The oil picture is always complex, but right now things are about as complicated as they can get. The unrest in Egypt has settled for the moment, but the future there is not yet clear as the military takes control on promises of free elections. Tensions are rising in Algeria, where the unofficial unemployment rate is along the lines of 40% and protesters are demanding change. Yemen and Bahrain are unsettled, to say the least. And now Libya is embroiled in the most violent protests to rock the Middle East during the current wave of uprisings, with 40-year ruler Colonel Muammar Gaddafi sending snipers and helicopters to shoot down protestors in the capital city Tripoli.
Unrest in Egypt mattered because of the Suez Canal and the Suez-Mediterranean Pipeline, which together transport almost 2 million barrels of oil per day. Protests in Libya and Algeria – with Libya inching closer and closer to full revolution status – matter because both are important oil producers and key suppliers to Europe. Algeria produces some 1.4 million barrels of crude each day, while Libya spits out 1.7 million barrels a day. Libya is Africa’s third largest oil producer after Nigeria and Angola and has the largest crude oil reserves on the continent, concentrated in the massive Sirte Basin.
The Egyptian revolution has not yet disrupted oil supply. In Libya, however, things are very different. Global oil companies are pulling employees out of the country, leaving exploration projects and producing wells sitting idle.
Al Jazeera reported that oil has stopped flowing at the Nafoora oilfield, which is part of the Sirte Basin. The largest and most established foreign energy producer in Libya, Eni (NYSE:E) of Italy, is repatriating its nonessential personnel. German firm Wintershall is winding down its wells, which produce 100,000 barrels daily, and flying 130 foreign staff members out of the country. Norwegian Statoil (NYSE:STO) is closing its Tripoli offices and pulling foreign workers out. OMV (OTCPK:OMVKY) of Austria, which produces 34,000 barrels of oil a day in Libya, is evacuating most of its workers. And BP (NYSE:BP) is flying its staff home as well, leaving its exploration operations unattended.
With foreign journalists banned from the country, phone lines cut and Internet access mostly severed, it is almost impossible to know just how much of Libya’s oil supply has been disrupted (one report pegged it at 6%). But Libya’s second largest city, Benghazi, has fallen to protestors, and it is in the country’s east, where the oil fields lie. With politicians defecting and government buildings literally burning in Tripoli, it is clear that, whether Gaddafi stays or goes, disruptions will continue and uncertainty is the new normal in Libya. If Gaddafi does go, it is not at all clear who can lead the country’s next phase, as Libya is a country bereft of institutions, with a non-cohesive army and old tribal structures that are both divisive and weakened.
The price of oil responded to Libya’s instability immediately. Europe-traded Brent oil prices hit above US$108 per barrel on Feb. 21, a high not seen since just before the recession, in September 2008. The West Texas Intermediate (WTI) oil price, which reflects the American market, also gained notably, adding US$3 to reach almost US$92 per barrel.
The head of oil research at Barclays Capital, Paul Horsnell, described the current situation as potentially worse for oil than the Iran crisis of 1979. "That was a revolution in one country, but here there are so many countries at once. The world has only 4.5 million barrels per day of spare capacity, which is not comfortable."
There are several comments to make about all of this.
First, oil prices might run out of control again. High oil prices reduce the amount of money people have to spend on other things, shrinking demand in the wider economy. Eventually a tipping point is reached where confidence collapses. Given the recent global recession, you might expect OPEC to act quickly to prevent that cycle, but the wave of protests across the Middle East and North Africa has OPEC leaders just a tad bit distracted.
Many are now wondering aloud if Saudi Arabia will be the next nation to see protests. In that context, what happens to the world economy is not exactly a priority for OPEC leaders right now – they are focused on survival. This is not an environment conducive to the kind of quick decision-making necessary to control oil prices.
Second, remember that benchmark prices for oil do not have a strong relationship to supply and demand. That is why prices could shoot up – speculation and manipulation by hedge funds and hoarders have as much impact as an actual change in supply. And a final benchmark price stems from a complex summation of interlinked spot, physical forwards, futures, options, and derivatives markets, which means the paper market is almost as important as the physical one.
The current spread between the two main benchmarks – Brent and WTI – is one example of how the benchmark pricing system fails to properly represent the oil market and all its complexity. WTI has historically been slightly cheaper than Brent, but over the last year the discount has spread to a record of as much as US$19 per barrel. The difference reflects ample supply in the U.S. Midwest (WTI is an American benchmark) compared to a squeeze on supplies from Europe’s North Sea.
While that part makes sense, why is the Brent price used to determine three-quarters of the world’s oil contracts, including those in Asia? A market with very low production volumes is used to price markets with very high production elsewhere in the world.
The system has led to many other nonsensical situations, like the fact that many U.S. oil refiners and consumers pay prices that track Brent, not WTI, so right now American gas station prices reflect greater-than-US$100-a-barrel oil even though the North American benchmark hasn’t yet passed US$92. When you add in the fact that no one really knows what’s going on in the world’s fastest-growing oil market, China, you have all of the ingredients for serious mispricing.
Third, transportation infrastructure plays a key role in oil pricing. North African oil and gas are especially important to Europe because the only other place with pipelines running into Europe is Russia, and no one likes relying on Russia for energy. Russia already exports 7 million barrels of oil each day, which constitutes roughly 10% of global production.
To get around reliance on Russia for both oil and gas, European countries have been working to build more pipelines from North Africa, including a new, US$1.4 billion Algeria-Spain gas pipeline set to open in March. The desire to avoid increased reliance on Russia is another factor driving the Brent benchmark upwards; European prices for natural gas and liquefied natural gas are also on the rise, for the same reason.
Right now in the all-important oil world of the Middle East and North Africa, short-term supply, future prices, ownership and preferred trading partners are all up in the air. Libya’s potential revolution poses a real threat to oil supplies – as mentioned, we only have 4.5 million barrels a day to spare, and Libya produces 1.2 million. On top of that, the fact is that oil prices are not decided in the most rational ways, and speculation plays a major role.
Can we profit from all of this? If you believe oil is on the rise, there are ways to get direct exposure to the price of oil, as well as many oil companies worth considering.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.