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A blighted dawn in the Straits of Hormuz?

May 21, 2012 Leave a comment

In early 2012, the US and its allies imposed crude oil export sanctions on Iran for alleged infringement of its nuclear activities. The market reacted in turmoil. The sanctions were met with a flurry of analysis. Possible scenarios were drawn on the blockage of the Straits of Hormuz and if Saudi Arabia has sufficient capacity to make up for the lost crude – in a worst case scenario up to 12mmpbd of crude. Prices were predicted to rise to $200/bbl derailing the world economic recovery.

Since then, European countries including Italy and Greece which import substantial Iranian crude highlighted the crippling effects of the sanctions at a crucial stage of the debt crisis. Several Asian countries including Japan, India and China too commented on the difficulties of replacing light sour Iranian crude in the existing tight market. The sanctions were delayed to July 2012 to allow countries look for replacement crudes.

Three months later in May 2012, the IEA reported that the Iranian production has decreased by 200kb/day and is expected to decrease by 1mmbpd by mid summer. Iran used to export 2.5 mmbpd before sanctions were imposed. Most of the reduction in crude exports (500kbd) is coming from European compliance, whilst Asian countries (including China, India, Sri Lanka) seek waivers. Meanwhile, a 1.5 mmbd pipeline from the UAE oil fields will be completed in mid 2012 to bypass the Straits of Hormuz for export via the Fujairah terminal.

Over the past few decades sanctions have proved to be an ineffective weapon against erring nations. The emergence of a multi-polar world has further weakened the sanctions. Emerging growth economies with a voracious appetite for oil provide alternative markets for exports. It did not help that the developed economies themselves have been preoccupied with restorative measures for their ailing economies. In France and the USA, presidential elections are held this year, which would have made any punitive measure on Iran likely. Early in May, Monsieur Hollande displaced Sarkozy as president. Sarkozy had been known for his hardline stance against the Iranian regime.

These reconciliatory stances appeared to defuse the tension due to the sanctions. This even as the frequent rhetoric of war in the media desensitized public reaction to it. Has a false sense of dawn and peace then set in the Straits of Hormuz? Will the looming sanctions actually impact the bargaining stance of the nations?

The Iranian oil minister recently predicted a rise to $160/ bbl if sanctions take effect – an increase of $70 from today’s $90 prices. At this price, Iranian oil revenues are estimated at $240 million (1.5 mbbls x $160/bbl) whilst pre-sanctions, oil revenues are estimated at $232 million ( 2.5 mbbls x $93/bbl). Depending on the amount of export loss and the resulting gain in crude price, the Iranians may actually ‘profit’ from the sanctions. The table below has export bbls lost on one axis and the export revenue gain on the other axis. Green cells indicate a net revenue inflow whence the gain in price outweighs the loss in crude, while the red cells indicate the opposite. Interestingly, the $70 price gain postulated by the oil minister corresponds to a positive revenue flow for a loss of 1mmbd in throughput.

Table showing effects of oil price change and export loss on revenue

It remains to be seen then if a surprise springs up. Afterall the weather is capricious. Nations are too. What the analysis above shows though, it will not be the sanctions that will provoke a reaction.

Does oil storage increase prior to rainy days?

March 31, 2012 Leave a comment

It is old wisdom that one should save for rainy days. Somehow in the economics sense, this adage was lost, especially in the modern context of optimising between saving for the future, or investment and consumption in the present. With the existing low interest rates environment, there is much less incentive to store and save for the future.

Supply disruptions are rainy days:

In the oil markets, do players store for rainy days? This is especially pertinent with the overhang of geopolitical tensions in the Middle East – what with Iranian sanctions planned for the middle of year and a much debated but never concluded Iranian threats in the Straits of Hormuz. Obviously, the governments do not agree as the US, UK and France contemplate a strategic oil release. Critics write it is politically motivated with the coming Presidential elections in November. The release can be construed for smoothing price increases or for discouraging speculators away. Even more so, the timing and size of its release remain suspense to market players. My game theory lessons on incomplete information equilibrium taught me it is a wise act to prolong its intended deflating effect. Speculators anticipate its release and dare not go long, whilst governments leverage on the information asymmetry to its full effects.

The original intent for oil storage is to buffer against surprise supply shocks so that users (the refiners) can maintain operational effectiveness. This must be seen in the different interests of the commercial players (oil producers and trading houses) and governments that store strategic petroleum reserves (SPR) though. Whilst commercial players seek to maximise profits, governments seek to minimise supply disruptions from inexorable events.

