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.


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.


Oil and Gas Trends: Decoupling of Refining and Marketing Assets

The transport sector currently accounts for a dominant proportion of the global crude oil consumption with refining throughputs spiking during peak driving seasons. As penetration rates for electric and hybrid vehicles are still at modest levels, that dominance is set to endure for some time to come, albeit in decreasing proportions.

Oil and gas companies have recently seen challenges in the downstream Refining and Marketing (R&M) subsector; but these challenges are different for developed and developing countries.

OECD Countries

Total OECD petroleum consumption peaked at about the year 2005 and has been declining since. Figure 1 shows that while OECD consumption increased by about 20% between 1990 and its inflexion year of 2005, that for non-OECD increased by more than 60% from 1990 through 2010.

Weak motor fuel demand and the consequent decline in refining throughputs (Figure 2) have combined with costly regulatory requirements particularly in the United States to bring about poor refining returns. In the United States for example, figures recently released by the Energy Information Administration show that for the week ended September 23 2011, gasoline demand was 419,000 barrels per day (bpd) less than year-ago levels while the four-week average for gasoline demand was 2.4 million bpd less than the corresponding 2010 period. According to the released figures, both Gulf Coast and Atlantic Coast refinery runs saw declines.

Unforeseen circumstances earlier this year also added to poor refining throughputs. For example, European refineries, which take about 80% of Libya’s light sweet crude production, saw significant decline in runs when unrest knocked off that country’s output. In addition, the Sendai earthquake in Japan still keeps about 500,000 bpd of refining capacity offline.

Faced with increasing difficulty to reserves replacement, resource nationalism as well as the aforementioned challenges, many Integrated Oil Companies (IOCs) embarked on various restructuring processes aimed at improving their profitability.

For ConocoPhillips, — which, among the oil majors had the highest share price gains year-on-year for 2010 — assets divestment was the principal restructuring tool. It was therefore no surprise that downstream R&M assets formed a significant proportion of that divestment. The oil major recently broke up into two companies with R&M operations comprising one of them. It is also in the process of selling off refining assets such as the 185,000 barrel-per-day refinery in Trainer, Pa. in the United States. Total and Shell among others have also been involved in R&M divestment.

It would however be incorrect to assume that R&M operations are loss-making ventures (Figure 3). Falling demand for refining products has meant that the most efficient refiners are the most viable. Niche-focused independent oil and gas companies have proved much more efficient in their respective niches than unwieldy IOCs. For example, independent Exploration and Production (E&P) as well as R&M companies recorded overwhelmingly higher share price gains year-on-year in 2010 than IOCs. The potential alliance between resource-rich National Oil Companies (NOCs) and these niche-focused independents may well add to the viability concerns of IOCs.

An upside to the break-up of integrated companies into smaller independents is that the sum of the market valuation of the smaller units has in many cases exceeded that of the original company. This may lend credence to the position that niche-focused companies boast higher operational efficiencies.


Non-OECD Countries

For developing economies, where demand is largely subsidy-driven, the challenges are somewhat different. Countries such as Saudi Arabia, India, Pakistan, Venezuela, Iran, China and Nigeria among many others have emplaced various forms of petroleum product subsidies. While such subsidy regimes provide for caps in domestic product prices, they often do not allow for adequate refining margins and have on massive scales, entrenched corrupt financial practices as well as natural resources wastage. With such operational climate, many IOCs have either spurned R&M investments or spun them off completely.

In India, due to the large subsidy burden, the government has mandated a series of increases — albeit gradual — in the prices for refined petroleum products.

In Saudi Arabia where crude oil is used for much of its domestic power generation, subsidies often bring electricity prices as unsustainably low as US$0.015 to US$0.04 per kilowatt. The country’s oil consumption increased by 75% over the last 10 years and is set to top an estimated 5.6% increase this year, against the estimated global average of about 1.4%. The head of  Saudi Aramco had earlier this year, warned that by the year 2028, more than 8 million barrels of oil equivalent per day would be internally consumed if the trend is sustained; and that would impose severe restrictions on export proportions, probably impacting global supply.

Nigeria is often considered emblematic of the oil resource curse. In Nigeria, gasoline prices have been fixed for the past few years at about US$0.42 per liter across the country, irrespective of international crude oil prices or transportation costs. A refining company in that country would therefore face very bleak profitability prospects if it were required to purchase crude oil feedstock at the highly volatile international prices. Of the 18 refining licences issued more than 7 years ago, none has received a final investment decision; and that, in a country which imports most of its refined product consumption. 

For most of those licences, there were no proper provisions for supply of feedstock or evacuation and distribution of product. Security issues as well as poor regulatory regimes compounded the case.  

