Commodities | Jun 29 2006
By Greg Peel
"There has been a contradiction evident in the oil market throughout [the second quarter]. On the one hand, a mass of analyst and oil company executive comment has talked of chronic over-supply and price crashes. Some press comments have taken that view on board, and run with it repetitively as if it were set in stone. However, on the other hand, physical markets have not manifested the supposed over-supply, there have been three straight monthly averages for WTI above [US]$70, and, rather than crashing in a suitably humble fashion, the market is now gaining strength."
And therein lies the dilemma. This is the way Barclays Capital currently reads the crude oil market.
The current state of the oil market can best be unravelled by simplifying into four distinct factors. (1) Supply – is it or is it not in a position of surplus? (2) Demand – are higher prices having any effect in lowering demand? (2) Products – regardless of crude supply, supply of gasoline and other products will remain tight. (4) Geopolitical tension is the wildcard (and throw hurricanes in there as well).
Merrill Lynch has just raised its oil price assumptions. The analysts now value oil companies on the basis of a 2006 price of US$67.50/bbl (up 8.5%), 2007 of US$65.00/bbl (up 18%) and 2008 of US$50/bbl (up 8%). The longer term assumption remains at US$42/bbl.
US$42/bbl might seem like wishful thinking, but Merrills insists that "the full cycle cost of large-scale marginal sources of supply" dictates that this is a realistic price. In English, it means that if the oil price stays high enough for long enough then peripheral oil sources such as Canadian oil sands (extensive resources) or gas-to-liquid conversion begin to look economic and worth pursuing.
It is on the supply side that Merrills go on to formulate its view, despite having just upped forecast prices, that over the next 18 months the crude oil price will drift lower. Merrills believes global oil production is set to expand rapidly over coming quarters. Production is declining in the North Sea and Mexico (largest supplier to the US) but substantial production is anticipated from the Former Soviet Union (specifically Russia, Azerbaijan and Kazakhstan), Africa (Angola and Sudan) and Canada. Brazil is also expected to increase production.
Merrills expects non-OPEC production to grow by about 1.5 million barrels per day in 2007.
Then we have OPEC, which is also bringing further production on-line. Nigeria, Kuwait, Algeria, Iran, UEA, Libya and Saudi Arabia all plan to increase production. This increase could be 1.1 mb/d, says Merrills.
However, increased production is not going to solve the problems at the pump. Global refining capacity is still woefully inadequate. Moreover, a lot of the supposedly excess oil being produced at the moment is "heavy" crude. Refiners gave up on heavy crude years ago. Turning excess heavy crude into useable product would mean major refinery rejigging. "Sweet, light" crude is what everyone’s set up for, and that is not in excess. One of the biggest sources is Nigeria, and its production has been slashed by terrorists.
If heavy crude producers end up creating even more of a bottleneck at the refiners they will have to consider actually cutting production. Otherwise the price of crude really will collapse. OPEC would not let this happen. Merrills suggests the next round of OPEC production meetings could be feisty.
If there’s currently such an excess, or an excess to come, says Barclays, why then is the oil price going up? Oil prices will finish higher in the second quarter of 2006 than where they started. When Barclays crunches all the available numbers, and the dust settles, it appears the market in the second quarter will be significantly tighter than last year.
One possible answer to the conundrum is gasoline. As suggested, you can pump out as much black gold as you like but if you can’t refine, it’s not worth much. Thus a tight gasoline market, and subsequently high gasoline price, is what’s dragging up the oil price.
Logic dictates that the higher prices go, the more demand will fall. So turning to the demand side, many economists base their predictions of, for example, a slowing US economy, on the fact that ongoing high oil prices will lead to demand falls that will curtail economic activity. Is there any evidence of this? Not much.
The demand effect comes down to price elasticity. In other words if the relationship between oil price and demand is elastic, each dollar of oil price will directly force a fall in demand. If inelastic, it won’t. The Australian example is one that shows just how inelastic the relationship is.
An average Sydney family may use a car to drive to and from work, and another to drive the kids to and from school. Although higher oil prices have affected some increase in public transport use, and motor scooter and bicycle sales, most Sydneysiders have continued to buy the same amount of petrol but give up something else. New clothes perhaps, or dining out. As the price of petrol has climbed ever higher, it is not petrol sales that have suffered.
Merrills finds that the global price elasticity of oil is very low. The analysts estimate that, on average, a 10% increase in the price of petroleum products affects only a 0.5% fall in demand. In parts of the world it’s even less. The greatest guzzlers of them all – Americans – have seen 40% higher gasoline prices this summer from last, but demand has fallen 1%.
While most economists expect the US economy to slow from here – not recede, just slow – global economic growth forecasts are hardly leaden. Merrills expects 4.4% global growth in 2007, which is still "above trend". This is not a figure that suggests a significant fall in oil demand. In fact, Merrills forecasts 2007 demand growth of 1.9 mb/d. (If you recall, aggregate supply increases were tipped to be 2.6 mb/d).
Merrills does not believe the refinery bottleneck problems will be solved before the second half of 2008. The analysts thus reason that demand for gasoline, diesel and jet fuel will simply have to slow to match available supplies. Maybe it will, but where does that leave the price? Merrills calculates that supply growth of light crudes (that which can be turned into fuel at present) will only be 1.4 mb/d.
On that assumption, Merrills suggests oil prices will drift lower over 18 months. If the fuel simply isn’t available, then other arrangements will have to be made. Price spikes in products will also curtail demand and make consumers think again. Get set for hybrid car sales to rocket. Once everyone’s reassessed their oil usage, then there’s no reason to pay up so much. At least that’s the theory.
But what of our old friend, geopolitical tension? Iraq, Iran, Nigeria, the nationalisation of South American sources – all are sufficient unknowns that can make a lot of hard core analysis worthless. FN Arena published the view of Credit Agricole’s Jean-Charles Lacoste on Tuesday which is that we are in for the next great global oil shock, just like the seventies, due simply to the risk of some further devastating event. Oil at US$100/bbl, says Lacoste.
And as we speak, the waters in the Gulf of Mexico are getting warmer, and warmer…