Commercial and strategic storage:

A look at the graph of the crude stocks by the EIA shows negligible storage by the US DOE over the past few years. In fact, spring of 2011 shows a SPR IEA coordinated release in response to the Libya civil war disruptions. An increase occurred in the spring of 2009 to take advantage of depressed prices in the financial crisis. A plateau has since occurred for the last year in 2011. A similar inspection of commercial storage showed the same market behaviour during the financial crisis in the second half of 2008 and spring of 2009, with an increase of inventory by almost 50 million barrels over half a year.

The author hesitates to draw any conclusion during 2011 when Cushing tanks were full. This was a period when WTI started to lose its importance as an international benchmark. Noticeably though since the beginning of the year 2012, commercial storage has increased by 25 million bbls. Was this in anticipation of the Iranian sanctions looming in June?

source: EIA, DOE

Contango and backwardation:

An analysis of oil storage is not complete without examining the forward curve contango and backwardation. Historically, commodities markets are in backwardation norm as producers willing pay a spot premium for their operations.  For the crude oil markets, this will be for the continued operations of refineries. After 2004, the oil markets begin to be ‘financialised’ and ‘globalised’ with more market players, and become more volatile with rising prices. The market structure flipped into contango seen in the graph below. The huge spikes above $10 in the second half of the 2008 and early spring 2009 during the financial crisis were periods mentioned when commercial storage increased greatly.

WTI M4-M1 : source EIA

Post 2004, major investment banks decided to enter into physical storage play alongside existing oil trading houses (like Vitol and Glencore), realising there were profits to be made. For storage to work, these entities long the spot cargo and short the forward curve a few months out to lock in their arbitrage profits with the higher contango. In the process, they lease out storage tanks and pay a leasing fee ranging from $0.15-$0.50/bbl per month.

Oil speculation or storage? A conclusion.

These storage plays account for major profits among so called ‘speculators’ or non commercial players classified by the CFTC1. Back to the original question if oil storage increases prior to rainy days? Oil storage occurred not due to some prudent mind saving up for the rainy days, but for an invisible hand of the market. Investment banks and trading houses invest in storage plays and in the process sold down the forward curves a few months out. Although storage plays increase spot prices, this potentially helped to smooth future price increases. The present contango to June ’12 out is about +$1.5o as of end March –  a result perhaps of the storage plays shorting and depressing the forwards. It would not be conceivable with the upcoming sanctions in June, the market ascribes only such a small premium from that month.

A re-look at the first graph on storage shows that actual oil storage has not changed much beyond the 1990s. In fact, storage was much higher during the 1990s, before the oil markets became ‘financialised’. This needs to be seen in context as oil prices were in the $10s and $20s back then and the opportunity and capital costs for storage were much lower. There was also a higher spare capacity of oil production.

Footnotes:

1 – Other strategies are geographical arbitrage plays where physical players ship oil from one region to another to take advantage of regional price differences. An excellent example of geographical occurred during the Hurriance Katrina and Rita, when gasoline shortages in USA were quickly remediated with imports across the Atlantic. Physical blending or the undesirable pure flat price punt are other strategies.

A demand-supply tug of war and $100 – $200 oil prices in 2012?

January 17, 2012 2 comments

In an earlier Sep 2011 article by the author, he wrote that a tug of war ensued between the elasticities of demand and supply to create range bound oil prices. The year 2012 started in earnest with dichotomous forecasts on the oil price. This is due to ongoing market uncertainties – with the Euro crisis damping potential demand and supply disruptions from the ongoing Iranian crisis. The author is convinced though this tug of war is increasingly won by the supply factors and the oil price will hinge on the upside.

Demand destruction and the Euro crisis:

During the financial crisis of 2008, OECD oil demand fell from 47.9 mb/d in 2Q 2008 to 44.2 mb/d in 2Q 2009 (IEA OMR data). Most of the demand loss came from the USA (1.8 mb/d). A look at the main demand figures from Europe during the financial crisis revealed important consumption patterns:

kd/b (product demand)

2008 Jun

2009 Jun

Change

France

1870

1930

+70

Germany

2430

2360

-70

Greece1

331

320

-11

Italy

1870

1610

-260

Portugal1

274

255

-19

Spain

1500

1470

-30

UK

1740

1670

-70

Ireland1

166

136

-30

 

TOTAL

-420

The consumption demand2 has actually decreased only a marginal 350 kb/d in continental Europe with the major powerhouses France, UK and Germany having minimal impact. A key reason for the relatively low demand destruction is the use of natural gas and other alternative sources of energy in Europe (for eg nuclear in France) as a primary form of energy. The peripheral countries – Italy, Portugal, Greece and Spain in the epicenter of the crisis lost 350 kb/d of demand.

