Investors are betting on crude oil prices because of fears of interruption of MENA crude oil supplies. Oil rose 14% MOM. Fighting in Libya may have shut as many as 850,000 barrels a day of output, according to the International Energy Agency. Prices dropped after Saudi Arabia said it would compensate for lost Libyan supplies, but rose again after protests spread to Oman (800,000 million barrel per day) and Bahrain.
Oil prices were already on the rise even before the turmoil in Egypt, increasing by $30 a barrel since the summer as the global economic recovery pushed up demand for crude. Brent Crude oil rose to $120 per barrel as Libyan protests escalated and managed money managers increased their aggressive bets. According to the latest report by CFTC, hedge funds and managed money increased their bets on crude oil price in anticipation of geopolitical risks. However, these are the investors who try to gate crash the market at the first sign of trouble.
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Quite recently Nomura Capital and Deutsche Bank (DB) predicted a crude oil price of $200 per barrel. Crude oil price momentum and commodity research community research response warrant a careful look into the assumptions which are driving investor’s expectations.
Together, the GCC states accounted for 23% worldwide oil production in 2008, which came down to 17% by the end of 2009. Undoubtedly, Saudi Arabia is the world’s largest oil producer and exporter, and contributed an average of 8 million barrels per day, accounting for 11% of global production, down from 10.8 million per day to global oil output of 82 million barrels per day in 2008, representing 13% of the total. Still, other GCC countries are notable oil producers, with the UAE, Kuwait and Qatar accounting for 3.1%, 3.0% and 1.2% of global production in 2009.
We don’t think that crude oil price is not sustainable beyond $150 per barrel because:
- Goldilocks crude oil price supported by sustainable demand is somewhere around $90 per barrel.
- If crude oil price rises to that level, it may bring another global recession compounded by social unrest.
- There is spare production capacity which can take care of any slack.
- There is a sufficient short-term inventory cover for crude oil and gasoline.
- Supply reaction to high crude oil price will bring marginal production of around 3 million barrels per day to the market.
- A high-risk premium added on the top of Goldilocks crude oil price may quickly grate to a risk discount.
- Crude oil demand can be substituted by other energy resources like natural gas.
Oil Output at Risk: We have identified Libya, Algeria and Oman as immediate risk countries. There is a risk perception on Iraq, Iran and Saudi Arabia. Please find the red columns in the chart below for the portion of supply which is under the risk of interruption. Amber columns represent the potential risk to crude oil supplies. The immediate level of risk is to the tune of 2.5 million barrels per day (Libya, Oman & Algeria), which is 3% of global demand. If there is unrest in Iraq, that could disable around 1 million barrels per day. If Algerian, Libyan and Oman supply is completely withheld, the market may face a deficit of +5% of global crude oil demand. In 1979, during the oil embargo, a 6% decrease in supply caused a four-fold increase in the crude oil price.
Libyan Outlook: Most of the Libyan (oil and gas) fields are well to the south of the country and in areas of low population (this is why the oil companies had to build their own airports). However, the crude is exported from Tripoli, Bengazi and Ajdabiya (40km south of Bengazi), so it is the infrastructure that is the main risk. But any incoming regime of whatever flavor will want to keep the oil and gas flowing, so we doubt there will be any "official" destruction of infrastructure ... but the risk of collateral damage remains. Libya produces around 1.6mb/d of crude and consumes 200kb/d. The whole of this output is at risk of being put out in the short term.
Algeria Outlook: According to the 2010 BP Statistical Energy Survey, Algeria had proved oil reserves of 12.2 billion barrels at the end of 2009, or 0.91 % of the world's reserves. Algeria produced an average of 1.5 million barrels of crude oil per day in 2009, 2.03% of the world total and a change of -9.1 % compared to 2008. Approximately 90% of Algeria's crude oil exports go to Western Europe, with Italy as the main recipient followed by Germany and France. Algeria's Saharan Blend oil, with negligible (0.05%) sulfur content, is among the highest quality in the world, and European countries have relied upon Algerian oil to help meet increasingly stringent EU regulations on sulfur content of gasoline and diesel fuel.
