How to deal with the volatility in the oil markets

Written by Frederic Grillet

These last few months we’ve seen oil prices bouncing up and down. Intraday movements between 5 and 10% were not uncommon. Current price levels, which are approximately 70% lower than their peak levels in june 2014 and are the lowest that we have seen in 10 years, seem to cause investors to overreact to every rumour in the market.

Brent front-month prices started January at a price level of 37.28 $/barrel and dropped 34% to 27,88 $/barrel on 20 January, only to rebound 25% by the end of the month. The main causes of the price surge were a vague statement by ECB-President Mario Draghi hinting on potential monetary measures to boost the EU economy and a rumour that OPEC & Russia were discussing a potential production cut.

Despite the fact that oil markets have always been quite susceptible to speculation, which amplifies any trend in financial markets, this volatility seems to edge on irrationality. The oil market has a structural problem of oversupply, with production having exceeded demand with 1 to 2 million barrels per day (depending on the source) over the past years. The US Energy Information Agency has indicated that it expects an average oversupply of 1.75 million barrels/day for the first half of 2016 as well, while crude inventories in the US are at record highs above 500 million barrels. An agreement amongst global oil producers, which is looking very difficult due to a variety of reasons, could of course address the issue from the supply side, but the demand outlook remains weak with major economies, including China, showing signs of a slowdown.

Although the downward trend in oil prices was strong in the past months and has reached historically low levels, the fundamental issues in the markets have not yet been resolved and no solution seems to be in the making for now. The very strong upward and downward movements despite the lack of changing fundamentals shows that price levels have entered a territory in which trends are mainly caused by speculators hedging their long and short positions.

Impact on other commodities

EU gas & electricity markets are generally shaped by a variety of factors, though for January, the trends showed that the main driver for prices were the oil prices. Markets in all countries have therefore seen a very rocky start of the year. The main question here from a procurement point of view is whether this volatility marks the start of a structural trend change after last year’s general downward trend and whether it is necessary to start taking bigger positions.

So when do you hedge?

Volatile times like these prove the value of the combination of market analysis and a strong purchasing strategy. The market analysis allows us to identify the opportunity moments, i.e. when markets start turning around. However, as the last months have shown, it is never a sure bet whether that is only a temporary or a fundamental turn of the trend. Hence the importance of spreading your hedging decisions and fix in small incremental amounts. In the end, how much you hedge and how far into the future should depend on your strategy. If your main risk is budget variability over the long term, than you can take large positions for many years into the future, although you should always do that in small incremental amounts. If your main risk is having an uncompetitive energy price, you should be much more prudent and make only small opportunistic fixings.

A long downward trend, as we have seen in the EU energy markets, tends to spark an urge to take bigger bets in the markets, e.g. by opting for fixed energy prices for years ahead, Although a bet can sometimes turn positive afterwards, it remains a bet and should have no place in a professional business. Therefore, although it would be a good idea to check whether the current movements in the markets make it necessary to take a position in your portfolio, it remains very important not to be seduced to overreact to an overreacting market.

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Declining oil price: geopolitics or just plain economics?

The main event in 2014’s energy market has been the sharp decline in oil prices in the second half of the year. In the first six months, geopolitical tensions regarding Ukraine & Russia still caused hick-ups in the oil markets, with Brent prices reaching 115,06 dollars per barrel on the 19^th of June. But then the barrel started a bear correction that even brought it below 60 dollars per barrel on the 16^th and 18^th of December. Even if oil pricing has lost much of its importance for European industrial energy consumers, due to the decoupling of natural gas from oil prices, I obviously want to share some thoughts on this sharp bear trend.

“It’s the economy, stupid”

 In general, the press is always quick in looking for geopolitical explanations of oil price trends. Even seasoned oil traders often have one eye on CNN and the other on their trading screen. However, a look at supply and demand dynamics of 2014’s oil markets is telling much more than the images of war and political leaders that color the many ‘the world in 2014’ retrospectives that we currently see on television. First of all, demand is not growing as fast as before. Economic growth in Europe and Asia is sluggish, and the one economy which is doing well, the US, is switching towards other fuels and higher efficiencies. Moreover, the US is producing more and more of their petroleum needs themselves. According to the International Energy Agency, the US have grown their oil production in the first nine months of 2014 by 3,5% compared to the same period in 2013. The US is now solidifying its position as the world’s biggest producer of oil. And they’re not there yet, but they could be heading for the enviable position of net crude exporter.