The latest economic data3 indicated that the US and China are likely to weather the contagion from Europe. More importantly central banks have learnt an important past lesson – it was the constriction of bank credit that led to the contagion in 2008 and in this respect, the European central bank (ECB) has offered low interest rate loans to banks to shore up liquidity.

A further base on the prices – $100 was cited by Saudi Oil minister Ali al-Naimi on 16 Jan ’12 as a level to be ‘stabilised’ at. This was the first time a price level was hinted at 3 years after $75 was cited in Nov ’08. It is an acknowledgement of the growing fiscal spending by the Kingdom in social welfare and wages in its public sector to balance the government budget.  A recent IMF report in Oct ’11 indicated that the break-even oil price for the Kingdom has grown by almost $30 since these 3 years.

MENA governments fiscal break even point

Demand never fully restored in US post crisis:

Importantly, the US has seen a dramatic fall in oil demand from 20.24 mb/d in Jun 2008 to 18.7 mb/d in Oct 2011. Most of it is due to higher vehicle fuel  efficiency and the higher average price of gasoline experienced in 2011 (even more than 2008)  slashing gasoline demand by 0.7 mb/d. The USA never fully recovered its oil demand post financial crisis.

USA demand (mb/d)4

2008 Jun

 

2009 Jun

2011 Oct

Change

Jun08 – Oct11

Gasoline

9.24

8.96

8.56

-0.68

Jet

1.59

1.4

1.45

-0.14

Diesel

3.85

2.87

3.76

-0.09

Others

4.67

3.7

4.08

-0.59

RFO

0.57

0.89

0.67

0.1

Total

20.24

18.04

18.69

-1.55

Supply disruption and geopolitical instability:

A list of existent supply disruptions issues is below. The list is not extensive with other disruptions in Libya and potential unrest in Iraq and Kazakhstan. However, these longstanding issues appear to have been ‘factored’ into market prices. A geopolitical theme permeates through the list with the Straits of Hormuz having the greatest impact.

Region Remarks
Iran (through Straits of Hormuz) Ongoing nuclear crisis could see the blockage of the Straits of Hormuz where 17 mb/d of crude flows. Mitigating factors include the 5mb/d Petroline to Yanbu and a 1.7 mb/d Fujairah pipeline ready from UAE ready only in 2H 2012. Still, up to 11 mb/d immediate supply could be lost in a worst case scenario. Iran itself exports 2.3 mb/d of crude. Comparatively, the OECD has oil stocks of 2630mb (IEA Dec ’11 OMR). An excellent article on the cruciality of the Straits of Hormuz is found here.
Nigeria Removal of fuel subsidies has triggered a strike among oil workers potentially disrupting its 2.4 mb/d of exports. On 16 Jan, the Nigerian president reinstated partial subsidy.
South Sudan Landlocked South Sudan seceded from Sudan but its oil exports of 350kb/d through Port Sudan appeared to have been routed for Sudan domestic consumption.

An observation is a relatively ‘minor’ supply disruption (in South Sudan or Nigeria) is expected to have the same order of impact as demand destruction in Europe. The author therefore postulates the supply elasticity of oil price to win this tug of war against demand, and consequently the oil price to surprise on the upside this year.

Footnote:

1 – Greece, Ireland and Portugal data are import data from EIA and not consumption data, but given that their own production is minimal, import and consumption figures should be similar.

2 – The dates were chosen as covering the period of the Lehman collapse – a defining moment of the crisis and to reflect the summer driving season in the USA.

3 – The labour market in USA is improving whilst the PMI data in China improved to 50.3 in Dec from 49 in Nov 2011.

4 – From IEA oil market reports in Aug 2008, 2009 and Dec 2011.

A recent game of chess in the world natural gas market

December 29, 2011 1 comment

A spate of events in the past month has shaped the natural gas markets for years to come. These are the announcements of the supply of Russian gas via the South Stream to Europe and China domestic price initiatives.

