Andreoli on Oil & Fuel: The fundamental problem with oil prices

It has been a tumultuous month when it comes to oil and fuel markets. As of the writing of my last column, which was submitted on the April 15, WTI (the crude stream traded on the NYMEX) was at $109.66 per barrel, up 19.8 percent from $91.55 where it sat at the beginning of the year. Meanwhile, the spot price for Brent Blend, the benchmark crude stream traded on the European Intercontinental Exchange (ICE), had climbed 30.1 percent from $95.82 on January 3 to $124.63 by April 15.

My warning in the last column was that refiners’ costs were better reflected in the price for Brent, and that supply chain and logistics professionals following the WTI price were going to get caught short as the refiner average acquisition cost had diverged from a historical average of $2 to $4 per barrel below the WTI spot price to $4 per barrel above the WTI spot price.

Since that column, the prices for a barrel of both WTI and Brent Blend have gone on a roller coaster ride. The spot price for Brent climbed as high as $126.64 by May 2 before falling by nearly 12 percent over the next three days alone. Meanwhile, the front month WTI futures price reached a peak of $113.93 on April 29 before falling by more than 16 percent to a low of $95.33 by May 12.  Check out these additional fuel articles.

Of course volatility is precisely what should be expected when oil markets are tight, as they have been since the onset of the recovery. Despite living up to expectations, however, the recent volatility has led some to conclude that the prices simply don’t reflect the underlying fundamentals of supply and demand, but such a conclusion is not supported by sober analysis.

The majority of recent news regarding the supply side of the equation strongly indicates a further tightening of oil and fuel supplies. Rather than taking my word for it, I present below a review and brief interpretation of recent news on supply coming from the largest oil producing countries.

Russia and Saudi Arabia are the world’s largest oil producers. They are also the world’s largest oil exporters, and from the perspective of a net oil importer like the U.S., oil exports matter far more than oil production. On this front, there is a critical difference between Russia and Saudi Arabia. Russia has continued to increase oil exports each and every year. Oil exports from Saudi Arabia, on the other hand, peaked in 2005.

Another important difference is that Russia, like nearly every other oil producing nation, does not claim to have any surplus production capacity. By contrast, Saudi Arabia is one of only four nations to claim that they have the ability to increase production at a moment’s notice. Saudi Arabia is, in fact, the only nation to claim significant surplus production capacity (3.15 million barrels per day), thus Saudi Arabia is the world’s swing producer.

Of course Saudi claims of surplus production capacity are not backed by transparent and verifiable information, so market observers are left to interpret Saudi Arabia’s actions in addition to their words. On this front, Saudi oil officials recently met with Halliburton to discuss plans to boost their oil rig count by roughly 30 percent – an action which suggests that Saudi Arabia is looking to increase surplus production capacity.

The fact that there exists a strong inverse relationship between the amount of surplus production capacity and oil prices leaves the market observer wondering why on earth Saudi Arabia would make such a large investment to increase production capacity if their claims of having more than 3 million barrels per day of surplus production capacity reflect reality. Do they think the price is too high, and look forward to earning less per barrel of exported oil? Obviously not.

Alternatively, could it be that they are worried that rising internal demand will quickly erode their production cushion unless they make a significant investment? This seems much more likely, but there is yet another plausible explanation. The Saudi claim of 12.5 million barrels of capacity in place may simply be an overstatement.

Perhaps their words will shed light on their actions. According to a Saudi oil official interviewed by Reuters, the investment in new drilling rigs “is not to expand capacity. It’s to sustain current capacity on new fields and old fields that have been bottled up.” This news on its own should be troubling as it infers that the Kingdom is facing significant declines on currently producing fields.

Even more troubling is the recent statement by another senior Saudi oil official that the Kingdom “expects oil production to hold steady at an average of 8.7 million barrels per day to 2015.” These statements made in regard to Saudi production call into question the Saudi willingness and ability to increase exports, which is tacitly understood to be the responsibility of the world’s only pivot producer. Moreover, these statements should come as a warning. If the Kingdom holds production flat, exports will decline by the rate of growth of internal demand, and Saudi domestic consumption has been growing at just under 10 percent per year.

Turning to Russia, I am equally concerned by the news reported by Dmitri Zaks (Yahoo! News) that “Russia decided on Thursday [April 28] to halt premium petrol exports and switch the flow to the home market to fight shortages and a price rise that is coinciding with growing voter discontent.” Apparently, fuel demand in Russia is climbing faster than the rate of supply, and exports are by default put into jeopardy, just as they are in Saudi Arabia and many other oil exporting nations.

But Russia is not alone when it comes to enacting export restrictions. The Financial Times reported on May 10 that “Beijing has put strong pressure on its state-owned oil companies to halt overseas sales of petrol.” Then on May 13, the Financial Times reported that “Beijing has suspended exports of diesel fuel indefinitely to help meet domestic energy demand ahead of the peak summer season, prompting concerns about knock-on effects across Asia.” In addition to battling inflation, China, like Russia, is facing fuel supply shortages.

When it comes to inflation, China is not alone. In an effort to battle inflation in Brazil, leaders there have called on state-owned oil producer, Petrobras, to lower fuel prices by 10 percent. Doing so would of course provide a perverse incentive to Brazilian consumers to increase consumption.

Even more importantly, lowering fuel prices would cause further problems for Brazil’s unregulated and privately owned ethanol producers who are already suffering from skyrocketing input prices as they compete with food producers for sugarcane. Perhaps this is why Petrobras was also recently ordered to triple its share of the nation’s ethanol production, and why there have been calls within the nation to begin regulating the sugar and ethanol industries.

Turning North to Venezuela we learn from the Wall Street Journal that, “the South American nation is swapping out its old system of royalties and will instead charge a higher levy of 80 percent or 90 percent on revenue above $70 and $100 a barrel, respectively.” As investment advisor and energy expert Jim Hansen points out, “The taxes will be directed to social programs and not into the poorly performing Venezuelan oil industry. About all this is going to guarantee is continued pressure on declining oil production from Venezuela and continued domestic economic difficulties.”

Given that 80 percent to 90 percent of revenues will be funneled away from Venezuelan oil producers, it will be difficult for Petroleos de Venezuela (Venezuela’s state-owned oil company) to continue investing in new production. And the Venezuelan government is not unique in levying what might be called a ‘political premium’ on top of production costs.

According to a study by the Institute of International Finance, a global banker’s trade group, the increase in Saudi federal spending in response to the unrest in the Middle East and North Africa has ensured that Saudi Arabia will need to sell its oil at an average of $88 per barrel in 2011 just to break even. Bearing in mind that Saudi oil, which is both heavy and high in sulfur content, sells at a discount to Brent, it is clear that even Saudi Arabia requires high prices moving forward.  Check out these additional fuel articles.

Perhaps these challenges that I’ve outlined explain why the majority of the 550 financial executives of global energy companies polled in KPMG’s annual energy survey believe that the price for a barrel of oil will average more than $121 this year. To quote Downstream Online: “Thirty-two percent think 2011 U.S. crude oil prices will peak between $121 and $130 per barrel. One-third of executives see even higher prices, with 17 percent of those predicting between $131 and $140 per barrel; nine percent between $141 and $150; and six percent expecting crude prices to exceed $151 per barrel before year end.”

Of course this analysis is one-sided in that it ignores demand. If demand falls as the result of lower than expected economic performance of the global economy, tightening supplies will be somewhat mitigated just as they were in late 2008/early 2009. And it bears mentioning that rapidly rising oil and fuel prices played an important role in the economic collapse in 2008.