The black art of oil pricing
By Ian Fraser, Financial Editor
AS the futures traders sat huddled in front of their flickering terminals on the Singaporean trading floor, they were focused on one thing: the world oil price. Last Thursday, they were determined to push it through another psychological barrier – $65 for a barrel of crude – and the time seemed right for yet another bullish speculative rally.
A cocktail of geopoliticial, economic and industry factors were on their side, all conspiring to restrict supplies and boost global demand for the black gold. These included fears of political instability in the Middle East – fears which had been exacerbated by the death of King Fahd of Saudi Arabia on August 1.
More recently, there is the stand-off between the West and Iran over its determination to restart uranium conversion at its Isfahan plant. The move is seen by some Western governments as a cover for a nuclear weapons programme and there are fears that sanctions might be applied – with devastating consequences for oil supplies, given that Iran accounts for about 5% of global production. There is also the problem of Iraq, Venezuela, Norway and Russia not producing to capacity. And last week came confirmation of a decline in production in the North Sea, with Royal Dutch Shell’s Brent field and BP’s Schiehallion field being the worst affected.
In the US, ageing refineries are struggling to keep pace with two years’ unexpected growth in demand for refined petroleum, exacerbated by a prolonged period of under-investment. And more recently there have been a spate of fires and other disruptions, with ConocoPhillips and US refiner Valero Energy Corp shutting down plants.
On Thursday, ConocoPhillips had to partially shut down its massive Wood River plant in Illinois – capable of processing 306,000 barrels per day – after a power failure and a fire in a processing unit. In March, a huge explosion rocked a BP refinery in Texas City, killing 14 people. US gasoline inventories fell for a sixth straight week last week, according to the Energy Department. It is also emerging that a shortage of diesel is imminent in Europe.
“Any excuse the bulls have to take it [the price of oil] higher, they’re going to use,” explains Peter Beutel, president of Connecticut-based energy consultancy Cameron Hanover. “Unless we see some large stock builds, our guess is that this market will continue to react bullishly to just about anything that the latest numbers have to show.”
Additional production from Opec – whose 11 member states are now pumping out 30.4 million barrels per day – has done little to allay such fears.
Yet against such a skittish backdrop, it has not been too hard for speculators and hedge funds to make a fast buck by driving up the price of a barrel of the black gold. Their method is simple. They buy up “oil futures” – contracts to buy or sell a quantity of crude at a fixed date and at a fixed price in the future – at whatever price they can. They can be relatively confident that, when it comes to making deliveries, the actual price is bound to be higher still. To guarantee this, they have a vested interest in ensuring that every piece of bad news echoes around the world’s media outlets. The aim? To give the impression the world is running out of oil.
So it wasn’t too hard for the traders to push the price of New York light sweet crude (the benchmark product) for September delivery to an all-time high of $65.17 a barrel – up 27 cents on the previous afternoon’s US close. By Friday it had climbed even further, to $66.11 a barrel.
That is more than double the $28 average price seen in 2003 but still a long way short of the $90 inflation-adjusted average for 1980, which followed the Iranian militant revolution that unseated the Shah in January 1979. But the developed world then was far less prepared to withstand such shocks. More heavily dependent on oil, and with labour markets far less flexible, the hike was enough to provoke a prolonged inflationary spiral. The economic backdrop is far healthier now, but the big question is what will be the effect on global economic growth this time.
Can the fundamentals of supply – the amount of black gold left in the ground, combined with mankind’s ability to extract it at economically viable rates – in any way justify the current oil price?
Not according to Julien Seetharamdoo, an oil expert at Capital Economics. He estimates that buying by speculators and hedge funds probably accounts for $10 to $15 of the current price.
Certainly there seems little chance of oil supplies running out any time soon. A 2000 study by the US Geological Survey found that the Earth probably still contains about 649 billion barrels of oil and that this figure is likely to increase over time as more is discovered. The report concluded that only 24% of the world’s oil has already been exploited .
James Hamilton, professor of economics at the University of California, San Diego, is sceptical we are facing a sudden collapse in supplies. He says: “It’s possible on today’s futures market to buy oil for delivery in December 2011 for $60 a barrel, something to which traders would never agree if they thought world production was just about to enter the declining phase.”
The fact global demand – with emerging markets in China, India and Brazil – growing fast must be set against this. Andrew McLaughlin, chief economist at the Royal Bank of Scotland, says: “The current high oil price is principally a function of demand. Globalisation is a thirsty business.” By 2020, the International Energy Outlook, produced by the US Energy Information Administration, predicts that the world’s energy consumption will be 40% higher than today.
Houston-based investment banker Matt Simmons, who argued in his recent book, Twilight In The Desert, that Saudi Arabia’s oil fields are at or near their peak, is one of the world’s gloomier commentators. Simmons’s fear is that the world is approaching its peak oil supply at a time of rapidly rising demand and that Saudi Arabia – which accounts for 13% of current global production but 25% of global reserves – has systematically over-stated its reserves for years.