A major energy security issue pertaining to the EU has been the supply of gas from Russia. This gas transported via pipelines transit through Ukraine and Belarus. Disputes between Russia and these countries over gas pricing and siphoning have led to temporary shut-downs/ reduction in the gas flow in 2006 & 2007 directly threatening the flow of natural gas to the west European countries.

Figure 1: Nord Stream pipeline

Since then, a new pipeline the North Stream with 20 bcm/ year capacity was laid on the Baltic Sea bypassing Belarus with a first delivery in Nov 2011. Agreement for a second pipeline between Russia and Turkey, the South Stream has also been reached this week. This is expected to bypass Ukraine in transit and underlie the Black Sea transporting 63 bcm/year from 2015. For a long while, this was an impasse with Turkey with the EU-backed Nabucco pipeline in the sidelines. The Nabucco pipeline was meant to transport natural gas from the Caspian region to Europe and reduce its energy dependence on Russia.

Figure 2: South and Nabucco pipeline

However, Azerbaijan and Turkey have signed a gas supply and pipeline contract this week. This is to supply 16 bcm/ year of gas via the Shah Deniz fields via the Trans-Anatolia pipeline, of which 6 bcm/ year is meant for Turkey own domestic consumption. This pipeline is expected to defer the costlier Nabucco project. Further, China and Turkmenistan have signed gas supply and pipeline contracts last month to supply 65 bcm/ year through its remote Northwest. This effectively curtailed the potential supply of gas from the central Asia region to Europe.

This sequence of events has actually lifted Russia’s hand in its gas supply to Europe and shifted its dependence away from the transit countries Ukraine and Belarus. What will be the impact of these moves? Firstly, the monopoly held by Gazprom (Russian main state owned gas company) is expected to strengthen its hands in ongoing negotiations to move away from oil-indexed pricing for gas. Secondly, it will actually hasten the growth of alternative energies in western Europe and may even prompt an unthinkable re-think of the nuclear policy. A third unintended result is the reliance on Iran as the only feasible supplier on the Nabucco pipeline with the ripple effects of potential UN sanctions hanging over.

Another event is China liberalising its well head costs at gas fields and piloting a scheme to liberalise its city-gate gas prices this week. Whilst China has just recently secured a gas supply agreement with Turkmenistan, its phenomenal rate of growth in natural gas use is expected to outpace supply. By liberalising the well head costs at natural gas fields, it is encouraging domestic investment into shale gas and other unconventional gas sources. An EIA survey in 2011 has indicated that China holds probably the largest unconventional gas reserves in the world.

Its pilot scheme in Guangzhou and Guangxi pegs city gate prices to a combination of fuel oil and LPG prices (both liberalised markets in China). Presently, city gate prices are fixed atop a margin on production costs. These city gate prices apply to both domestic and imported gas. These recent measures by China are expected to increase its domestic production much as what USA did over the past 3 years. This can shift its dependence away from imports from Russia and other countries and significantly impact world gas markets. Price reforms are also expected to reduce potential future gas shortages seen in its oil markets.

Energy Security – at a price

March 27, 2010 1 comment

Introduction:

Among the major factors that affect energy use are depleting resources, technological innovation, weather and geopolitical risk. Unlike technology and energy reserves which are long term factors, geopolitical risk adds to the immediate volatility of energy prices. Weather as a factor of nature cannot be controlled. On the other hand, geopolitical risks can impact both market supply and demand on a short and long term basis and directly impact energy security.

Geopolitical Risks:

How it started:

Energy security is normally perceived as geopolitical risks that disrupt supply including attacks on oil and gas infrastructure like oil and gas wells, pipelines, shipping routes and refineries. A defining moment in energy security stems from the oil embargo in 1973, when Arab countries retaliated against the USA which had supported Israel in the Yom Kippur War.  The embargo lasted till Mar 1974, after which the USA enacted the strategic petroleum reserve. The SPR stores crude and products reserves which are to be used only in times of emergency.  To this date, the SPR stores more than 700 million bbls of oil or about 34 days of use.  See link.

Since then, various geopolitical events have occurred that disrupted energy supplies. Some major events include the Iranian revolution in 1979, Iraq-Kuwait war in 1991 and Sep 11. Energy security is a particular concern as the major oil producing countries are in the Middle East, a politically unstable place.

