. The increases have been in spite of weak global demand. According to the International Energy Agency (IEA) for example, 4Q 2011 demand fell by 530,000 and 690,000 barrels per day (bbl/d) year-on-year for North America and Europe respectively, in a net global (albeit slight) decline. In the United States, total petroleum product demand measured on a four-week-average basis fell by 6.7% to 18.054 million bbl/d year-on-year the week ending 17 February 2012, the Energy Information Administration (EIA) reports. That value was the lowest since April 1997.

Gasoline prices show fairly high correlation with crude oil prices. In the U.S. for example, even with falling gasoline demand, pump prices have been on the increase (See Figure 2) and will probably remain high for as long as global crude oil supply issues remain. Crude oil prices are internationally set; and so except for an improbable price enforcement by the U.S. government over domestic producers, the idea that increased U.S. domestic oil production will lead to lower domestic petroleum product prices is misplaced.

Global oil prices are unlikely to fall substantially for some time to come even with demand growth among OECD countries projected to be largely flat through 2030. Of course there would be the usual spikes and dips but issues such as a potential Israel-Iran flash point, capex delays in the MENA region (which according to the IEA would account for 90% of the world’s marginal production increase through 2035) as well as countervailing demand growth among emerging markets (particularly the Asia-Pacific Region, see Figure 3 below) would most probably sustain prices. In addition, production among non-members of the Organization of the Petroleum Exporting Countries, OPEC, has often fallen short of forecasts, Iran’s output has been severely curtailed by sanctions, Japan is ramping up imports to replace offline nuclear power capacity and OPEC’s spare production capacity looks set to be critically tested.

Mergers and Acquisitions

When share prices are depressed in equally depressed, cost-of-money regimes, windows inevitably open up for Mergers and Acquisitions (M&A). Last year, Canada’s “unconventionals” for example — relentlessly buffeted by environmental groups and weighed down by low valuations even when largely profitable — looked particularly amenable. Another round of acquisitions since gas-seeking U.S. players took advantage of low Canadian dollar rates about a decade ago, loomed large. Bigger operators such as Encana and Talisman have large natural gas (and oil, in the case of Talisman) assets as well as better financial standing to make them attractive. Mitsubishi Corporation recently acquired a 40% interest in Encana’s Cutbank Ridge Partnership. That however was not a replacement for PetroChina which last year pulled out of a $5.4 billion deal for a 50% interest in Encana’s Montney shale play due to a disagreement on terms.

As the oil and gas majors continue decoupling of Refining and Marketing (R&M) assets, niche-focused independent operators in the U.S. look set to dominate that subsector. These independents have often proved more efficient in their respective niches than the majors. For example, independent Exploration and Production (E&P) as well as R&M companies reported much higher share price gains year-on-year in 2010 than the majors.

Outside North America, deep offshore assets are set to witness a lot of activity, continuing from last year. In Northwest Europe for example, where drilling operations declined 12% in 2011 according to Argus, there were 118 deals as more prone companies sought relief from financial risk.

Natural Gas Production Levels

Technological advances such as hydraulic fracturing and horizontal drilling have opened up access to very large volumes of natural gas in the United States and increasingly in other parts of the world. However, the massive supply overhang and the consequent depression of prices have led to consolidation and refocusing in the industry. Smaller, financially prone producers have been taken over by bigger corporations and liquid-rich plays have become more attractive. Producers are also turning to Liquefied Natural Gas (LNG) production; but such is the rate of capacity expansion, that a global glut may develop by the year 2018, just six years on, according to a PennEnergy report; for the U.S. that would mean another wave of depressed natural gas prices and possibly, further restructuring in the industry.

Beyond the medium term however, natural gas prices would probably rebound with increasing demand (especially for power generation) and prospects of supply constraints. The latest estimate of U.S. recoverable shale gas reserves made by the country’s Department of Energy saw a 42% decline over previous-year levels.

 

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Renewable Energy: Gradually Coming of Age

The 17th Session of the Conference of Parties (COP 17) to the United Nations Framework Convention on Climate Change (UNFCCC) is currently holding in Durban, South Africa. It aims to agree on a successor to the Kyoto protocol which expires next year. A recent report by the International Energy Agency (IEA) reinforces the urgent need for that agreement. According to the IEA, if the world is to stand a better chance of keeping the rise in global temperature below 2o C — and therefore avoid the deleterious effects of climate change — it must maintain a (universally-accepted) carbon emission ceiling of less than 450 parts per million, ppm; however, many scientists maintain that significantly lower values are more realistic.  With the current, global, carbon-emissions trajectory, that ceiling will be breached by 2017, due principally to fossil fuels. Fossil fuels account for more than 70% of global electricity generation and as a result, electricity accounts for about 40% of energy-related carbon dioxide emissions.

A rapid increase in renewable or “clean” energy’s proportion of the global energy mix therefore becomes imperative. Global investment in clean energy has grown at a compound annual rate of 29% since the year 2004, to more than US$1 trillion, Bloomberg New Energy Finance reports.

