Build-up to a new peak for oil?
It had seemed like the worst was over. After peaking at around US$75/bbl in September, crude oil prices had quietly drifted back into the fifties, and suddenly it seemed as if it were all just a bad dream.
Mind you, a couple of years ago US$50/bbl would have seemed outlandish, but since China ’s long term emergence and Katrina’s short term destruction the world has found comfort in believing US$50bbl to be almost cheap. But just when we thought it was safe to go back to the pump…
The longer term rally in the oil price to date has been driven from the demand side and not the supply side. The supply side has played its part in that capacity has been caught short, hence as demand outstripped supply the only way for the price to go was up. Economists are less concerned about demand-side rallies in the shorter term than they are about supply-side rallies, as demand will always find a level at which the price is simply too high.
This was actually happening. Post Katrina, the demand for oil, particularly in the US , began to subside. Basic economics was at work. To assist in reducing the price of oil the US released crude oil reserves while refineries went into overtime to make up for lost production. Regular maintenance was postponed. It was also very fortuitous that the US experienced a balmy fall which, to date, has given way to a balmy winter.
But now the real spectre looms. Comparisons are often made in oil price terms to the oil shocks of the seventies. Those shocks were supply-side shocks, brought about by OPEC oil embargoes instigated to hurt the evil West. Increased demand in the new millennium has meant that we’ve had to get used to generally higher oil prices. But as suggested, demand will always begin to drop off when the price is just too high.
If supply is affected, however, real panic can set in. Supply disruptions mean actual shortages that have immediate effect on everything from workers getting to work to factories being able to operate. Naturally, the price responds, but whereas increased demand forces a general consideration of alternative fuels or lifestyle choices, loss of supply causes fear.
So this is now where we find ourselves – back in the seventies. Followers of the business news have noticed the crude oil price push back towards US$70/bbl. Average Joe Car Driver hasn’t noticed so much because petrol prices have not spiked like they did last year. They haven’t spiked, because petrol prices normally lag crude prices. This was not the case in the time of Katrina because at that point refineries had been shut down as well as oil rigs, and the gasoline/crude spread had blown out severely. The usual lag ensures Joe will no doubt notice soon.
Iran was the centre of attention in the seventies and Iran is back in a big way. No one trusts Iran ’s exhortations that its defi ance of nuclear restrictions is based on energy considerations, and not death and destruction considerations. If the US , UN and anyone else with an interest starts really giving Iran a hard time, the expectation is that the next step is oil embargoes.
Iran is the second-largest producer of the OPEC countries, after Saudi Arabia . It produces 3.9mmbpd (million barrels per day). Were Iran to stop selling its oil to the West, a big hole would appear in an already stretched supply side. The result would be a new high in oil prices, and that’s exactly what the market has been quietly anticipating most recently.
And of course it doesn’t stop at Iran . As Merrill Lynch notes, Nigeria crops up next in the list of trouble spots, with terrorist activity having shut down production of about 220,000bpd. Iraqi oil production declined from 2.0mmbpd in September to 1.59mmbpd in December. Venezuela is also an oil producer, and a newly self-declared enemy of the US .
That’s the current list of oil-specifi c geo-political problems. Now let’s consider all the shenanigans going on with Russian gas, the fact that Sharon ’s demise and Hamas’ election does not bode well for Middle Eastern peace, and that Osama’s been back on the box making more threats of attacks against the US . And add to this another hurricane season coming up at the end of the year.
A supply-side shock is quite a distinct possibility. It is thus no surprise that speculative long positions have been gradually building in oil futures. Merrills reports that speculative longs in futures and options increased from 19 million barrels in mid November to 104 million barrels last week. That’s why the price has been going up again. And were a supply disruption to occur, Merrills only expects these positions to significantly increase, causing further price rises.
Outside of the supply shock scenario remains the simple fact that supply growth is otherwise poor.
Since the second quarter of 2004, non-OPEC production growth rates have suffered a dramatic pullback, Merrills reports, driven by steep decline rates in the OECD region and slowing production growth from the Former Soviet Union. 2005 saw a paltry 200,000bpd supply growth. While Merrills is tipping an improved performance for 2006 and 2007 (1.3mmbpd and 1.2mmbpd respectively), such improvement will still leave supply growth short of predicted demand growth.