As Nigeria’s oil and gas production is now predominantly offshore, floating refining operations would stand the country in much better stead. They would provide proximity and ease of access to feedstock as well as better security against sabotage or terror threats.

The issue of caps on some product prices would still have to be addressed. A one-step (total) revocation of subsidies would probably throw up much greater and unsavory challenges for leadership and country. However, since the R&M or downstream sector creates far more jobs than the upstream counterpart, part of current product subsidies may be used initially to guarantee refining margins as a first step in the total subsidy revocation exercise. That would spur investment and with positive, multi-sector  knock-on effects.

Such guarantees are not novel. Capital expenditure (Capex) is critical for sustained oil and gas production. When global crude oil prices were at capex-crippling lows, the Nigerian government entered into contracts which guaranteed investors a certain margin on each barrel of oil produced. Even with the contracts’ inherent flaws, the result was that while global upstream activities were at a lull, operators in Nigeria paved the way for the subsequent, timely increases in the country’s oil and gas reserves.

For Nigeria, the burden of petroleum product subsidy is already unbearable. According to the country’s Petroleum Product Pricing Regulatory Agency, PPPRA, about US$13 billion was expended to subsidize refined petroleum products between January 2006 and June 2010. In comparison, about US$6.4 billion was provided for capital expenditure in the country’s 2011 budget.

One single element of data in Nigeria’s refining statistics, tells all the story:  over the past ten years, the country’s refineries have averaged an abysmal aggregate capacity utilization of less than 30%. The values are 10.90% and 21.53% for 2009 and 2010 respectively according to the Nigerian National Petroleum Corporation, NNPC. There has been either a lack of adequate feedstock supply, or a lack of technical maintenance. Without provisions for adequate refining margins and supply of feedstock, the country would be hard-pressed to find worthy investors for that subsector.

As seen in Figure 2, non-OECD refining throughputs have been on the increase (30% between 2000 and 2010), driven principally by the Asia-Pacific region where economic growth over the next few years is expected to be strong. Singapore refining margins are also expected to see significant upticks through the next few quarters.


Arsène Wenger and the Arsenal: Still Shooting Blanks?

Arsène Wenger, manager of the English Football Premier League club side Arsenal, has been receiving scathing criticisms by both fans and football analysts alike; and for good reason: the top-flight club has, under his management failed to win any silverware for about six years now, nor has he shown any willingness to procure quality players to fill glaring inadequacies in the club’s squad of players.

In a show of defiance, after the club’s 2-1 win over Udinese earlier in the week to qualify for the European Champions League draws, Wenger denied any “crisis” in the team despite the departure of two key players, former captain and talisman Cesc Fabregas (amid perhaps the longest transfer saga in modern, European footballing times) and Sami Nasri. With about £60 million in proceeds from the sale of these players, his immediate concern was a temporary deal for a 30-year old midfielder valued at about £5 million and a £6 million offer for (£12 million-rated) Bolton’s defender Gary Cahill. Bolton’s manager Owen Coyle referred to the offer as “derisory”.

Mr. Wenger’s business model has been one of self-sustenance, buying very young boys cheaply and then developing them and selling them with good profit a few years later. The club plays very exciting, quick-passing and fast-paced football. However, since the adoption of this model, the club has never won any silverware. To his credit, Wenger has overseen the movement of the club to a new sixty-odd thousand capacity stadium while maintaining the club’s top-four position as well as UEFA Champions League qualification for fifteen consecutive years. In spite of these, the manager and his team were booed off the field by fans after a 1-1 draw at home with North American Soccer League club side, New York Red Bulls in an Emirates Cup encounter just over a fortnight ago.

The draw with Red Bulls was symptomatic of the Arsenal malaise: good, possession football, several missed scoring chances and conceding of cheap goals. In February this year, the club was active in all four major titles – FA Cup, Premier League, UEFA Champions League and Carling Cup – but crashed out of three of them in three weeks, including a last-minute give-away to lowly Birmingham. The team won only three of  its last fourteen matches in that season. During the 2007-2008 season, the club was 5 points clear on the leadership table with 12 matches to the end, but lost the title to Manchester United. Last season, the club led Newcastle United by 3 goals in the first few minutes of a  match only see the match end in a 4-4 draw.

The club’s inadequacies have been mainly in the forward and center-back positions. The main forwards, Robin Van Persie and Theo Walcott are injury-prone and were side-lined for a significant part of the 2010-2011 season. The frenchmen, Marouane Chamakh (forward) and Sebastien Squillaci (center-back) purchased by Wenger to make up the inadequacies have been woeful flops, the latter guilty of give-aways that led to losses. In just a few months, no less than four key players in the club would have a year left in their contracts, and the whole Nasri-Fabregas saga may be replayed fourfold.

