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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.

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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 case of déjà vu on oil prices?

September 15, 2011 2 comments

Back in July 2008, oil prices slumped dramatically from the 140s to the 40s in a space of 6 months. Whilst not as dramatic, oil prices have fallen for some $20 over the past few weeks but have started to stay up this last week. With the world possibly on the cusp of a recession, it takes a little imagination to compare then and now.

What does the industry say?
With just three months before 2012, most banks have lowered their forecasts of Brent by some $10 to $110-115/bbl. Noteworthy is Citibank calling for a price drop by a further 10-20%. This time round, both the fundamental and speculative factors are at work – albeit differently.

Supply and demand driven
Both OPEC and the IEA have lowered forecasts of oil demand in the OECD countries by an estimated 300 kbbl/day. Whilst this demand is forecast to decrease, the oil demand growth in China and other developing countries is more than enough to make up for it. The growth in the developing countries is expected to reach 1.4 mb/day, topping overall growth forecasts to 1.1 mb/ day in 2011. Back in 2008, overall global demand destruction was about 1 mb/day.
The coming online of Libya and Kuwaiti crude, and supply curb lifts in non OPEC crude in the later part of this year are expected to add some 1 mb/day crude. In all, spare oil capacity is expected to be near 4.5 mb/ day, a level much higher than the 2008s.

Elasticity tug of war? Rangebound prices amid the tightness?

In a scenario of tight fundamentals, the price elasticity1 of oil is normally driven by its demand elasticity. However, the present scenario sees both supply and demand elasticity of oil playing a part. On one hand, the slower economic growth and increased supplies drive down prices, Yet from a global point of view, global demand continues to grow. It pays to realise that WTI prices in the USA have been some $20 lower than the global brent benchmark consistently. Such lower prices mean no further demand swing destruction in the world largest oil market.

Regulatory landscape change
In an earlier article, the author likened oil prices to be running on gears. Perhaps the oil prices are running on a lower gear now with more regulatory oversight and transparency by the CFTC? Yet aside from higher margins requirement and more transparent reporting, the regulatory landscape has not changed much. The debate to implement position limits on funds/ banks – maybe the most stringent measure has been held back pending further analysis.

Footnote:

1- Notwithstanding supply has been maximised in a tight scenario and there are no more ‘surprises’ from sudden disruptions to existing infrastructure.

OPEC and climate change

April 17, 2011 7 comments

Being the major producer of fossil fuels which are the single important contributor of carbon emissions, OPEC role in climate change is pivotal. The key to reducing greenhouse emissions is the use of renewable and alternative energies and less use of polluting fossil fuels. Whilst OPEC has to ensure the future profitability of its oil revenue, it at the same time wants to be perceived to be an advocate of climate change issues.

Change in OPEC stance

In the early 2000s when climate change starts to gain global attention, there were initial rumblings among members of OPEC. There were fleeting suggestions of compensation for schemes like carbon trading and carbon tax that would have reduced the attractiveness of crude as a fuel source. OPEC wanted an assurance that even as it invested in its capacity, future demand would be assured.

Over the past decade, even as climate change talks stagnated and gained more prominence, OPEC has changed its stance. In 2007, it adopted a $3b climate change fund to fund research in carbon capture and sequestration (CCS) technology, especially in the area of enhanced oil recovery. This research is envisaged to reduce the carbon emissions from the use of fossil fuels and increase its attractiveness. Such technology is more suited for immovable facilities like power plants and industrial facilities (eg refineries). At the moment this technology is prohibitive and will be cost effective only if carbon price reaches more than $60/tonne. (Comparatively, the present EUA on the european trading scheme is about $22 at time of writing.)

The electric vehicle and transportation fuels

The advance of CCS technology is not likely to make an immediate significant reduction in carbon emissions due to the exorbitant costs to modify existing industrial facilities, and potential fuel switching to the less pollutive and cheaper natural gas.

