The Petroleum Economics Monthly

Transcription

1 The Petroleum Economics Monthly Philip K. Verleger, Jr. Volume XXXI, No. 9 September 2014 A Conflict of Necessity: The 2014 Oil Price War Dollars per Barrel 140 Dated Brent Price vs. Gross Product Worth (GPW) Computed for New York Harbor Products, January 2013 to October Brent GPW 80 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Source: PKVerleger LLC. (Publication Date: 10/30/2014) 2014, PKVerleger LLC. All rights reserved. ISSN Reproduction of The Petroleum Economics Monthly in any form (photostatically, electronically, or via facsimile), including via local- and wide-area networks, is strictly forbidden without direct licensed permission from PKVerleger LLC. Contact Dr. Verleger at 540 Fox Run Dr, Carbondale, CO or phil@pkverlegerllc.com.

2 A Conflict of Necessity: The 2014 Oil Price War Philip K. Verleger, Jr. PKVerleger LLC Disclaimer: Although the statements of fact in this report have been obtained from and are based upon sources that PKVerleger LLC believes to be reliable, we do not guarantee their accuracy, and any such information may be incomplete or condensed. All opinions and estimates included in this report constitute the judgment of PKVerleger LLC as of the date of this report and are subject to change without notice.

3 Table of Contents Summary... 1 A Conflict of Necessity... 4 A Surprise... 6 Shrinking Market Share... 7 Defending Market Shares... 8 Controlling Global Exports... 9 The Dynamics of Significant Price Changes The Stimulus from Lower Prices Market Dynamics: How Long? How Deep? How Fast? Conclusion: Complacency Reigns Glossary Statistical Appendix List of Figures Figure 1. Projected Market for Middle East Producer Exports as Might Be Anticipated in Late 2014 Given the Market Envisioned in Figure 2. Weekly US Crude Oil Imports from Three Middle Eastern Countries and Canada, 2011 to Figure 3. WTI Forward Price Curve on May 9, 1997 and November 28, Figure 4. WTI Backwardation or Contango vs. Weekly PADD III Crude Inventories, January 1997 to December Figure 5. Monthly Global Crude Oil and Product Stocks vs. End-Month Sixth Brent Price Spread, 1997 to Figure 6. Monthly Crude and Product Stocks Held by US Refiners, January 1980 to December Figure 7. Percentage Spread of January 1987 Heating Oil Futures Contract to Cash Heating Oil Futures Contract, April 1986 to December Figure 8. LLS Crude Price vs. Price Predicted from Gulf Coast Product Prices, May 2006 to October Figure 9. Weekly Crude Oil Stocks Held in PADD III Facilities, 1990 to Figure 10. Weekly Crude Oil Stocks Held in Cushing, Oklahoma, 2005 to Figure 11. Traditional Supply-of-Storage Relationship for Crude Oil Stored in Cushing, Oklahoma, 2004 to Figure 12. Supply-of-Storage Curve for Crude Oil Stored in Cushing, Oklahoma, 2004 to 2014, and Observations Figure 13. WTI Forward Price Curve on May 9, 1997 and November 28, Figure 14. WTI Forward Price curve on October 10, 2014, and a Date in 2015 Should the Example Apply Figure 15. Monthly Global Commercial Crude Stocks vs. Sixth Brent Crude Spread, January 2004 to September i

4 List of Figures (continued) Figure 16. Settlement Price of Six-Month-Forward Brent Contract vs. Dated Brent Price, January 2008 to December Figure 17. US Consumer Expenditures on Nonfuel Items vs. Relative Gasoline Price, Monthly Data, 1959 to Figure 18. Current and Projected Global Supply-and-Demand Balance through 2015 assuming No Change in OPEC Output Figure 19. Positive Cumulative Crude Oil Inventory Accumulations, 1985 to Figure 20. Positive Cumulative Crude Oil Inventory Accumulations, 1985 to 2014, and Looking Forward to List of Tables Table 1. Estimated Crude Oil Exports from Middle East Producers in Aggregate and Selected Countries, 2000 vs and Forecast for Table 2. Saudi Arabian Price Differentials, May through September Table 3. Calculated Comparative Attractiveness of Bonny Light and Arab Light to Singapore Refiners in September Table 4. Crude Oil Storage Capacity in Cushing, Oklahoma Table 5. Summary of October Forecasts of Average Brent Prices as Published in Energy and Metals Consensus Forecasts ii