Algeria uses seven coastal terminals for the export of crude oil, refined products, liquefied petroleum gas (LPG) and natural gas liquids (NGL). There are facilities located at Arzew (Algeria's largest crude oil export port), Skikda (its second-largest), Algiers, Annaba, Oran, Bejaia, and La Skhirra in Tunisia. Arzew handles about 40% of Algeria's total hydrocarbon exports, including all of its NGL, LPG, and oil condensate exports. This 40% of Algeria may be at risk of being taken out if protests spread and become violent.
Iraq Outlook: Iraq’s proven oil reserves of 112 billion barrels are the world’s second-largest, behind Saudi Arabia. Lack of investment and restrictions on imports of machinery and technology have taken their toll on the oil industry, which was also battered during the Gulf War. Iraq has been able to recover some of the output it lost in two gulf wars and sanctions that dried up the investment. Crude oil production declined from 3.2 million barrels per day to less than 0.5 million barrels per day. Current oil output is 2.3 million barrels per day which is split between Mosul, Kirkuk and Basra. The most vulnerable areas are Mosul and Kirkuk, which have a crude oil output of around 1.5 million barrels per day.
Saudi Arabia & Bahrain Outlook: Saudi Arabia has 4mb/d of spare capacity and arguably any loss could be offset given time. The Saudi oil ministry announced recently that it is ready to take up any slack from a drop in Libyan output. But it would obviously take Saudi time to ramp production up, and Saudi crude is 15-30 days' sailing from major markets -- so any outage would cause a temporary shortage, increasing the risk of a crude spike.
But we would expect it to be reversed once Saudi crude started to ramp up. Saudi Arabia has a total production capacity of 11.5 million barrels per day, of which 60% is in the eastern part of the country, stretching from its border with Bahrain to the border with southern Iraq. This oil-rich part of Saudi Arabia has a substantial Shia population, which may be exposed to discontent. If discontentment spreads to Saudi Arabia from Bahrain, this can potentially put around 6 million barrels per day at risk and the crude oil price may break any ceiling. However, we consider this a remote possibility. If the Bahrain situation is resolved amicably, this will reduce the risk for Saudi output and will calm the global crude oil markets; thus the price may come down from current elevated levels.
Iran Outlook: Iran pumped 3.7 million barrels a day in February, according to estimates compiled by Bloomberg, making it OPEC’s second-biggest producer behind Saudi Arabia. Opposition supporters are planning to hold a demonstration today after leaders Mehdi Karrubi and Mir-Hossein Mousavi were transferred to a Tehran prison, according to the opposition Kaleme website. The European Union yesterday imposed an arms embargo and other sanctions on Libya, while the U.S. said it has frozen $30 billion of the country’s assets.
Oman Outlook: In Oman, the largest Middle Eastern producer outside OPEC, two demonstrators were killed and several wounded in clashes with police on Feb. 27, according to hospital and government officials. Oman pumped 885,600 barrels of oil a day in January, according to data reported by the state-run Oman News Agency. Regional protests spread to oil-producer Oman although oil flows had not been impacted. But this could flare up concerns over further disruptions in other parts of the Middle East.
MENA Spare Production Capacity: Crude oil spare production capacity had been closely correlated to crude oil price. In times of economic expansion, spare production capacity decreases because of the increase in crude oil demand. In recessions, crude oil spare production increases because of erosion of demand.
However, a decrease in spare production increases the drilling, and marginal crude oil supplies become economical at higher crude oil prices. An increase in crude oil spare capacity reduces the E&P activity and reduces the marginal crude supplies at lower crude oil prices. Both factors tend to dampen the crude oil swings and also determine the price inflection points. Middle Eastern and North African crude oil production capacity is 32.06 million barrels per day, which is 37% of the global demand of crude oil and liquids.
