Wet barrels versus paper barrels
According to the International Energy Agency, the global population can be expected to considerably force up its daily consumption of oil in the five years to come. This growth is completely due to a highly increasing demand for oil in the developing (non-OECD) countries, particularly in Asia. The increase of production capacity, on the other hand, is expected to be considerably lower. This means reserve production capacity will drop drastically. It is not unlikely that the financial sector will see this as a signal that the time has come to abandon the relatively stable range of around $70 to $80, within which the oil price has fluctuated for a considerable time now, and once again drive up the oil price.
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The record-breaking oil prices of the summer of 2008 and the subsequent drop in the price of oil led to much discussion whether or not the volatility of the oil price could be and should be curbed in some way or other. These discussions focused on limiting the speculative oil trade (see ‘France declares war on oil speculators’ and the interview with Jean-Marie Chevalier). The huge trade in so-called "paper barrels" that had developed was said to have had a huge effect on driving up the price of oil. Paper barrel trading does not involve trading in real ("wet") barrels of oil, but the right to purchase or sell a barrel of oil at a certain time and at a certain pre-fixed price. In 2009, trading in paper barrels exceeded trading in wet barrels by a factor of no less than thirty.
It appears that paper barrel trading has developed dynamics of its own, to some extent independent of the fundamentals. The question is to what extent the fundamentals, the decisive factors in terms of supply and demand, are still decisive with respect to the price of oil. We will return to this in a moment.
The IEA’s recently published medium-term outlook sketches the expectations regarding the development of fundamentals in the next five years. And these are worrisome. In its ‘business as usual’ scenario, the IEA expects the world to consume around 92 million barrels per day (mbpd) in 2015, 7 mbpd more than in 2009. The increase is accounted for entirely by the non-OECD countries. Non-OECD Asia (51%), the Middle East (21%) and, to a lesser degree, Latin America (13%) are the most significant growth regions. Total consumption increase of the non-OECD countries is expected to be 8.9 mbpd in 2014. The IEA bases this expectation on a model that describes an energy ladder that developing countries climb along their road to economic growth. For instance, with regard to mobility, in which oil is the most significant factor, the energy ladder is as follows: walking -> cycling -> public transport -> motorbike -> small car -> large car. At each step of the ladder, energy use tends to increase exponentially before reaching a saturation point, where growth markedly slows down (a so called ‘S-curve’). The fact that the countries concerned are now halfway up the ladder means that their need for oil will increase radically in the time to come as a result of increasing prosperity.
The IEA expects the OECD countries to collectively consume 1.8 mbpd less, a decrease of 0.7% per year until the year 2015. According to the IEA, industries with a low oil-intensity will account for the economic recovery in the OECD. 'As far as the OECD is concerned, the emergence from the 2008-2009 recession will in practice translate into an "oil-less" recovery over the forecast period.' The IEA expects to see only a limited increase in the demand for transportation fuels in the OECD, as most of the fleets are saturated. Moreover, this slight increase will be counteracted by a decrease in the demand for burning and industrial fuels.
As a result of the increasing demand for oil in the non-OECD countries and the decreasing demand for oil in OECD countries it is expected that oil consumption of the non-OECD countries will be higher than that of the OECD countries for the first time around the year 2015.
The IEA expects the supply of oil to grow from 91 mbpd to 96.5 mbpd in the period to 2015. However, the oil mentioned here no longer solely refers to conventional crude oil. In effect, a mere 16% of the extra 5.5 mbpd actually concerns conventional crude oil; the remaining 84% consists of bio-fuels, unconventional oil (like the Canadian tar sands) and Natural Gas Liquids (NGLs). The joint non-Opec production of crude oil, for example, is expected to decrease by 1 mbpd. This decrease is to be compensated by an increase in the production of bio-fuels (+0.8 mbpd), unconventional sources (+0.7 mbpd) and NGLs (+0.4mbpd).
Opec too has ceased to depend solely on the traditional production of crude oil. Of the incremental 4.5 mbpd production capacity that the IEA expects OPEC to realise over the next five years, almost 60% will consist of NGLs. This will increase the proportion of NGLs in Opec’s production capacity to 7.2 mbpd, or 20% of Opec’s total production capacity.
With an increase of 3.0 mbpd (or 56% of the total oil supply growth), NGLs make up the ‘cornerstone of oil supply growth’, as the IEA puts it. NGLs consist of ethane, propane and butane (collectively LPG), pentanes-plus and gas condensates. NGLs are often added to crude oil in order to improve the quality of the oil before it is refined, rendering it possible to produce oil products of a higher quality. This is an important positive side effect of the increased production of NGLs, as this partially compensates for the decrease in the quality of crude oil.
Interestingly the IEA points out that many mature oilfields show a lower decline rate that than expected. A calculation on the part of the IEA shows that a 0.5% change in the average decline rate of oil fields leads to a 1mbpd change in production in 2015. As the IEA expects the decline rate to go down from 5.8% to 5.1%, the loss of production capacity in 2015 will be 1.4 mbpd less than expected. Still, production from mature fields will decline by 3.1 mbpd each year. To compensate for this natural decline will be a tough job, the IEA notes.