5 Summary The title of this report comes from a book by Richard Haass, president of the Council on Foreign Relations, titled War of Necessity, War of Choice. 1 Haass points out that nations sometimes choose to go to war. At other times, they have no option. Russia, for example, decided to take on Ukraine with its annexation of Crimea. For Ukraine, however, the conflict was not voluntary. Middle Eastern nations have been forced into a price war. Specifically, the Middle East Troika Kuwait, Saudi Arabia, and the United Arab Emirates must fight to defend its position in the global market. The Troika countries share several unique characteristics. First they rely on sales of domestically produced oil for much of their revenue and GDP. Second, the production cost for their oil is lower than such costs anywhere else in the world. Third, each of these nations has very large foreign currency reserves, which means their economies can tolerate months or even years of low oil prices. Finally, if they do nothing, the Troika nations stand to lose market share as US and Canadian producers boost output aggressively. While the instigators of this price war of necessity are clear, their opponents are not. The Troika has set out to protect or even increase market share. It has not announced specific targets. In fact, it may not have any. The Troika countries want to force one or more other producers, whoever they may be, to cut production. At some point, someone in the oil business will do so. For example, shale field developers in the United States may reduce capital expenditures, slowing or stopping growth and thus reducing pressure on the Troika; developers of high-cost oil sands projects in Canada might cut expansion and slow operations, at the same time backing away from efforts to steal market share in India and Asia from the Troika; Russia may curtail production and exports, leaving a larger market for the Troika; oil production in Venezuela might collapse as the country s economic problems spread to the oil industry, creating an alternative market for Canadian producers and relieving pressure on the Troika; Brazil may curtail its aggressive efforts in the Atlantic, which are yielding very high cost oil, making more room for Troika exports; or other oil-exporting countries might slash output as they did in 1998, giving market share back to the Troika. The Troika does not care. Its only goal is to have other parties step out of its way. To that end, it will continue to apply pressure, putting more oil in the market and forcing prices down until it wins. The three countries will succeed in this if they stick to their program. The price war is being fought with a very simple weapon: refining margins. The Troika is cutting premiums or raising discounts for crude oil buyers. This strategy assures good refining margins, prompting the Troika s refining customers to operate at maximum rates and produce 1 See Richard N. Haass, War of Necessity, War of Choice (New York: Simon & Schuster, 2009) [ 1

6 extra gasoline and diesel volumes. This surplus is then dumped on the market, driving down all product prices. The lower product prices pull down refinery netbacks and spot crude prices, confirming the theory espoused by PKVerleger LLC that product prices lead crude. Over the last few months, declining product prices created by the aggressive refiner processing have pulled down spot crude prices, creating wartime pain for oil producers across the globe as the Troika intended. The cover figure compares the Dated Brent price to the per-barrel product yield value (gross product worth or GPW) computed for the New York market by PKVerleger LLC. The Troika s goal and the mechanism for achieving it seem obvious. Apparently they are not obvious, though, to many individuals who ostensibly have the experience and expertise needed to comprehend the Troika s war on other producers. To the contrary, most still seem to assume Middle Eastern countries are passive bystanders that willingly sacrifice market share. The authors of Understanding Crude Oil and Product Markets, a report published in September for the American Petroleum Institute, exhibit this blissful ignorance. 2 Writing as global crude prices collapse, they assert that price stability is assured by the existence of spare capacity, reiterating a point made in clearer fashion by an IHS report. 3 The API authors also declare that a decline in excess capacity has put upward pressure on prices: In summary, a combination in increasing demand in Asia Pacific markets, supply disruptions, and uncertainty (supply risk) have caused global spare capacity to decline and spot and forward crude prices to rise. Put another way, the global price of oil has risen in order to balance demand with available supply. 4 Ironically, crude prices had already fallen twenty percent from recent peaks when this study appeared. Apparently the writers ignored market publications as they worked. Oil-exporting countries were more aware but came to the game late. The Troika was likely lulled into complacency by research papers predicting ever higher prices. One of these is a complicated analysis of the world s resource base by the International Monetary Fund. It concludes that prices will rise dramatically over the next decade. 5 Economist James Hamilton has also projected much higher prices over that period. 6 The Troika s need to wage war only became evident in August as reports on a global economic slowdown began to appear. The deteriorating situation in Europe was evident. Alarm may have increased as it became clear that growth in Asia would also slow. As a result, the Troika took action in early September and the war began. Here we chronicle the events that started the price war, highlighting the changing pattern of world oil flows and the weakening economic circumstances. We then discuss how the battle can be brought to an end. Large increases in inventories can be expected if past patterns repeat. The stock rise will push spot and forward prices down and markets into deep contango. For example, 2 See Steve Levine, Gary Taylor, Daniel Arthur, and Michael Tolleth, Understanding Crude Oil and Product Markets, American Petroleum Institute, September 2014 [ 3 See IHS, US Crude Oil Export Decision, 2014 [ 4 Understanding Crude Oil and Product Markets, p See Jaromir Benes et al. The Future of Oil, Geology versus Technology, IMF Working Paper WP/12/109, May 2012 [ 6 See James D. Hamilton, The Changing Face of World Oil Markets, July 20, 2014 [ 2

7 Dated Brent traded at a discount of $18 per barrel to the sixth-month-forward Brent contract in early 2009 during the price collapse that accompanied the Great Recession. Falling oil prices may stimulate the global economy. Oil producers would welcome this because economic growth is the best cure for decreasing commodity demand. Past price wars have boosted consumption. This war could have a different impact, though, because the specter of deflation hangs over the world. As Paul Krugman has written, most economic rules do not hold in deflationary situations. This may apply now to declining oil prices. On this occasion, they might not provide much stimulus. Our report concludes with a speculation on the price war s length. One could surmise it will be short like the two previous occurrences. The 1998 war ended quickly when Mexico, Norway, and Oman agreed to join OPEC nations in cutting production. The 2008/2009 price collapse was over in six months as producers reduced output and banks financed inventory accumulations by traders. On the other hand, this war could be much longer. As our concluding section explains, complacency is widespread among market participants. Some (the API report authors, for example) do not even know a war has begun. Others do not think it is not a big deal. Twenty-four of twenty-five forecasters surveyed by Consensus Economics on October 20, for instance, did not see Brent averaging less than $90 per barrel in the fourth quarter of 2014 or any quarter of (Through October, it has averaged $87 for the fourth quarter of 2014.) Prices could very likely continue to fall for the next six to twelve months given the slow response to the Troika s aggression. The reluctance to act will probably result in widespread industry bankruptcies and chaotic shutdowns. If this comes about, the future, in keeping with the nature of war, will be ugly. 3