Leading oil commentator Daniel Yergin, president of the Boston Massachusetts-based Cambridge Energy Research Associates (CERA) is more positive. He argues additional supplies will come to the rescue from 2007. He says : “Prices around $60 a barrel, driven by high demand, are fuelling the fear of imminent shortage – that the world is going to begin running out of oil in five or 10 years. This , it is argued, will be amplified by the substantial and growing demand from two giants: China and India.
“Our new, field-by-field analysis of production capacity leads to a strikingly different conclusion: there will be a large, unprecedented build-up of oil supply in the next few years. Between 2004 and 2010, capacity to produce oil could grow by 16 million barrels a day – from 85 million barrels per day to 101 million barrels a day – a 20% increase. ”
Yergin predicts additional supplies will come from Canada, Kazakhstan, Brazil, Azerbaijan, Angola and Russia. Among Opec countries, he detects significant growth potential in Saudi Arabia, Nigeria, Algeria and Libya.
He insists his organisation’s forecasts are not speculative. “Many of the projects that embody this new capacity are already under development and were approved in the 2001-03 period, based on price expectations much lower than current prices.”
He adds: “This is not the first time the world has ‘run out of oil’. Cycles of shortage and surplus characterise the entire history of the oil industry. A fear of shortage after world war one was one of the main drivers for cobbling together the three easternmost provinces of the defunct Ottoman Empire to create Iraq.
“In more recent times, the ‘permanent oil shortage’ of the 1970s gave way to the glut and price collapse of the 1980s. A common pattern in the shortage periods is to underestimate the impact of technology. Once again, technology is key.”
Yergin believes the share made up of “unconventional oil” – which includes the product of Canadian oil sands, ultra-deep-water developments, and natural gas liquids – is set to rise from 10% of total global capacity in 1990 to 30% by 2010.
Sandy Nairn, founding partner of investment management house Edinburgh Partners, is no less optimistic. He believes that given the long-term realities of supply and demand, the current oil price should, in fact, be no higher than the mid 30s – [around $35 per barrel].
He explains: “Most of the current oil price is actually down to bottlenecks of supply. The trouble is we don’t know how long those bottlenecks are going to last. The finding and extraction costs have gone up – but nowhere near enough to justify the current price.”
Citing figures from the BP Statistical Review of World Energy, Nairn says: “In 1984, the world had 35 years’ of proven reserves at the then existing production rate, and between then and now we have used up 70% of those reserves. But we currently have 42 years’ of proven reserves at today’s production rates. So we have extracted more oil than we expected to, yet the level of known reserves has gone up, not down.”
McLaughlin says: “The amount of oil we consume and produce is a function of price and technology. That’s the fundamental economics of this. As the price rises, the use of substitute fuels, such as biomass, coal and nuclear, starts to become more attractive again.”
Conservation will also kick in, with gas guzzlers disappearing from the roads and even SUVs becoming more fuel efficient. Voluntary reductions in consumption will also kick in. As a result, the oil price tends to slide back down again.
McLauglin adds: “With the price at $50-$60, oil firms have the incentive to invest in new technology, for example, to extract oil from the deep sea bed.
“Every year the supply curve moves up and to the right. The world’s oil is never going to run out. The stone age did not end because we ran out of stone, but because technology moved on. We haven’t run out of stone, wood or coal.”
But Nairn does not believe the current high oil price will be without economic consequences: “Some commentators are suggesting it doesn’t really matter this time. But actually it does. You can’t sustain such a large increase in input prices and not have it filter through to slower growth in some shape or form.” Oil at $64 has been described as a sizeable indirect tax. The effect is to slow consumption, as everything becomes more expensive.
Last week, Bank of England governor, Mervyn King, acknowledged there are “substantial risks” surrounding the oil price, with potential spin-offs for growth and inflation. “But so far, it has not brought any movement in inflation expectations,” he says. If oil prices do keep rising, King reckons the central bank would “look very carefully on the effect of that on inflation expectations”.
But what about the longer term? Robert Kaplan, professor at Boston University’s Centre for Energy and Environmental Studies, says he expects that the production peak – after which producing oil will become much more expensive (but before which the price is unlikely to rise much above $60 per barrel) – to occur in 2015-25.
Contributing to a blog on WSJ.com, Kaplan predicts the transition to alternative energy sources will be painful. “The 20th century could be called the petroleum age,” he writes.
“Inexpensive oil means goods can be imported and exported at little extra cost, people can live far from work and a small fraction of the workforce can feed those that produce the goods and services we associate with modernity. All this may change after the global peak in oil production. As such, the peak isn’t just an economic problem, it’s one of the biggest social and political challenges for this century.”
But what about those pesky Singaporean speculators? Nairn suggests it is unfair to single them out as the villains of the piece, that the blame cannot fairly be laid at their door. Prices, he insists, cannot surge upwards unless there is some underlying reason – the “bottleneck” effect, not traders, he says, is the guilty party.