The increase of oil production in the US is caused by the rapid development of shale oil production, the petroleum equivalent of shale gas. This boom is obviously attracting much attention. But we shouldn’t forget that oil production booms are happening in other countries as well. Still according to the International Energy Agency, Canada has grown its oil production in the first nine months of 2014 by 6,5% compared to 2013, thanks to the development of oil sands. And the deep sea oil production of Brazil, causes that country to report an 11,5% increase of oil production in October compared to one year earlier (source: Forbes).

Is Opec waging a price war?

All that increasing production in non-OPEC countries should obviously provoke a reaction from OPEC countries. Traditionally, we expect OPEC to cut supplies when prices hit historical lows. But that’s not what it is doing. On Monday the 22^nd of December, the Saudi oil minister, Saudi-Arabia still being the most important OPEC-member, announced that OPEC would not cut supplies, however low the oil price would drop. This strongly confirms the decision at the latest OPEC summit at the end of November not to cut.

A hawkish interpretation of OPEC’s policy of not cutting supplies sees it as a price war. OPEC is consciously dragging down prices, hoping that it will undercut the economics of that new oil production in the US, Canada and Brazil. We’ve seen OPEC (and Saudi-Arabia) attempting similar price wars in the 1980’s, then mostly hoping to stop the development of North Sea and Gulf of Mexico offshore oil production. It failed spectacularly, with the competitors continuing their development and the Saudi budget fatally hurt by low oil prices. Price wars are a tough game. Mostly because of the way that supply and demand dynamics or price elasticity work. For understanding them, you need to make a firm distinction between fixed or investment costs and variable or operating costs.

Short term price elasticity is mostly influenced by operating costs. If the price of a product drops below the operating costs, producers will stop producing the product. In terms of crude oil, if the price of crude drops below the variable costs of operating a well, the producers will shut down production from that well. Now, as far as oil production is concerned, we need to make an important remark here. Operating costs of oil wells are often quite low. Wells are often quite expensive to drill, causing a high investment cost. This is especially the case for the US shale oil and Brazilian deep sea offshore wells. But once drilled, the costs of letting the oil flow out are not very high. To understand this, look at the situation of Brazilian oil producer Petrobras. They have just invested hundreds of billions of dollars to develop their deep sea offshore oilfields. Why on earth would they stop producing from those wells now? Of course, they and their American shale oil colleagues would prefer getting the 110 dollar plus prices for their oil of a few months ago. But the less than 60 dollars that they get at this moment is still giving them some return on their massive investments. Stopping production and getting 0 dollars per 0 barrel is not paying back anything.

With its combination of high investment and low operational costs, the oil market is not a good place to see short term effect in a price war. Price warlords should therefore aim for the long term effects of lower oil prices. Investors in the US, Brazil and Canada could be frustrated and stop investing in the oil developments in those countries. Lower stock prices of oil companies seem to point in that direction. This could have only limited effect on large scale developments like those that we’ve seen in Brazil. However, it could be more effective in hurting the US shale oil development. Shale oil wells typically have steep production decline curves, meaning that most of the oil is produced in the first years after drilling the well and then the production volumes per well drop rapidly. So, you need to maintain investment in drilling new wells to keep up the overall production rate. If lower prices would cause a decline in investment, the expansion of US shale oil production could be slowed down or even reversed. However, experience in the shale gas industry has shown that investment has been more resilient to lower prices than initially thought, especially since a fall in natural gas prices coincided with a drop in the investment costs due to the falling cost of the newly developed horizontal fracking technology. Therefore, it’s all but certain that a conscious price war by OPEC (and/or the Saudis) against further investment in new oil production could produce results.