A recent Apr 2011 report by the IEA highlighted the progress of the use of renewable fuels. However, since the strong production growth of 2010, its growth (including bioethanol and biodiesel) has slowed to less than 2mb/d. The use of such biofuels is also strongly dependent on mandates and subsidies, making it an unattractive proposition.

An analysis of the usage of fossil fuels indicates transportation fuels to be the main demand driver. Gasoline, jet fuel and diesel constitute 21.3 mb/d, 6.9 mb/d and 21.2 mb/d or 55% respectively of 90 mb/d global demand (notwithstanding bunker fuel which will change to use marine diesel in the next decade).

It is the advent of the electric vehicle that may potentially displace the major use of transportation fuels and thence fossil fuels. It is this area that OPEC will probably be watching. The use of such vehicles will take time to filter through as old vehicles are replaced. Further it requires infrastructure to be built for the re-charging and maintenance of expensive batteries.  A research by Goldman Sachs estimates this revolution to slowly take place over the next 5-10 years. For its use by the mainstream consumer, this will take an even longer time.

In the interim period, the insatiable global demand for crude oil from the emerging economies is expected to increase, creating a temporal period of imbalance in demand/ supply. The world is not going to wean itself of dependence on fossil fuels in the medium term. This will continue to incentivise OPEC to invest in existing capacity.

Does the oil market listen to OPEC anymore?

November 6, 2010 Leave a comment

In 2009, the world consumes about 87 million bbls of oil each day, of which OPEC contributes almost 30 millions. Being the largest and only cartel that has spare oil capacity, the markets often hears out OPEC for price signals and production quotas.

For the past few years or so, it appears OPEC signals have ‘waned’. Presumably no country in OPEC adheres to their production quota, choosing instead to maximise production, with only biggest producer Saudi Arabia holding some spare capacity at estimated ~1-2 million bbls. The fast growth of the global oil demand outpaced global supply. It was only after the global recession of 08/09 that spare capacity returned to a healthier 4-5 million barrels, boosting inventory in OECD countries to 61 days of cover, the highest level since 1998.

OPEC meets once a month, where a ”call on OPEC’ had been determined since 1973.  This call on OPEC is the oil production OPEC needs to produce to make up for the difference in global oil demand and non-OPEC supply. Over the past few years, this “call on OPEC” has not changed much. This is as most of the recent increase in the oil demand especially from China and the developing countries has been met mainly by Russia and the former Soviet republics. Notwithstanding its ‘normal’ capacity production and dwindling share of world oil demand, do the markets even listen to OPEC moves anymore?

The author is of the opinion that OPEC has a more long term influence than a short term influence on the markets. In other words, the back end of the forward curve takes its cue more so than the short end of the forward curve. A plausible explanation for this is due to the volatility of the short end caused by supply outages and seasonal oil demand. This negates the market influence of OPEC production hikes or cuts. Another reason is logistical as it takes almost 2-3 months for oil from the well heads in the main Arabian gulf production areas to reach the main markets in the developed markets. An interesting article in the Energy tribune and the conclusion reached by IEA or the EIA is the continued dependence on OPEC oil production into the next two decades.

The world needs OPEC oil for its economic growth and standard of living even more so in the future. OPEC is ‘needed’ to meet the expected growth in demand even as supply dwindles in the non OPEC countries.

The longstanding ‘interaction cues’ from OPEC and the market have also led to prices equilibrate faster. It is almost a case of ‘after all these years I know what you will do next.’. OPEC determines its production quotas from the oil prices or inventory. It is an almost open secret that OPEC will not cut production when prices are high but not too high, so as not to disrupt economic growth and speed up the usage of alternative fuels. In Mr Ali al-Naimi, the Saudi oil minister’s words, “Good demand, reliable supply and beautiful prices

It will cut production when prices drop too low, as in the recent case in 2008 when prices dip to $30, to maximise its overall revenue. Prices equilibrate to $40 after that for most of the recession, as the markets put a floor on prices. Such range bound prices are what OPEC seek to achieve. Under this presumption, the oil price spike to $150 in Jun 2008 can be understood.  OPEC can just do no more as it has zero spare capacity, causing prices to break out of its ‘normal’.