Crude Oil Price Shocks and Market Fundamentals

Includes: DBO, OIH, OIL, USO, XLE
by: Dennis U. Atuanya

The International Energy Agency, IEA, last year projected a crude oil price shock by the year 2012, just about two years away. The agency had argued that when the global economy began to rebound, crude oil demand would outstrip supply capability, the latter having been impacted by reduced capital expenditure (capex) associated with the global economic slump.

According to market reports, crude oil price reached US$80 per barrel in intraday trading on the last day of 2009, ending the year 78% up for the front-month contract on the New York market; that was more than twice the prices seen at the same period a year before. Price rallies saw some analysts adduce certain price markers, above which a surge would be triggered.

In a previous post on oil price shocks and market fundamentals, l argued, and for three reasons, that even in the unlikely event of a short-term oil price shock, such would be unlikely to show any market fundamental support. First reason was the somewhat, overstated figures for capex reduction as well as the increased viability of projects (due to reduced operational costs of mainly labor and materials) which arise from the economic slump; secondly, the increasing reserve additions; and finally, substitution and efficiency. Implicit in the reference above, to fundamentals, are the so-called “traditionals” or “physicals” such as inventories, demand and supply, as distinct from the “financials” such as currency values, bonds and equities.

Recent industry data do give credence to my arguments on all three scores:

  1. 1. Current data from IHS CERA and the U.S Department of Labor Statistics reportedly indicate that aggregate upstream capital costs declined by 12% (year-on-year) in November 2009. The implication then is that even with reduced capital deployment (some recent reports put the capex decline at 15%), effective investment in the industry may at worst, be little changed while actual production may increase. The latter has been the case with Russia for example; the Natural Resources minister for that country, as reported by Platts, revealed that even with substantial capex reductions, reserves in 2009 grew by 5.3% over the previous year. Even the capital-intensive tar sands projects of Canada are set to benefit from such costs reduction. Capex values however, though currently lower than those for the period before the global economic crises, have been increasing. According to Oil and Gas Financial Journal, capex in 2Q09 for the 20 largest U.S. publicly traded companies increased by more than 47.5%, nearly doubling the $28.1 billion spent in 1Q09.
  2. Global crude oil production and reserves are also set to witness substantial additions (even in the short and medium terms). For example, Abdalla El-Badri, secretatry-general of the Organization of the Petroleum Exporting Countries, OPEC, as reported by Financial Times Energy Source has confirmed that “the current investment is going to be enough to satisfy demand and provide a cushion of spare capacity of 6 million barrels by 2013”. Rigzone reports that CEO of the Brazilian NOC, Petrobras says the company is on course to increase its reserves by 21 billion barrels from 2009 levels in just less than two years, increasing its production capacity in the process. In 2009, Russia’s addition to reserves exceeded production by 25% and, though there are still political hurdles to be crossed, Iraq’s oil production is set to equal or exceed that of the long dominant Saudi Arabia in seven to ten years. Substantial capacity increases are also expected from the massive Atlantic provinces of Africa, where first production from Ghana’s 1.8 billion-barrel Jubilee fields for example, is expected later this year. According to Argus, non-OPEC supply grew by more than 500,000 barrels per day last year mainly from Russia and the Gulf of Mexico. It also expects 2010 oil demand to rise by 1.5 million barrels per day, bbls/d, after falling by 2 million bbls/d last year, adding that 2010 consumption is unlikely to exceed 2006 levels. These are in addition to large inventories. Interestingly, recent United States Geological Survey, USGS, data have put Venezuela’s technically recoverable reserves in that country’s Orinoco oil belt at a massive 513 billion barrels (about the world’s largest), out of about 1 trillion barrels. In truth, though most industry operators know where Venezuela is, few if any, for the moment, would be rushing down there; but it could only take a regime change to spur fervent interest.
  3. Finally, a steep rebound to robust, global economic activity, a major driver for energy demand, is not likely. The International Monetary Fund, IMF, for example, in its recent Global Financial Stability Report and World Economic Outlook press conference, expected global economic growth rates in 2010 and 2011 to be 4% and 4.3% respectively (another report has 2.7% for 2010). It also warned that recovery of the global economy remains rather sluggish and fragile (especially with fears of a ‘double dip’), and such is quite indicative especially when viewed in the light of the depths to which it slumped. Even when economic activity does fully rebound, oil demand in developed economies would most likely not return to pre-slump levels due mainly to substitution and increased efficiency. Driven principally by China and India, oil demand growth in emerging market countries is expected to outstrip that of developed economies; but product subsidies (many of which are now being repealed or reduced) in emerging economies often distort demand projection figures. According to the IMF’s Oliver Blanchard, China’s growth “is still partly based on very strong fiscal stimulus and credit easing” and some analysts have hinted at a scaling back on fears of economic overheating among others. It is also noteworthy that according to most evaluation accounts, China boasts the steepest growth rate in renewable energy development, matching her “aggressive” oil policies. The latter therefore may largely be interim and supplementary.

These factors largely do not admit a short-term (or even a medium-term) supply crunch, which has been projected as the driver for a short-term price shock. That said, prices may surge even with adequate supply. During the oil price surge of 2008 for example, prices spiralled higher while the market was well supplied. The causative factors were aptly described by Chris Cook, former Director of the International Petroleum Exchange (as quoted in an article on He said

the principal cause of the financial crises and of the volatility are one and the same – to wit, the ‘leverage’ or ‘gearing’ derived in the former case by deficit-based credit creation by banks, and in the latter case by both bank credit creation and forward/futures contracts.

Subsequent price spikes were in spite of bloated (including massive floating or unconventional) inventories as well as very weak demand. The result was that in 2009, even with a doubling of crude oil prices (between Q1 and Q2), major IOCs posted as much as 76% decline in their Q2 earnings reports.

Disclosure: None