China which leads the world, spent US$54.4bn in 2010 according to Pew Charitable Trusts. The country, which currently derives more than 92% of its primary energy consumption from fossil fuels, has set a target of 15% share for clean energy in its energy mix by the year 2020; this is almost quadruple ExxonMobil’s projection of a 4% share for renewable energy in the global energy mix by the year 2040. BusinessGreen, in a recent publication, reports that, “The IEA predicts China’s electricity demand will grow by an average of four per cent per year to reach 9,000 terawatt hours (TWh) by 2035, which represents a tripling of its 2009 demand and equates to 18 times that of France.”

Of the world’s largest wind energy and solar energy companies by capacity, three and seven respectively are Chinese. Chinese entry into the sector has bred steep competition, driving down equipment costs. Bolstered by lower equipment costs as well as vast improvements in technological and operational processes, production economics for some subsectors of the renewable energy industry is already at par with coal, nuclear and natural gas in some locations and will most likely attain global parity in the very near future. According to Bloomberg New Energy Finance for example, wind energy produced by the average wind farm will be at price parity with natural gas by the year 2016, just about five years away.

Growth of the renewable energy industry has not come without challenges which in recent times have stemmed principally from the industry’s own success story: a rapid capacity expansion which, with falling demand — due to the global economic decline — has led to a large supply overhang. The case of Solyndra, a recently-bankrupt manufacturer of solar energy components in the United States is typical. The effects can be collateral. For example, some manufacturers of batteries for electric vehicles also became insolvent when demand for particular vehicle lines slipped due to the global economic decline. There are also concerns that First Solar, one of the world’s largest solar companies may be under viability pressures following the earnings downgrade just a few weeks ago.

Some commentators have derided the state subsidies extended to the renewable energy sector; it is noteworthy however, that in  2007 for example, fossil fuel subsidy in the United States was more than three times that for renewable energy, according to the Energy Information Administration (EIA). Even large corporations such as those in the financial and automotive sectors, have been beneficiaries of massive government financial assistance. In addition, complaints about the whirring of wind turbines in residential areas for example, pale in comparison to outcries over incidents such as the infamous Macondo well explosion or the despicable degradation of the Niger Delta environment, all associated with fossil fuels production.

Growth in renewable energy is expected to be driven by government policies especially among the Organization for Economic Cooperation and Development (OECD) countries. In addition, a global economic rebound is expected to see an uptick in numbers of the more efficient electric and hybrid vehicles at the expense of standard gasoline- or diesel-powered ones.

All said, while fossil fuels will most likely remain the dominant form of energy consumed over the next few years, renewables will take increasing proportions of that consumption.

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Global Crude Oil Prices: More Volatility Ahead

Global crude oil prices declined yesterday following reports by the United States Department of Energy showing larger-than-expected levels of stockpiles. Crude oil for December delivery fell US$2.32 to US$90.85 per barrel on the New York Mercantile Exchange while Brent declined by 1.42% to US$109.35 per barrel on the ICE Futures Europe exchange.

Just one day earlier, Nymex crude futures traded at near three-month highs, the projected decline in stockpiles spurring backwardation — the situation where near contracts trade at a premium to futures — which was last seen about three years ago. United States oil inventories had been on the decline over the past few months and this put speculative upward pressures on the benchmark WTI. Inventories at Cushing, Oklahoma, the hub of U.S oil storage reached a peak in April and have since declined by about 25%. Despite this decline, the WTI-Brent price spread has widened (Figure 2); the implication then, is that other factors other than the high Cushing stockpiles may be driving the spread.

 

Fundamental imbalances in Europe at the beginning of the year combined with the outage of Libyan light sweet crude — a staple feedstock for European refining — to cause steep increases in Brent prices.

This price volatility is likely to endure for the next few months. On the one hand, financial uncertainties threatening the euro zone look set to escalate, with Italy, which boasts one of the largest GDPs of the zone laboring under huge debt burdens. The zone’s sluggish economic growth which implies lower crude oil demand, holds knock-on effects on high-end, oil consumer-countries such as the United States and China. Europe for example is one of China’s largest export markets and Platts reports that China’s apparent oil demand recorded a lower growth rate year-on-year in 3Q ‘11. According to RIGZONE, 1H 2012 demand for OPEC crude oil is expected to fall by 1.3 million barrels per day and this, along with the rapid rebound of Libya’s production would most likely exert downward pressures on prices. In addition, if European banks involved in the funding of oil and gas development projects are impacted by current euro zone debt problems, global crude oil reserves additions would most likely suffer delays and with knock-on effects on prices.

On the other hand, any perceived risk associated with regional unrests and the potential impact on both actual and spare production capacities or ease of transport, would add premiums to oil prices. While flashpoints are difficult to predict, Iran (which boasts the world’s second-largest oil reserves and allegedly pursuing a hostile nuclear weapons program), Bahrain (which is close to Saudi Arabia’s major crude oil production zones), Yemen (which also is close to major international crude oil transport routes) as well as Syria are all areas of concern. Current price levels may well reflect such premiums.