Today’s issues:

Today, the Iranian nuclear standoff has potentially the greatest disruption on oil supplies. Iran borders the Straits of Hormuz, a narrow strait between it and the UAE. Between 15 to 16.5 million barrels of oil pass through the Straits daily, which is about 20% of the world’s consumption. Other choking points that are major channels for the transportation of crude oil are the Suez channel, the Straits of Malacca and others. See the world choke points.

Supply disruptions come not only from sovereign wars but also terrorism and militant attacks. During the period 2006-2008, militant attacks in Nigerian oil producing delta kept offline the production of almost 1.3 million barrels of oil. This happens at a time when the world surplus crude capacity was thin at about 1.5 million barrels.

Gas affected too:

Aside from crude oil, natural gas is also affected by geopolitical concerns. In 2007 and 2008, Russia twice cut off the gas supplies to Ukraine on price disputes. Ukraine is a transit point for the gas pipelines to the major consuming nations of Western Europe. Western Europe suffered from shortages for almost a week, during which alternative fuel oil was used in power stations.

However, geopolitical risks have less of an impact on natural gas than crude oil. A major reason is that the major producers of natural gas are Qatar, Russia, Algeria and Indonesia, and the natural gas trade is not as globalised as crude oil due to higher transportation costs. The countries mentioned also have relatively lower geopolitical risks.

Demand impact:

Geopolitical risks can also affect demand, and a consequent decrease in prices. This was evident in the September 11 incident. The initial reaction was a spike in oil prices as it was suspected that the act was linked to the main Saudi oil supplier. When that turned out to be untrue, demand fell in the later months on lower economic activity and reduced air travel. Air travel worldwide used an estimated 4-5 million barrels a day.

Offsetting Security Measures:

The SPR reserves by the USA was a response to enhance energy security. Since then, the OECD countries in Europe, Japan and South Korea have started their own reserves. In 2003, China also launched its own storage reserve programme with an initial capacity of 210 million barrels, with eventual capacity reaching up to 90 days of forward demand or 270 million barrels. These purchases put a floor on crude oil prices in early 2009, as China and others buy up crude oil to fill up the storage tanks when prices fall too low.

New transportation routes:

New pipelines for oil and gas have also been planned and constructed to diversify and complement energy transportation routes. These pipelines have surfaced especially in Central Asia across the Caspian and the Black Sea, bring natural gas and crude oil from Kazakstan and Azerbaijan to the Turkish ports, and bypassing the transit pipelines normally used for Russian gas and oilfields. China too has constructed pipelines to divert crude and gas from the Western Siberian fields to its main consuming coastal regions.

Alternative sources of fuel:

Alternative sources of fuel are another solution for energy security. These can include the oil sands, coal, renewable energies like solar, wind and tidal, nuclear fuel and bio-fuels. These alternative fuels all have their own limitations. For example, the oil shale deposits in the USA and Canadian Rockies potentially hold about 1.5-2,5 trillion barrels, even larger than 250 billions of oil in Saudi Arabia. However the cost of extraction is enormous – about $70 to $100 per barrel, and oil prices have to be sustained above this level for economic feasibility.

The global trends of renewable energies use are expected to increase from 6% in 2006 to 10% in 2030 of primary energy use (World Energy Outlook 2008). This is the result of improved technological efficiency, accommodative energy policies and assumed higher fuel prices. Whilst the share of renewable energies will grow, total energy use is also expected to increase and fossil fuels are expected to still account for 80% of the world’s energy use.  An additional 20 barrels of crude oil is expected from the present daily ~85 million barrels presently. Most of the increase in crude oil production is expected from Middle East and Africa. As a result, the continued reliance on imported crude oil is expected to continue.

Coal and Climate change:

Another source of energy, coal is found in abundance in China and USA, and other major consuming countries. In fact, coal accounts for about 25% of the present energy mix. However, coal is a major contributor to greenhouse gases. It is estimated that the emissions from all the coal powered plants in USA together account for about 40% of the total gas emissions in the country. This can be solved by implementing carbon sequestration technologies in plants. Such implementations are more economical in new plants (and there are not many new constructions) but cost more to retrofits in existing plants. It is estimated that subsidies either in the form of a carbon tax of $40-60/ tonne or direct subsidies are needed to sustain its use. With technological improvements though, the prices may decrease over the years.

Energy Security – at a price

Thus said, energy security comes at a price. The world is not expected to wean of its dependence of oil or imported oil for that matter over the next two decades. This is in spite of increased use of alternative sources of energies. Economics can be the solution but this means the average consumer paying more for energy in an era when the competition and demand for energy resources are already increasing.