Over at OPEC, things aren’t that hot either. The world puts faith in OPEC’s “spare capacity”, but Merrills suggests that a predicted production growth of just 1.0mmbpd over the next two years is not going to have a huge effect.
Moreover, OPEC capacity projects currently awaiting the go ahead would probably only do so based on the sort of higher oil prices that may yet eventuate. This adds to the belief that prices must rise before they can fall.
Back on the demand side, the initial response to spiked prices – being a drop off in demand – has subsided. Whereas demand growth in 2005 came in at a low 1.3%, a sharp rebound is expected, Merrills reports, driven by economic growth expectations for China and the US , which should see demand growth levels of 2.0% in 2006 and 1.8% in 2007.
It would seem the world has taken higher oil prices in its stride. Merrills expects world GDP growth to be 3.9% in 2006 and 3.5% in 2007, suggesting the global economy has simply weathered the higher oil price environment. At the household level, indications are that the retail sector has taken the hit, such that the demand for petrol has not noticeably fallen. It has been signifi cant that infl ation has not become a problem, and thus interest rates have remained low. The irony is that China – held largely responsible for the demand surge – has also provided cheap exports that have counteracted higher oil prices in the infl ation balance.
There are, however, little signs that suggest higher oil prices are indeed on the back of everyone’s minds – globally. Take Iceland for example. Iceland is fast-tracking plans to harness thermal energy and switch to hydrogen-powered transport, eventually banishing the need for any oil. Okay – if Iceland stopped importing oil no one would notice, but the thought’s there.
Brazil – now this might make people take notice – is leading the world in ethanol production as a fuel additive/alternative. It helps if you’ve got lots of sugar, but Brazil wants to sell ethanol to the world. Even the greatest gas-guzzler of them all – the US – has just been given a wake-up call as well, as Ford has begun laying off staff, and GM is teetering on the brink. The response? “We need to satisfy the demand for smaller cars and hybrid vehicles”. Who would have thought?
Oh, and the sale of bicycles in Australia has jumped considerably.
Then of course there’s the renewed world interest in nuclear power (including from Iran ). But that takes us down another path. Suffice to say, indications are that there must be a longer term ceiling on the oil price. It cannot just keep going up forever. And that’s without even considering the genuine desire from most of the world’s little people – the Joe Averages – to reduce greenhouse gases.
These are all longer term considerations. In the short term, not only has crude oil production capacity been slow to respond to increased demand, the situation is further exacerbated by twenty years of underinvestment in refi nery capacity. It’s no good if there’s enough crude around but a bottleneck holding up conversion into usable fuel.
This bottleneck has had as much to do with higher fuel prices as anything else. Merrills believes the situation is unlikely to change in the near to medium term as global refi nery capacity looks to remain constrained until at least 2008, with only 2.4mmbpd capacity expected to come on line before then.
Katrina and Rita were a sharp lesson in what happens when refi nery capacity is taken off line. Capacity was restored as quickly as possible, but at the expense of postponing regular maintenance. Morgan Stanley notes the US refi neries are about to begin a seasonal maintenance period that will be 20% longer than usual, as they catch up with work needed post hurricanes. They also need to spend time making modifi cations for new US environmental standards.
This adds up to likely upward pressure on prices ahead of the US summer “driving season”. As by far the world’s largest consumer of oil, this has global ramifi cations. We also can’t rule out the possibility of the present US balmy winter suddenly turning into a cold snap. If North America were to suddenly receive some of the weather Russia has been battling with of late, demand for heating oil and gas would skyrocket.
(Morgan Stanley suggests all eyes will be on world celebrity Punxsutawney Phil, who fans of the movie Ground Hog Day will know as the indicator of whether six more weeks of winter will ensue. Phil’s call is made on February 2, so on that day, world attention will be no doubt focused on the town of Gobbler ’s Knob.)