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Global Crude Oil Prices: Four Defining Issues

Global crude oil demand has declined over the past few months, due principally to sluggish economic activity, particularly in the United States and Europe but also to higher crude oil prices. For example, MasterCard in its Spending Pulse, reported about a fortnight ago that U.S. retail gasoline demand declined significantly over year-ago levels while crude oil prices rose by more than 30% over the same period.

While some investors are still bullish on oil stocks, a good many are thinking otherwise. Four issues will most likely define the future of crude oil prices:

The Global Economy

Global stocks last week, ended their worst quarter since the 2008 financial meltdown. According to Financial Post, the MSCI All Country World Index, had by Thursday last week lost about US$4.7 trillion in market capitalization; and for the Wiltshire 5000 index — the broadest measure of U.S. stocks — that loss was US$2.2 trillion.

The International Monetary Fund last week warned that the global economy was at risk of a double-dip recession. The United States Federal Reserve Bank also warned that the country’s economic growth was disturbingly sluggish. In the event of a protracted second dip, the impact on the already-troubled European and U.S. economies could be devastating and would most likely spur a global knock-on effect. The result would most likely be a slump in crude oil demand, putting downward pressures on the commodity’s prices.

Many analysts had proffered that the decline in oil demand among OECD countries would be offset by an increase among the emerging markets, particularly China; and that was supposed to bolster crude oil prices. That, however has not been the case. Though total OECD petroleum consumption declined in the first half of 2011 compared with the previous year, that for non-OECD recorded only a lower growth rate (Table 1).

Indeed, China’s implied oil demand (domestic refining throughput plus net import) fell to a ten-month daily average low in August, Platts reports. While the country’s consumption of oil products has grown over the last few months, the growth rate has declined significantly. In July for example, it recorded four consecutive months of decline in crude oil imports, according to the Center for Global Energy Studies, CGES. And the prospects for a rapid rebound are somewhat precarious: the sluggish global economic activity may impact the country’s export-oriented manufacturing capacity as may domestic debt and inflationary pressures which, for some time have been of concern to the country’s leadership. In what may also be of concern not only to China but the global economy, China’s manufacturing sector shrank for the third consecutive month.

Risk Premiums and Speculative Activity

The prices for crude oil, as those for commodities in general, should in theory be defined by market fundamentals; but that has often not been the case. For example, in 2008, global crude oil prices spiraled higher to a record US$145 (approx) per barrel even while the market was well-supplied. The spike was attributed to massive influx of speculative investment capital which fled the troubled housing and other markets. Again, as much as US$20 per barrel in risk premiums associated with the MENA region unrest, was probably added to Brent prices earlier in the year. Current Brent and WTI price levels may reflect some risk premiums.

The last may not have been heard about these regional crises and the current object of scrutiny is Saudi Arabia. The kingdom holds the world’s largest oil reserves, exports the largest volume of the commodity and boasts the largest spare production capacity. Any disruption — perceived or real — in the country’s production would most probably propel global crude oil prices to record highs.

Perhaps mindful of developments in MENA countries such as Tunisia, Egypt, Libya, Bahrain and Syria, Saudi Arabia’s monarchy is set to spend more than US$43 billion on palliative projects. Only last week, the king announced that for the first time, women would be allowed to run for public offices.

It is clear that socio-political changes will come to Saudi Arabia. What is not too clear however, is what manner those changes will assume; and that will most likely determine the trajectory of global oil prices in the short to medium term.

Demand Destruction

The United States alone currently accounts for just under a quarter of the global crude oil consumption, and as such its oil demand profiles are always of interest to analysts. One particular aspect of that profile stands out: while the country’s GDP has rebounded to pre-recession levels, its oil consumption is still about 1 million barrels per day below those levels; and it is unclear if that demand shortfall will be recovered. In the event that it is not, and if the trend is sustained and extended to other — particularly OECD — countries, then global oil prices will most likely see downward pressures.

Capital Expenditure

Capital expenditure (capex) in the oil and gas sector is necessary for sustaining oil and gas output. For most oilfields, there is usually an average of 5 to 8 years from development to beneficiation and when there is a break in developmental funding, that beneficiation is often delayed.

The International Energy Agency (IEA) and the oil super major, Shell, a few days ago projected a steep rebound in global crude oil prices. They held that low capex regimes occasioned by low crude oil prices would cripple reserves additions which would in turn lead to a supply crunch as demand spikes with a rebounding global economy.

In 2009, IEA rather ceremoniously projected — and for the same reasons — an oil price shock within three years, to wit in 2012 (next year). In my analysis at that time, l maintained that even if an oil price shock were to take place in 2012, it would most likely show no market fundamental support. There is currently no indication of any such support for an oil price shock next year nor is there likely to be.

To be sure, a very deep economic recession — and many analysts are currently projecting such — could bring global oil prices to capex-crippling lows. That said, Brazil’s ultra-deep, pre-salt production has a breakeven price of about US$40 per barrel while for Canada’s oil sands, that value is about US$60 per barrel. Even the massive resources of Venezuela’s Orinoco belt have breakeven values of about US$55 per barrel. With Brent prices currently about US$100 per barrel, project economists around the world are probably sleeping easy.

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