After OPEC production cuts in 2009 / 2010, MENA’s actual production was 27 million barrels per day. The region has a spare production capacity of 4.7 million barrels per day. However, if Libya and Algeria’s oil output is affected, it reduces the spare production capacity to around 3 million barrels per day. If Iraq’s oil production is jeopardized, it reduces the spare production capacity even further to 0.7 million barrels per day. In the case of the Saudi Eastern region, where Shias make a significant part of the population, being affected, it may create a crude oil deficit of 8 million barrels per day, which cannot be filled with any other available sources of crude oil supply. Saudi claims of having a production capacity of 12.5 million barrels per day should also be taken with a pinch of salt, as there will be a decline in crude oil production from Ghawar field.
OPEC agreed to a record 4.2 million barrel-a-day production cut in late 2008 as global demand fell 0.6%, the first decline since 1983. Higher GCC output “should keep prices from rising dramatically” (as IEA suggested) but it also pares down GCC spare production capacity, which has had a close historic link to crude oil price jumps. Oil prices “could be significantly higher” from today’s forecast if GCC doesn’t increase production as supply is interrupted from other parts of the Middle East. However, there are a myriad of permutations of the events. Please find below a comparison of crude oil spare production and oil production at risk. Amber shows a higher risk compared to yellow.
Risk Premium / Discount on Crude Oil Price: Market-required crude oil price is thought to be the sum of risk neutral price and risk premium or discount. Investors put a risk premium at the top of risk neutral price if there is higher risk of market-tightening, and a risk discount if the market faces the prospect of loosening too much. Risk premiums and discounts can be estimated by options premiums and implied volatilities (COBE). This risk premium / discount can be related to spare production capacity. By June 2008, global crude oil spare production capacity had gone down to 2 million barrels per day. Risk premium in June 2008 was estimated at around $50 / barrel (crude oil price of $147 per barrel). In December 2008, global crude oil production capacity had expanded to 6 million barrels per day and risk discount was estimated to be around $ 50 / barrel (crude oil price $34 per barrel).
Our earlier statistical analysis suggested a risk-neutral price of $84-86 / barrel. From non-parametric analysis, it appears that risk-neutral spare production capacity of 4 million barrels per day would be at a risk-neutral price of $84 per barrel. In the case of the crude supply from North Africa being interrupted, this may decrease the crude oil spare production capacity to 2.4 million barrels per day. In that case, it may be fair to expect a risk premium of $38 per barrel, which implies a crude oil price of $118 per barrel.
On the other hand, if the global economic recovery keeps on track, around $ 20 / barrel will be tacked on top of the crude oil price by the end of 2011, which implies a crude oil price of around $100 / barrel. On one hand, if supply from Iraq is affected, it may erode the spare production capacity to almost none, which should add $70-80 per barrel to the risk neutral price, implying a crude oil price of $170 per barrel. In the case of the crude oil supply from Saudi Arabia being jeopardized, that may create a real panic in the market and any lid on the price may fly away.
An increase in crude oil price above $150 / barrel and possibly more than $120 / barrel will create a worldwide tsunami of inflation, decrease disposable income and hence affect consumption, seriously affecting the companies’ toplines despite the increase in the prices. Further, because of the inability to pass 100% inflation, the companies will feel the margin squeezes. This may create serious confidence deficits, which may bring the budding global economic activity to a halt. This will bring on another worldwide recession, which may hit the developing, low- to middle-income countries first and hardest. This may create substantial uncertainty about the global crude oil demand and will create a risk discount on the crude oil price. If this demand uncertainty creates a potential discount of $40 per barrel, it will bring the crude oil price down to $40 per barrel.
Crude Oil Inventories Cover for Short Term: Visible effects of a market-tightening because of tensions in the Middle East may create a call on global oil inventories in coming days, which may propel crude oil prices beyond ]$120 per barrel. However, we feel that U.S. crude oil and gasoline inventories are sufficient to fill up any short term interruption. The inventories are still higher than the 5-year average; we expect a gradual draw down in the coming six months.