Maybe, what we are seeing is far from a conscious attempt by OPEC to wage a price war, but a simple struggle for market share. OPEC cannot idly sit by and watch the US, Brazil and Canada steal away its market share. Oil supply growth is currently outstripping oil demand growth, meaning that the oil market is currently a buyers’ market and not a sellers’ market. In such a market, price wars are usually not fought in an offensive attempt at hurting competitors, they are fought as a defensive strategy for keeping market share. In the end, at the sellers’ side everybody is hurt and only the strongest survive. The Saudis could be hopeful that they will prevail with their low cost oil production.

Are Opec and the US working together?

Amateurs of geopolitical explanations of the events in oil markets are pushing an opposite theory. Saudi-Arabia and the US are not fighting each other, they are collaborating. Flanked by the economic sanctions of the EU, they work together to lower the oil price down to levels that really hurt the Russian enemy. Early in November, Vladimir Putin himself put forward this theory by stating that he believed that politics were the cause of the lower energy price. Whether this global conspiracy theory is true or not, it is indeed effective, if you see the turmoil of the Russian economy and currency in the last weeks.

 

All in all, these events are showing once again how utterly unpredictable energy markets are. Six months ago, Russia, an important oil producing country was engaged in a deep geopolitical conflict, with concerns over the impact on supply causing oil prices to increase. Anyone that would have said then that by the end of 2014 the oil price would drop below 60 dollars per barrel would have been declared a nutcase. But it happened. We can make educated guesses about its causes: simple supply and demand dynamics, a conscious commercial policy by OPEC or a complicated geopolitical intrigue? Or a combination of two or even all three of these options? Which explanation we choose, probably depends more on our own personal convictions than on empirical reality. Which obviously shows that we shouldn’t attribute any predictive quality to our theories. What has happened has happened. The oil price is historically low, benefit from it. And prepare for the next move which will come just as unexpected as this decline.

Are we approaching an age of energy abundance?

Do you remember the first months of 2008? Every week, prices increased. Oil prices rose near an all-time high of 150 dollar per barrel and some analysts “predicted” that they would soon reach 300. That was obviously a disaster every time you had to fill the car. But European buyers of natural gas were also affected as back then almost all the gas contracts were pegged to oil prices. Natural gas prices rose above 40 euro per MWh. And if you were impressed by the tripling of oil prices, what to say of coal that rose from a level around 50 dollar per ton to more than 200. Electricity prices were obviously affected by these increases in combustible prices and in many countries baseload prices rose to a level near 100 euro per MWh. For buyers of energy these were terrifying times. Every delay in price fixing decisions caused a frightening increase in energy costs. We had several emergency meetings with companies in those days that were desperately looking for ways to avoid dramatic increases of their energy budgets.

Most analysts agreed on the root cause of this unprecedented bull-run. As countries like China and other emerging economies grew at exponential rates, the planet just wasn’t capable of producing enough commodities to fuel that growth. The developed economies had already depleted the world’s geological reserves so much, that there wasn’t enough left now that the developing economies joined the race. We were just plainly running out of oil, coal and natural gas. That was the simple logic behind the 300 dollar per barrel prediction of a Goldman Sachs analyst that forced many buyers of energy into panic decisions. And the fact that other commodities such as copper were also rising to historical highs proved the point. The peak oil theory became wildly popular. This was a calculus introduced decades ago by a Shell geologist called M. King Hubbert. According to Mr. Hubbert, production of oil reserves followed the elegant path of a bell-shaped curve. At some point the peak was reached and after that ever declining production rates were inevitable. Mr. Hubbert had applied his bell-shaped calculus to the US oil production and produced a reasonably accurate forecast of the peaking moment. As oil prices increased exponentially, more and more observers became convinced that we had reached or were at least near the peak of the curve of worldwide oil production. Some were even convinced that we were on the right side of the bell shaped curves of coal and natural gas production as well …