Mr Wenger’s business model just has not worked and stubborn adherence to it smacks of false economics. Trophy-less seasons do not generate lucrative club endorsements nor do they attract quality players. Without spending to procure the services of quality players to make up squad deficiencies, the club’s trophy-less seasons would likely endure, especially when competitors such as Manchester United, Manchester City, Chelsea and Liverpool have all invested substantially in the reinforcement of  their respective squads; and that just may seal Mr. Wenger’s fate while relegating the club to the nether sections of the leadership table.


Three Reasons Why Crude Oil Prices Will Stay High

Global crude oil prices have risen significantly since the beginning of the year, largely driven by the unrest in the Middle East and North Africa (MENA) region. Brent prices for example, rose by more than 21% between the beginning of the year and the end of March; but with the seeming adaptation by markets to the risks associated with the unrest, as well as the recent advice issued by Goldman Sachs to its clients to sell their investments in oil, investment decisions have focused on a possible crude oil price collapse and its implication for oil stocks.


The MENA unrest has undoubtedly added to recent global crude oil prices but it is worth noting that the latter were already on an upward trend since 2009 (See Figure 1 below), bolstered largely by strong emerging market demand in a rebounding (even if sluggish) global economy.

However, recent spikes such as the thirty-month highs seen about a fortnight ago may reflect more of a risk premium than any fundamental tightening since there were, and currently are no near-term shortfalls in supply projections. About the same period for example, Energy Intelligence reported that global crude oil production exceeded demand by about 500,000 barrels per day, bpd; and last week, the Saudi Oil Minister revealed that the country’s crude oil production for the month of March fell by 833,000 bpd from February’s production levels due to lower demand.  Though the International Energy Agency, IEA, in its latest report held that growth in global oil consumption for 1Q’11 dropped to 2.6% from the 4.1% recorded in 4Q’10, that may be set to change; the second quarter typically sees an uptick in crude oil demand even as refineries return from maintenance.


That said, high crude oil prices boosted energy stocks during the first quarter of the year. The Energy sector at S&P for example, showed better than threefold return over the market average (See Figure 2 below).

Though there may be dips or corrections, crude oil prices would probably remain high and for three reasons:

First, emerging market demand has been a strong driver for oil prices in recent years and even when the economies of China and India declined in 2008 for example, their total petroleum consumption increased. Oil demand in many of the emerging economies is driven in the main, by subsidies, which, given their rather low socio-political flashpoints may not be removed anytime soon; and that raises fears of inflation. China, in an attempt to curb inflation recently increased banks’ reserve ratios by 50 basis points to 20.5% but only allowed domestic fuel prices to rise by a smaller rate (5%) than the rate of increase (14%) for its reference crude oil basket. These may not translate to any significant reduction in the country’s oil consumption though the longer-term sustainability of these subsidies remains to be determined.

In spite of rising oil prices, the Asian Development Bank expects a growth in the region’s economy, of 7.8% and 7.7% for 2011 and 2012 respectively. According to Financial Times, while European crude oil demand for February was largely flat, that for Asia was up 5.9% (China’s up 9.6%) and that for the U.S. up 2.9% (possibly rising higher in the summer or driving months).

Secondly, despite pockets of problem zones, the global economy is seemingly set for growth, and with it crude oil demand, even if in the medium-term. The International Monetary Fund, IMF, in a recent report for example, expected global economic growth for 2011 to be 4.4%. In addition, the Organization for Economic Co-operation and Development estimated the annualized 1H’11 growth rate for its G7 member-countries (exclusive of Japan) to be 3%. However, a major oil price shock, especially if sustained, would most probably end all such growth prospects. Current crude oil price levels inevitably draw comparisons with the record values of 2008. Energy Information Administration (EIA) data show that in 2008, average prices for Brent and West Texas Intermediate (WTI) crude oil grades were US$96.94 per barrel and US$99.64 per barrel respectively; for 1Q’11, the values were US$104.96 for Brent and US$93.54 for WTI.

Finally, quite a few members of the group, Organization of the Petroleum Exporting Countries, OPEC, have embarked on various elaborate short- to medium-term projects which require certain oil price levels to break even. Estimates for these levels range from US$79 per barrel to US$92 per barrel and would be significant factors in setting target crude oil prices. This is compounded by the group’s rising domestic oil consumption profiles which, if sustained, would amount to between 35% and 40% of its total production in a little more than a decade. The consequent reduction in available export volumes would further tighten global supply, putting upward pressures on prices.


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