Increased demand, constrained supply, and any number of possibilities of supply-side shocks all add up to a general consensus that we may not have seen the high in oil prices. 2006, it appears, may be an expensive one for oil consumers. This will have ramifi cations across all markets, and as Macquarie points out, 2006 is not shaping up as a rosy return to profi ts for the retail sector.
Both Morgan Stanley and Merrill Lynch agree, however, that 2007 should be a different story. More refinery capacity will be added to the global supply chain. Morgan Stanley suggests that with GDP growth expected to slow to 3.8%, demand for crude oil should increase by less than in 2006. The analysts are tipping 1.6mmbpd demand growth in 2007 compared to 1.8mmbpb in 2006, and markets at both the crude and refined end will be well supplied.
Merrill Lynch is sticking to its long term view that the next few years will see prices fall back into the US$40-50/bbl range. The analysts are factoring US$42/bbl (as an average) for 2008. Net global supply additions are projected to be around 2.5mmbpd in 2006 and 2007, levels not seen since the mid-nineties. This should result in global capacity utilisation falling back to 2002 levels.
So we may have to suffer the short term pain before enjoying some long term gain. Of course, talk of supply capacity comes down largely to known reserves which are presently being tapped. There is always some chance of a new, signifi cant oil fi nd, and a lot of money is thrown at exploration.
One of the world’s biggest oil fi elds currently lies untapped underneath the Colorado River Valley . Lying, as it does, within a major national park this reserve has been largely left alone. The Bush Administration has, however, renewed feasibility studies on the area. The problem, of course, is that a major oil drilling program would likely be environmentally devastating.
Would the government take that step? It may yet have to come down to the American public – not so much in the terms of an environmentally-driven public backlash, although this would likely occur, but in whether Americans can actually temper the need for ever more oil. As stated earlier, at least two of the US ’ longstanding bastions of car manufacture – General Motors and Ford – have been forced to take a long hard look at themselves. If the US can get over its love of guzzling SUVs, and turn to smaller, more efficient vehicles, it may force the question of whether raping and pillaging for the sake of ever more oil is actually necessary.
For a long time, any development in alternative fuels in the US , or elsewhere, has been scuppered by the oil industry. Now, at least according to their own publicity, oil companies are joining in development and research of alternative energy sources. Have they seen the writing on the wall? Or is it all just a propaganda smokescreen?
Then there’s Kazakhstan . Investment newsletter, isecureonline.com, points out that what has been discovered offshore in the Caspian Sea is actually the second largest oil fi eld in the world. According to the US State Department, there are about 178 billion more barrels of oil and gas waiting to be discovered. Asia On-Line has gone as far as to say “Most of its fields are yet to come on stream, but when they do they’ll likely hold sway over enough oil supply to destroy the price setting power of OPEC.”
Well – that’s put things into perspective a bit. Perhaps the world will not need to rush into alternative fuel sources based on dwindling supply and high prices after all. Perhaps greenhouse gases are here to stay. But what do we know of Khazakhstan?
Firstly, Khazakstan is not a hotbed of Islamic activism. In fact, it is the only Central Asian republic in which Islam is not mentioned in the constitution, and religion plays little part in politics.
The latest president was democratically elected last year, although the 90% win was questioned by international observers. Nevertheless, this large but sparsely populated country is dedicated to being good little capitalists. And foreign investment is encouraged.
The isecureonline.com website is urging its readers to look out for small oil companies with an interest in Khazakhstan, as bargains may still exist. In the meantime, the question of the world’s oil actually running out does not seem such a matter of concern.
This question does, however, have its fl ipside, as there is one group of experts who believe the world’s currently exploited oil fi elds may only have three years of production left.
This is the “peak oil” argument, based on the fact that when an oil fi eld is tapped, the oil is easy to recover based on the pressure within the well forcing it to the surface. Eventually that pressure subsides, and oil has to be forced out of the well by pumping in water, and the oil and water combination that results needs to be separated.
Somewhere around 50%, the oil becomes harder, and more expensive, to extract. Thus the life of an oil reserve is not solely based on estimations of the total amount of oil contained therein. At some point past the peak, the fi eld will be abandoned. The group of experts who warn of an apocalyptic end to oil production some time soon is well-credentialed, and also mostly scoffed at. Who’s right?