GDP Sensitivity of Energy: Crude oil prices have triggered recessions in 80% of past instances. In 2008, oil prices approached $150 per barrel. Shortly afterwards, the global economy collapsed. There were, of course, other problems at the time – an imploding U.S. housing market, the beginnings of a securitization crisis, the collapse of Lehman Brothers – but events three years ago nevertheless offer plenty of evidence that substantial changes in oil prices are big news for the global economy. Indeed, for those who believe the global economy is ultimately fuelled by oil and gas (as opposed to, for example, excessive credit), events in 2008 simply confirmed a pattern seemingly in place since the 1970s. This chart shows the level of oil prices in real terms (adjusted using the U.S. consumer price index) tracked against U.S. recessions. Regular as clockwork, increases in oil prices of more than 100% lead to declining GDP.
We’re not quite there this time around; oil prices would have to rise to $150 per barrel, a return to their 2008 peak, to double in real terms. But there are enough warning signs around for investors to feel a touch edgy. On the chart, there are some (modest) exceptions to the 100% rule of thumb: The 2008-09 recession (which merely supports the idea that oil was not the only, nor indeed the main, influence on events at the time), the 1991 recession (which was probably more affected by the credit crunch than by the temporary spike in oil prices following Iraq’s invasion of Kuwait), and the 1987 experience, when real oil prices did indeed double but there was no recession. That doubling came from a very low level (oil prices had collapsed in 1986) and, although recession was avoided, a stock market crash wasn’t. For those who were around at the time, memories of October 1987 are enough to make the blood run cold.
It is unlikely that the crude oil price can sustain above $150 per barrel. In the case that the crude oil price stays around $150 per barrel, it will bring a new recession, accompanied by social unrests. However, stagflation may not happen, as commodity prices will collapse as focus will shift to demand from supply. Developed markets will ultimately follow the emerging markets into recession. But for that to happen, we shall expect to see commodity prices (food and energy) increase a tack further and see other symptoms from the economy. On the basis of historical behavior of GDP growth and energy intensity of GDP, we have estimated that crude oil price between $80-100 / barrel do not cause a severe demand and supply reaction in an atmosphere of a slow economic recovery. We are of the view that the U.S. economy now could absorb that crude oil price and still post some GDP growth.
Crude Oil Share of Energy Use & Substitution: Higher crude oil prices may result in the substitution of crude oil by other sources of energy like natural gas, coal and nuclear energy. Simply rising NG and coal consumption offset what was at the minimum optimization of oil consumption to the transport sector -- if not an outright decline. Conservative estimates of EU / US / Japan and China GDP / crude oil consumption (i.e. increasing) and higher crude oil substitution flexibility to crude oil price may result in a decline in crude oil demand.
Goldilocks Price: In the current environment of slow economic growth and a fragile recovery, it may be useful to estimate a goldilocks price which may not hurt the nascent economic recovery based on estimates of consensus global GDP growth estimates and crude oil consumption, which is needed to sustain this growth. Although, on a relative basis, a crude price of $100 per barrel seems justified, we estimate a goldilocks price of around $86-90 per barrel.
Total U.S. energy consumption (measured in quadrillion BTU) grew rapidly until the oil price shocks at the end of 1973 and 1979. Consumption was fairly stable until the late 1980s. Since then it has been growing.
The rise in crude oil demand was higher in commercial and residential sectors, but was lower for industrial sectors (although at a lower rate than in the years prior to 1973). Part of the reason was outsourcing of industrial activity to China and the developing world. As services became a bigger part of the economy, commercial use growth outstripped industrial use. Residential use has risen with the rise in suburban sprawl and the increase in the population.
Another impact is the impact of higher crude oil prices on the U.S. trade deficit. The U.S. has contracted out much of its manufacturing to developing nations; the impact of higher oil prices will be more visible on American consumer behavior (gasoline). The gasoline segment, which is the largest product segment of crude oil (at 8 mbps), is susceptible to higher crude oil prices. This can be seen from the number-of-miles-driven data reported by FHA as below.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.