Open-minded people will acknowledge that reality is in most cases way too complicated to fit elegantly bell-shaped curves. But I have to admit, that as prices just kept on rising, even I was tempted into some Hubbert-style thinking. What explains the attractiveness of the peak theory? I believe it is our instinctive scarcity scare. Most of the people reading this blog article can satisfy their basic needs without much trouble, just like me. Just consider the most essential needs, warmth and food. Heating myself and my family means the occasional phone call to the plumber to fix my gas-fired boiler and checking gas bills and contracts from time to time. And the struggle for daily food means phone calls with my wife in which we discuss food variety and who will take the ten minutes to stop by a shop on the way back home. However, thinking about it, I have to return just two generations to find ancestors for whom the struggle for essentials was much harder. I remember a story told by my grandfather in which he scattered white flower on his coal reserves in the shed to check whether his suspicions of a coal-stealing neighbor were true. Less than a century ago, people still had to fight daily to get their share of the scarce energy and food. Unless you are born in some old aristocratic family, you carry in yourself the genes of people that survived due to their scarcity scare. This explains why perfectly civilized societies start the completely irrational hoarding behavior or even worse, looting, as soon as the first signs of scarcity are on the horizon. Slightly ashamed of our luxurious contemporary life styles, the idea of increasingly scarce energy supplies fascinates as well as scares us. The horror picture of 300 dollar oil fascinated us, because we are silently scared of having to return to the harsh daily struggle for the scarce commodities for keeping your family warm.

Some economists kept their cool and displayed a ‘what goes up must come down’ mentality. They remarked that this wasn’t the first peak in oil prices, and that previous peaks had been followed by deep decreases. They argued that high prices would put the laws of supply and demand at work, leading to corrections. Only, as the lead times for adaptation in energy are very long, this takes some time. As the bull-run extended in time, some renegade economists started to declare that energy was a basic good and hence not price-elastic. Whatever its price, consumers would continue to consume ever more energy. And accepting the ‘inevitable’ truth of M. King Hubbert’s peak theory, even if producers wanted to increase supply, they couldn’t. The cooler economists responded that energy supply and demand are price-elastic, but it is slow elasticity. Investing in more energy-efficient equipment and in new production isn’t done overnight. These delays explain the ‘boom-and-bust’ cycle of energy prices. Cool-headed economics has proven to be right again. In the second half of 2008, the energy prices corrected sharply and dropped back to their pre-peak levels. Peak oil (and other energy) theorists used the economic crisis as an excuse. As soon as that crisis would pass, the plain logic of the bell curves would kick in again. But isn’t the economic crisis in itself a sign of the elasticity of energy demand? If energy prices rise too high, this pushes the world into a recession, causing demand to drop sharply. The 2008 crisis (which still isn’t over, at least not in Europe) has a complicated web of causes. But high energy prices are definitely part of that. The increasing impact on their budgets of high fuel prices was one of the reasons why so many Americans couldn’t pay back their mortgages. So, even if 300 dollar oil prices and equivalent prices of other energies are possible, they would very probably be extremely short-lived, as they would push the world in a deep recession. That draws a bleak picture of life in a perpetual economic crisis on the other side of Hubbert’s peak. The last five years have learned that economic stagnation isn’t fun, so we all have a moral duty to avoid ever ending up there.

As the economy has recovered, specifically in the commodity-devouring developing economies, energy prices on the world markets have increased again, but they haven’t hit the previous highs (yet?). Electricity in many countries of Europe is currently even trading at its lowest level since 2005. And we are clearly seeing that energy demand and supply are impacted by more fundamental phenomena than just the economic crisis:

DEMAND SIDE:

– Combined with climate policy measures, the high prices of 2008 have caused renewed enthusiasm for energy efficiency improvements. This seems to have caused a sustainable downtrend in energy consumption in the developed world (both the EU and the USA). However, the effect of this is largely undone by continuing growth in energy demand in the developing world.