At a recent oil conference – hosted by the reputable Dutch energy think tank Clingendael International Energy Programme (CIEP) – it was evident that not everyone agrees with the expectations of the IEA. Paul Stevens, oil expert and senior research fellow at the British think tank Chatham House and author of a recent report entitled ‘The coming oil supply crunch’, feels that the IEA is over-optimistic in its expectations. In his opinion, both demand and supply will be lower than sketched by the IEA. Stevens argues that the IEA does not sufficiently allow for the dismantling of subsidies for oil consumption by various national governments. He points out the fact that oil intensity of the economies of many developing countries is relatively high due their policy of subsiding oil consumption. Increasingly governments are reducing their subsidy schemes because of their high cost. This will have a limiting effect on the demand for oil.
At the same time, Stevens does not expect the oil industry to be able to expand its production capacity to the extent predicted by the IEA. He points out that investments in the upstream sector are lagging, for two reasons, related to the policies pursued by the private international oil companies (IOCs) on the one hand and by the national oil companies (NOCs) within Opec on the other. According to Stevens, the policy of the IOCs is aimed at creating as much shareholder value as possible. Any projects with an expected rate of return less than a predetermined lower limit (often around 25%) do not get off the ground. As the IOC's increasingly lack access to the so-called "easily accessible oil" in Opec- and other countries, they are forced to invest in expensive deep offshore and unconventional oil projects. However, there are not enough projects that meet the IOCs' profitability standards. As a result, the IOCs have been massively buying back their own shares instead of investing in the exploration and production of oil. This has put a sharp brake on the growth of oil and gas production by IOCs.
Unlike the IOCs, access to oil reserves is not a problem for most of the NOCs in the Opec countries. However, while the IOCs would benefit from the highest possible production level, the NOCs are pursuing what Stevens calls a depletion policy. They aks themselves whether they should produce now or in the future and they increasingly conclude that oil in the ground may be worth more in the end than oil in barrels. These countries are often already extremely wealthy and pumping extra funds into their economy would merely result in overheating. Moreover, the financial crisis of 2008-2009 reminded them once again of the risk of maintaining major financial positions abroad.
Stevens also points out that the energy ministries that supervise the NOCs are not always convinced that the companies operate in the interest of the country. As a result, the ministries are often reluctant to grant investment funds to the NOCs. According to Stevens, this has created a significant barrier for investments in production capacity.
The question, however, is to what extent such supply and demand fundamentals still determine the oil price. As everyone knows the high oil prices in 2008 could not be explained by market fundamentals. As Stevens puts it, 'What have oil supply and demand to do with the oil market? It may seem an odd question at first, but it turns out to be a justified one!' Stevens explains that for a long period until 2004, the supply of oil had kept pace with the increasing demand for oil. The year 2004 then saw a sudden moment of scarcity on the market. This, according to Stevens, was mainly due to the fact that the refining capacity did not match with the crude oil quality, and this scarcity was overcome rather quickly. Nevertheless, the oil price then began to rise sharply after 2004, without regard to the ample spare production capacity and large oil reserves in the OECD countries.
The New York Mercantile Exchange is one of the world's major oil trading centres
However, according to Stevens, the money managers have only a limited knowledge of the real developments in the oil market. ‘The problem is that so called money managers (hedgers, institutional investors, portfolio managers of pension funds, etc.) have actually very little understanding of the oil market. They often misinterpret market signals. Once I had a conversation with an institutional investor. I asked him: why is there such a high oil price? He answered: Because the market is very tight. I asked him: How do you know it is tight? He answered: Because the prices are going up!’
Bassam Fattouh, senior researcher at the Oxford Institute for Energy Studies, who has recently done an in-depth study on the interaction between the wet and paper barrel markets (see ‘Price formation in oil markets: Some lessons from 2009'), pointed out at the CIEP conference that the relationship between speculative and physical trade has become extremely complex. In his opinion, the old framework for describing oil price developments, in terms of market fundamentals, no longer suffices. The players on the market no longer feel that they can fall back on the traditional feedback mechanisms in the system. For example, he notes that the recent period of high oil prices did not result in a lower demand for oil. It also did not result in a speeding up of non-Opec oil production or in extra investments in this sector. And Opec did not step up its oil production either. Hence, Fattouh argues that a new framework for explaining oil market developments is required.
According to Fattouh, at this moment there is a consensus among market players that the oil market will be characterised by increased scarcity in the years to come. This explains the stable, relatively high, oil price of the past year. After the huge uncertainty at the beginning of the financial crisis in 2008 and 2009 began to make way for a stabilisation of expectations regarding the world economy, concerns about investments in oil production capacity quickly surfaced again. Although current fundamentals would perhaps justify a lower oil price – there is after all a supply surplus and reserves are high as well – the pessimistic outlook on future fundamentals has an upward effect on the oil price. ‘There was (and still is) a strong sentiment that the oil industry can no longer function in a low price environment.'
According to Fattouh, the $70-$80 range offers the parties in the market a focal point. A convergence of expectations has taken place which has led to this stable price. ‘There is consensus that too high or too low oil prices can be damaging for the industry. The major stakeholders appear to be satisfied with the outcome. No one wants to rock this boat!’ The stable range offers consumers peace of mind and a sufficiently high price for the producers. Moreover, the fluctuations within the range still offer enough opportunities for traders.
The question of course is whether or not the price of oil will stay within this range or if a new focal point will come about. Fattouh argues that this depends on the underlying "story" that will be dominant in the market. The current vision ("story") of tight future oil markets and oil shortages that dominates the market has itself become a significant price driver. As long as no alternative story emerges, we may expect oil prices to remain in the current range.