A blighted dawn in the Straits of Hormuz?

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?

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?

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?

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.

The other side of the story on speculation in the oil markets

When oil prices spiked to $147 in July 2008, debate centred on if speculation or fundamentals contributed to its rise. An initial report by the CFTC attributed fundamentals as the main reason for the rise. This was later reversed in late 2009 to speculation having a part to play.

A paper by the author attributed both fundamentals and speculation to be important in the rise of the oil prices. A study using stochastic parametric regression indicates the sensitivity of the oil prices to fundamentals and speculation had varied with time. This is likened to fundamentals acting as a steering wheel that determines the oil price direction while speculation is the gearbox. Depending on the gear level, the oil prices can move quickly up or down. Indeed the oil price fell to $40s in half a year after reaching a peak in July 2008. No one however seemed to mind that too much.

The Obama administration in 2008 mandated to curb speculation in the oil markets. Some of the measures include:

1. limits on speculative positions
2. increased margin requirement on trading
3. increased transparency in the reporting of the weekly CFTC traders’ report
4. regulation of the exotic commodity products by exchanges
5. more cooperation among exchanges worldwide to curtail oil trading

Interestingly, except for point ii and iii, none of these measures has been passed two years after its initial release. It was only in January last month that as oil prices started to climb that politicians have renewed calls for laws to be implemented to curtail speculation.

The limits on speculative positions on non bona fide investors are hard to determine. Restricting these limits too stringently dries up the liquidity for bona fide hedgers and causes the oil markets to malfunction. Further, in this inter-connected world, traders could have easily taken their positions to other exchanges which have lesser restrictions and would welcome the revenue from increased oil trading.

Regulation on the exotic oil derivatives on exchanges is difficult. There are no standard contracts for the more popular products including target redemption funds, window barriers, extendible options etc.  These are customized to customer needs with different targets, window periods and specific contract characteristics which make them difficult for delivery in an exchange. Perhaps the simpler Asian swap contracts can be listed on the exchanges, but these contracts are already marked off the monthly futures contracts listed on the exchanges.

Increased margin requirement is also unlikely to have much effect on curbing investor interest in oil trading. The additional millions just don’t deter cash-rich banks and hedge funds in an environment flush with liquidity.

Perhaps the increased transparency in the CFTC reporting has done some good segregating the banks and index traders in the oil markets. At present, this is however more useful in shedding light on speculative and hedging interests than actually curbing trading interest in the markets. It must already be realized that the CFTC has all along their proprietary set of inside data in  deriving their conclusions.

Why investors’ participation (speculation) is necessary?

In spite of the criticism on investor participation in oil markets, it has actually done some good. Firstly it creates liquidity in the markets allowing the prices to adjust quickly to the fundamentals and also allows oil producers to hedge their production. When the spare capacity in the oil markets decreased to about 1-2 million barrels in 2008, investor interest drove the prices up as any further supply disruption will severely disturb the demand supply balance. This caused the consumers to take heed (fortunately) and gasoline demand in US decreased by 1 million/ barrels a day even in the peak summer driving season. One could only imagine if consumption continued to stay high depleting further the oil reserves in the short and medium term. Instead consumers are encouraged to use oil optimally and as a scarce resource.

Perhaps one may argue high oil prices hurt the economy. Whilst this is true, high oil prices have actually accelerated investment into deep sea technologies and other improved oil drilling methods, increased exploratory activities and investment into alternative forms of energies. In 2007/08, there was a rush into investment in bio-fuels supported in part by government subsidies. A similar spike in oil prices now will further accelerate development into renewable fuels, many of which will not have been feasible in a low oil price environment.

In conclusion, the free markets still triumph. Investor participation in the markets is a necessary gear box that allows the markets to react to the times.

What if $150 oil happens again?

Back in July 2008, oil breached a record $147/bbl. Prior to that period, it only took 5 months for the oil price to climb from $100 to the record. The spike in prices portended a period of economic crisis as the world slipped into recession. The fall in oil price from the $150 to the $50s was equally dramatic in less than 6 months.

In recent weeks, the oil price has broken out of the range $70-80, as high inventories in the developed countries are quickly consumed by robust demand amid the improving world economic outlook. There has been chatter that oil will breach $100 (a comfortable level mooted by OPEC), or even $110 as suggested by Goldman Sachs this year, but none has been ambitious as the level $150.

The consensus is that this level is less likely to be reprised again in the near future due to the higher spare capacity 4 million bbls/day that OPEC has than the 2 million barrels back then. However, it is anyone’s guess whether supply disruptions of the sort happened again. (Back then, it was the hurricanes, ThunderHorse breakdown and the Niger oil producing delta shutdown. In a separate article, the author likened oil fundamentals to be the steering wheel while speculation to be the gearbox. The fundamentals set the direction for price growth, while speculation simply moved it to top gear.)

Instead, the author postulates what if the $150 oil price happens again. How different is the world now compared to 2008, and how will the economy react? Three factors stand out: 1) the availability of cheaper gas especially the recent discovery of shale gas 2) several new oil refineries in the Asia 3) development of renewable energies over the past 2 years

Natural Gas and substitutes

The recent advancement in hydraulic and horizontal drilling technologies has almost doubled the amount of gas reserves in USA. The availability of export gas volumes from Qatar, Australia and Indonesia has also cushioned natural gas prices from local disruption shocks.  Of the 87 million/ bbls of crude being consumed each day, about 8 million bbls are used as fuel oil for power electricity generation and bunker fuel. An estimated one third of the stations in USA can substitute their fuel oil requirement to natural gas when economics permits.  Further, natural gas can also substitute naphtha as a feed to the petrochemical industries. Naphtha itself is a feedstock for gasoline.  The availability of natural gas can thence soften the impact of high oil product prices in power generation and petrochemicals, important drivers in world manufacturing*. (see footnote)

Refinery capacity surplus

This in turn is derived from the final price consumers pay for oil product use. Back in the 2007/08s, gasoil and gasoline cracks reached the 20s due to a temporal deficit in refining capacity. With oil refineries in Asia running at 80% run rates presently, these crack values are not expected to venture much higher. In other words, when crude prices hit $150 other oil product prices are more inelastic in breaching $160.

Renewable and other forms of energies

In 2007/08, when oil prices hit $150, the world responds through converting sugar, palm oil, rapeseed oil to bio-diesel and bio-ethanol. Land for agricultural food was converted to grow these crops in a knee jerk reaction to high prices. However, these measures proved too slow and little, as the number of bbls of equitable oil produced was less than 1 million bbls, and at the expense of increased food prices. The past two years have seen the proliferation of wind farms, solar installations and soon nuclear plants being set up in China and Europe. A rise of oil price to $150 will further expedite investments in these forms of energies and even more deep-sea and Arctic drilling.

Conclusion

In a way, technological developments over the past two years have made the world economy more resilient to oil price shocks. Increased natural gas supplies & renewables for power generation have increased substitution for oil products especially diesel, naphtha and fuel oil.  Increased refining capacity means prices will be mainly crude driven and not oil products driven. As such, the author believes any jump in record prices, if ever reached will be short-lived like 2008. Back then, it was the collapse in the financial sector, but it will be technological and infrastructure resilience that has readied the world this time round.

Footnote:

*In a study by the IEA, the impact of oil prices on developed economies was concluded to be mainly driven by its oil intensity of the economy.