Andreoli on Oil & Fuel: OPEC to the rescue…maybe not

Staying abreast of developments that impact oil supply and demand helps shippers and carriers understand and plan for fuel price fluctuations; so the recent news coming out of Saudi Arabia must have left many in the logistics and transportation industry scratching their heads.

A recent Saudi statement said “the current price is too high…we would like to see oil prices back to $100 per barrel.” This statement, released on September 18, caused oil traders to speculate that the country will ramp up production and the price for a barrel of Brent crude fell from $117 per barrel to $112.

It’s one thing to suggest that production will increase, and another to actually open the taps wide enough to push oil prices down. Today’s prices are a far cry from $100, and over the last year, oil prices have dipped below this level only once during a six-week period between June and July.

Instability in the Middle East North Africa (MENA) region, which provides one out of every three barrels of oil that the world consumes, continues to drive risk premiums up, and it’s doubtful that Saudi Arabia—the only nation with any appreciable amount of surplus oil production capacity—has enough firepower to cause oil traders to avert their attention from the violent protests in Libya, the mounting tensions between the West and Iran, and the steady decline in surplus production capacity.

According to the Middle East Economic Survey, in August, Libya produced 1.5 million barrels per day (mbd) and Iran produced 2.8 mbd. According to the EIA, total OPEC surplus production capacity is only 2.1 mbd.

Surplus production capacity expressed as a percentage of global consumption is the best predictor of oil price movements. Prices spike severely whenever surplus production capacity dips below 1.5 percent of global demand, and prices rise when surplus production capacity declines.

Currently global demand is 89.5 mbd, and surplus production capacity is hovering at 2.5 percent of global demand. If just 750,000 bpd of production is lost, surplus production capacity will dip below 1.5 percent, and prices will skyrocket. Alternatively, demand rising faster than the addition of new capacity will drive the same result.

With the advent of hydraulic fracturing and the rapid rise in production of shale oil, one might be inclined to think that surplus capacity has been on the rise. But this is not the case. In fact, surplus production capacity peaked at 5.1 percent in the fourth quarter of 2009 and the average price refiners paid for a barrel of oil was just $73. Surplus capacity as a percent of global consumption has declined each and every quarter since then with the exception of the fourth quarter of 2011.

Looking forward, we must ask ourselves what could reverse this trend in declining surplus production capacity. What could cause production capacity to begin growing faster than demand?

On the demand side, the decline in consumption amongst the advanced economies that comprise the OECD is longstanding. In fact, OECD demand reached a peak in 2006, but declining OECD demand has been more than offset by rising emerging market demand.

Though much ink has been spilled discussing the “faltering” Chinese economy, what often gets lost is that China’s economy is still growing at nearly 8 percent per year. Historically, the double-digit, year-over-year increase in Chinese GDP growth has driven Chinese oil demand up faster than any other country.

Since 2000, Chinese oil consumption has increased at a compound annual rate of 6.6 percent, so shaving three points off their average annual GDP growth rate of 11.4 percent (2000 to 2011) shouldn’t drive the growth in oil demand down much under 5.5 percent. Even at 5 percent Chinese demand in 2012 will be nearly 500,000 bpd greater than in 2011.

Backing this growth out from the 750,000 bpd that separates current surplus production capacity from dropping into the danger zone (1.5 percent of total consumption), we are left with only 250,000 bpd buffer.

Turning to India, we see that 2011 consumption was up 140,000 bpd over 2010 levels, on the back of an economic expansion of 7.25 percent. Looking forward, India’s GDP growth rate is expected to slow to 5.5 percent, but even if it slows to 5 percent, it is still reasonable to assume that India’s oil consumption will grow by at least 100,000 bpd, and thus the buffer is reduced to only 50,000 bpd.

Similarly, consumption in Latin America, which is home to some of the fastest growing economies, was up more than 160,000 bpd in 2011, and Asia Pacific (excluding China and India) demand was up another 100,000 bpd. All else being equal, rising demand alone would push surplus capacity into the red zone.

Of course when oil prices are high, the incomes of the world’s oil exporters are given a significant boost, and this translates to rising domestic oil consumption which eats into export capacity. When we look across the globe, seven of the ten countries with the fastest growing rates of oil consumption are oil exporters—Saudi Arabia ranks third. The only three that are net importers are China, India, and Singapore.

Across the Middle East, oil consumption was up nearly 200,000 barrels per day last year, and with higher prices we should expect consumption in the Middle East to be up even more this year. Of course OECD demand was down, but on balance, global demand in 2011 was up nearly 600,000 bpd over 2010 levels. Looking forward, we may expect global growth in 2012 to come in around 500,000 bpd.

Where is the oil going to come from? On the supply side, in the first 8 months of 2012, OPEC production was up a scant 180,000 bpd. By comparison, in the final four months of 2011, OPEC production was up 800,000 bpd. This slowdown in growth is due to sanctions against Iran that have driven that country’s oil production down by 700,000 bpd since January.

Unfortunately, although these sanctions have been effective at compressing Iranian oil exports and national income, they have not effectively addressed the intended goal, which is to stall Iran’s nuclear build out. The International Atomic Energy Agency released a report in September indicating that Iran had doubled the number of centrifuges bringing it three-quarters of the way to the number it needs to produce nuclear fuel. With this recent discovery, the West has ramped up its rhetoric, leaving little reason to think that sanctions won’t be further intensified.

Iran’s declines over this eight-month period have been checked by gains on the order of 400,000 bpd in Libya and nearly 500,000 bpd in Iraq. But the gain in Libya was due to the resumption of oil production from fields that were taken offline during the civil war. Future gains will require exploration and new development, thus recent gains will not be easily reproduced. And with fresh violence in Benghazi, investors will be giving second thoughts to development projects there.

Iraq is another story altogether. Under Saddam Hussein’s 24-year reign, underinvestment in exploration and production was the rule. In the last couple of years, exploration and production have both picked up, with Iran hitting yet another 30-year export high in August on the back of strong southern loadings.

The country, however, has yet to establish a modern hydrocarbon law, and this fact has stymied production in the northern region of Kurdistan where exports stalled in June. To state that sectarian tensions are high in this country where nearly 60% of the population is Shia and 40% is Sunni, would be an understatement. To underscore this point, in September, the Iraqi Vice President Tariq al-Hashimi, a Sunni, was convicted of murder and sentenced to death following a series of bombings and insurgent attacks that left scores, if not hundreds dead. It is widely believed that this move was a politically motivated attempt to concentrate power into the hands of the Shiites and Shia President Nouri-al-Maliki.

It is impossible to know how MENA geopolitics will evolve over the coming days, months, and quarters. What is certain is that the global oil market is tight, and as a consequence any disruptions to supply will have a disproportionate impact on prices. It is equally certain that even under a slow global growth scenario, growth in demand will likely continue to outstrip capacity.