Crude Oil Prices: A Brief on Current Drivers

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

Global crude oil prices have seen significant increases over the last two months; Brent spot prices for example have increased by about twenty percent since December last year. According to Bloomberg, last week, Brent for April settlement touched US$119.79 per barrel (the highest since 22 August 2008) on the London-based ICE Futures Europe, while NYMEX crude oil for April delivery reached its highest intraday value (US$103.41 per barrel) since 29 September 2008.

The effects of oil price shocks on the global economy have been the subject of many theses. Previous oil price shocks have shown both similarities and peculiarities but with regard to current oil price concerns, two factors, are noteworthy:

1. Fundamentals

The group, Organization of the Petroleum Exporting Countries, OPEC, is believed to hold the marginal capacity to raise global crude oil production as non-OPEC production is essentially at near-peak levels. OPEC has over the past few months been upbraided by leaders of developed economies for allegedly holding back on production in order to boost oil prices. Whether by OPEC complicity or by sheer coincidence, global crude oil consumption outstripped addition by 1.3 million barrels per day between 2Q10 and 4Q10, according to Center for Global Energy Studies, CGES. This fundamental imbalance along with strong demand from Asian economies maintained upward pressures on oil prices. Asian demand has been boosted by subsidies and price controls, and as long as these conditions prevail, upward pressures on global crude oil prices will most likely remain. There have been concerns about rising inflation among these economies but as noted in my previous post, even when India’s economy declined substantially in 2009, its total petroleum consumption increased as did that of China.

Undoubtedly, the current wave of regional unrest significantly added to the upward pressure on global crude oil prices but reports about global stock levels mask the regional or continental differences which have been fundamental to price increases. For example, Energy Information Administration data show that U.S. crude stocks increased for six consecutive weeks through 18 February 2011; Midwest regional stocks increased by more than 20% over the corresponding period a year earlier. In Europe however, January saw a drawdown on stocks to a six-year low for that period according to CGES. This drawdown has been compounded by the crisis in Libya which is a substantial supplier to Europe. The result has been much higher prices for the European benchmark crude over that of the United States (Figure 1 below). The Brent-WTI price spread has been one of the largest in recent times.

2. Spare Production Capacity

Questions about Saudi Arabia’s ability to ramp up oil production may have been answered even if in part; Energy Intelligence recently reported that the country has increased production to more than 9 million barrels per day (up by about 700,000 barrels per day from end 4Q10) to pick up some of the shortfall.

There are however, lingering concerns (apart from logistics) about total spare production capacity among OPEC members.

First, if the wave of mass unrest were to flow into regional member-countries (and some, in anticipation of such unrest are currently drafting placatory measures) then OPEC spare production capacity, currently estimated to be between 4 and 6 million barrels per day becomes severely challenged, since the region holds a substantial proportion of that spare capacity.

Secondly, even where this spare production capacity is available, getting the appropriate grades and blends may be a little tricky. For example, the bulk of Libya’s crude sold to Europe is "sweet" (low in sulfur) and particularly suited to European and some Asian refining preferences; Saudi Arabia holds a substantial "sour" crude production capacity but this may not be suitable for refiners in Europe, unlike the United States where there is greater refining flexibility.

As a postscript, very high crude oil prices sustained over longer time periods present greater hazard to the global economy than flash spikes. The MENA region accounted for about 45% of global oil exports in 2009 and the current wave of unrest there constitutes a wild card in global crude oil supply projections. If its oil and gas installations suffer substantial vandalism — as some media reports imply Libya’s have — then global supply may be disrupted for months if not years, time periods necessary for complete reconstruction or rehabilitation; and therein lies the fundamental problem.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.