SUPPLY SIDE:

– Oil production in 2011 was 1,5% higher than in 2008. So, we are not on the right side of the bell-shaped curve yet. It should be remarked that these extra barrels are increasingly expensive to produce, causing oil prices to remain high. But it looks like we still have enough oil left. Thanks to shale oil, US oil production was 16,44% higher in 2011 than in 2008 and some are optimistic that these unconventional resources could ultimately mean an end of oil imports in the US. So, Mr. King Hubbert, the tail end of the US oil production curve is not bell-shaped …

– Peak theorists that simplistically extended the peak oil theory to coal and natural gas, were ignoring the fact that undeveloped reserves of those fossil fuels were much higher than those of oil. As oil prices remain high, the world has tapped into its coal and gas reserves. Coal production in 2011 was 12,8% higher than in 2008, gas consumption grew 7,5%. This clearly shows that the peaks in coal and natural gas were nothing more than an expression of slow elasticity. Natural gas production has been boosted by conventional and unconventional gas production. I have extensively written about the shale gas revolution on this blog. If it can spread across the globe, gas abundance could become a reality.

– The prices of wind and solar power production have dropped to a level that necessitates only limited subsidies to stimulate their growth. Therefore, the growth of the share of energy produced from these renewable sources seems unstoppable.

The previous energy crisis (the 1970’s) was followed by a long period of energy abundance and historically low prices. Are the trends above sufficient for the world to be entering an age of energy abundance again? The hunger for energy of the developing economies is continuing to put pressure on the world’s energy markets. But if shale gas becomes a worldwide reality, energy abundance could become a fact, especially if it is combined with an adoption of more energy-efficient and more renewable technology by the developing economies.

There are many obstacles on the road to energy abundance. And the legendary unpredictability of energy markets makes it impossible to say if we are heading for it or not. So please don’t interpret this blog as a forecast of low energy prices. The important message is that abundance is not unthinkable. Still, we see many energy buyers that continue to be driven by scarcity scare in their price fixing decision. This is partly due to the fact that abundance stories don’t get much political and press attention. Many conservative politicians prefer the peak energy theories because they fit within their energy independence policies that are supportive of their hawkish geopolitical position. Do you really think that the American public would have allowed the sacrifice of American blood and money in the Iraq War if back in 2003 they would have known that they were heading for the abundance of homegrown shale gas and oil? On the liberal side, the scarcity scare fits within the anxiousness to do something about climate change. This seems to be the predominant policy of Europe. We need to be very careful as we are approaching a possible age of energy abundance. If Europe unilaterally choses for more efficiency and renewable rather than more (unconventional) oil and gas, we might end up with a much higher bill than the rest of the world. Can we really afford that?

Benedict is giving a presentation on this topic on our (Central) European Energy Procurement Conference on the 16th of May in Warsaw. Send an e-mail to info@eecc.eu if you want to attend or click here.

Brent price in euro per barrel at an all-time high

Have you recently visited a petrol station somewhere in a Euro country? Shocked by the price level? Well, unnoticed by the press, the cost of oil has risen to its highest nominal level ever. The Brent price ended the day at 120,11 dollar per barrel on Thursday the 16^th. This is well below the Brent-in-dollar peak of 146,08 on the 3^rd of July 2008. However, the euro was then trading at almost 1,6 dollar, whereas now the euro trades below 1,3. The consequence is an all-time high Brent-in euro price of 92,52 euro per barrel. That is the reason why filling your car these days is a costly affair on Europe’s roads.

Fortunately, Europe has managed to significantly reduce its dependence on oil products. Due to fuel efficiency standards, cars guzzle less fuel. Residential heating has been switched away from oil products thanks to environmental policy and the expansion of the gas grids. And environmental policy again, has reduced the usage of oil for industrial and power producing purposes. The consumption of oil in Europe is displaying a steadily declining trend ever since 2005.

High oil prices would have been bad news for almost every continental European consumer of natural gas three years ago, as they all had contracts with the price of natural gas pegged to oil prices. Fortunately, the end market in North-Western Europe is now massively switching to the gas-to-gas pricing of Hub markets (NBP, Zeebrugge, TTF, NCG, Gaspool, PEG). True, these gas prices have also risen in the past year, but not as much as oil prices. With the oil-indexed gas contracts of the past, natural gas would have cost more than 40 euro per MWh by now, just as it did in 2008. At the forward Hub markets, gas consumers can now fix prices below 30 euro per MWh and spot prices haven’t risen much above 25. However, natural gas consumers in countries where access to Hub markets is difficult (Spain, Portugal, Italy, Eastern Europe), have every reason to look worryingly at oil market developments.

High energy prices are particularly bad news for Europe at this moment. Financial markets continue to worry about the potential cataclysm that Greek bankruptcy could cause in Europe’s banking sector. Partly due to this fear, economic growth has stalled. This week Germany published a -0,2% figure for the last quarter. Policymakers across Europe are hesitating between austerity programs to reduce budget deficits (right wing) and policies to support economic recovery (left wing). High energy costs might push struggling businesses over the bankruptcy line. Other companies might have possibilities to pass through higher energy costs in the prices of their products. But is this increasing inflationary pressure a good idea at a moment that consumer confidence drops due to the fear of a Greek tragedy? We should all hope that the combination of a recovering US economy and a weak euro supports export-oriented businesses. But it is clear that the record high Brent-price is bad, bad news for Europe.

The reason for increasing oil prices is simple. OK, here in Europe we reduce the consumption of oil. And yes, the US is reducing as they have also embraced the reduction of fuel consumption by cars. However, such declines are completely undone by developments in emerging economies where the consumption of oil doesn’t stop from growing. On a worldwide scale, we consume more oil year after year. There is enough of if left for the time being. But producing it comes at ever higher costs, which explains the increasing oil price. Squeezing petrol out of the oil sands of Alberta simply is a much more expensive affair than drilling holes in the Arabian dessert. Of course, there is some risk premium added to the price, as the markets ponder the consequences of an oil embargo on Iran and the increasing risk of military conflict in the Persian Gulf. Of course, the forces of speculation are also back. But beware of under-estimating the underlying problem. The increasing demand in oil cannot be met with cheaply produced stuff. The marginal cost economics of oil markets explain the high prices and volatility.

Even if the world’s economy is growing at a slow pace at this moment, it is still growing in the emerging economies, and faster than anywhere else in the world. And countries like China, India, Brazil or Russia, haven’t managed yet to decouple economic growth from oil consumption increases. So, unless we get a repetition of the financial-economic catastrophe of 2008, there isn’t much chance that filling your car will get much cheaper in the near future.

Lybia and the day that oil prices were almost 120 dollar

It is with increased horror that I look at the images of Lybia. This shows the true face of dictators, they shun no crime in their lust for power. However, living in the West, I also feel shame. We live in our shelter of a free and democratic society. And we don’t protest when our politicians befriend these dictators. We don’t mind the foreign policy of “rather a dictator that is our friend than a democratic government that is hostile” . The hypocrisy of Western policy in the Middle East and Northern Africa was clearly illustrated by British PM David Cameron’s latest trip. He visited the Tahrir square in Cairo to express his sympathy with the pro-democracy protesters in the region. He was joined by British defense industry people that where on their way to a Defense expo in Abu Dhabi where they will try to sell their weapons to the Middle East’s autocratic regimes. What is the message here? We support your protest for democracy, but we also sell the weapons to shoot at you? (For more on this controversial trip, read the Huffington Post.)

It is hypocrisy, but it is also understandable. The Middle East and Northern Africa have an immense economical importance for the West. They produce the bulk of the oil and the natural gas that fire our economies. The recent unrest has pushed these prices through the roof. The gas price for 2012 is already trading around 25 euro per MWh and Brent oil prices traded near 120 dollar per barrel on the 24^th of February. Everyone of us will feel the consequences of the rush for democracy in the Arab world the next time that we fill our car. Is it therefore surprising that we sometimes prefer the stability of a dictatorship? As Berthold Brecht told us ‘Erst das Fressen, dann die Moral”, it is human to put economic interests before ethics. The current situation in Lybia should inspire modesty in the West. We are not the super-ethical beings that can impose our moral superiority upon the rest of the World. We were shaking Colonel Kadhafi’s hand in exchange for his oil. We even got fascinated by his extravagancy, the tents and camels and female bodyguard that he brought in his many recent visits to our capitals. I am not judging anyone. I am only observing that we are only humans. And that we sometimes confuse madness with bling.

The 2008 financial crisis confronted us with the madness of financial markets. Politicians claimed that they would curb the extravagancies of speculative behavior on the markets. And what did we see yesterday morning? A seven dollar price increase in 20 minutes. This reminded us of 2007 – 2008 when similar crazy price moves were observed in the oil markets. What have we learned from the financial crisis? The manic-depression-like movement of energy markets continues. Buyers of energy continue to be confronted with volatility and unpredictability. Until one month ago, we warned energy buyers that rising gas prices should not be taken for granted. There are sufficient gas reserves on this planet for gas to be cheap for some decades to come. But we also warned that supply interruptions from the Middle East could push up prices. Of course, nobody could say then that a few weeks later the whole region would be on fire.

It is not madness that energy prices rise when revolutions brake out in the region that has the largest energy reserves of the world. We are particularly worried about gas prices. We are now in the last weeks of the coldest winter in decades in North-West-Europe. However, our gas prices didn’t rally to previous heights. This was due to LNG ships unloading gas nearly every day in our import terminals. Eight in ten of those ships came from Qatar. These were the marginal MWh’s that kept the system sufficiently supplied. So far, no trouble has been reported in the gas-soaked emirate of Qatar. But trouble in the Suez Canal or in the Strait of Hormuz, the sea passage between Iran and the Arabian peninsula could mean that the LNG ships fail to reach Europe.

However much we sympathize with the protesters in the Arabian countries and in Iran, from an economic point of view this is bad news. Continuing instability will affect the output of the oil and gas industry, as is now already seen in Lybia. This will cause rising energy prices. Moreover, the economy of the region is coming to a standstill. This is bad news for the recovering world economy. These countries are huge importers of consumer goods (the lack of jobs in domestic industries is one of the main reasons for the fiery protests). If people in that region buy less, this will affect the economy. China, whose growth has powered the recent economic recovery, exports ¼ of its goods to the Middle East and Northern Africa. We are starting to fear the disaster scenario of stagflation. Energy prices that continue to grow due to supply cuts while the economy is going into recession. If supply drops faster than demand drops due to economic recession, we will enter this scenario. Both from an ethical and from an economic point of view, we sincerely wish that all these countries make a rapid shift towards a peaceful democratic government. But how likely is that? Therefore, as an energy buyer, you better prepare for a continuation and worsening of the current market situation. We obviously cannot predict the outcome of the current political crisis. But we fear that a swift return to normality is idle hope.

In the longer term, the current situation should be another motivation for Western governments to promote energy independence. Promote the widespread usage of the energy sources that we have in our own region, such as renewable energy and shale gas. In that perspective, the peoples of the Middle East might be shooting in their own foot. But would you care about the longer term economic consequences when you are fighting for your life in the streets of Tripoli?

100 dollar oil: back where it all started?

Yesterday the Brent has traded above 100 dollar again. This is its highest level in 28 months. The first time that the oil price broke above 100 dollar was on the 28th of February 2008. It was then followed by a speculative craze that pushed the Brent price all the way up to 146,08 dollar per barrel. By that time oil demand in the US, the key oil consuming region, was going down. More and more US citizens defaulted on their mortgages and one of the reasons for this was the derailing fuel budgets. It is clear that rising fuel prices and their consequences for other commodities such as food was one of the reasons for the 2008 financial crisis.

This time, the consequences for European consumers of oil products and oil-indexed natural gas are even more severe than in 2008. Back then, the euro was worth 1,5121 dollars whereas now its value has declined to 1,3692 dollars. This means that in euro, a barrel of crude oil is now more than 10% more expensive than in February 2008.

There are parallels to be found with the situation in 2008:

• The underlying fundamental is similar: the 10% growth rates of emerging economies, foremost China, sucking up commodities faster than production can grow.
• It’s not only oil that is rising, metals, coal and soft commodities are also contributing to general inflationary pressure.
• Analysts’ hysteria is contributing to the bull run. This morning already you can read plenty of articles of enlightened minds that “forecast” even higher levels.
• Opec claims to have spare capacity but refuses to bring it to the market, saying that there is more than enough oil in the market.
• The contango in the market has almost disappeared and turned into backwardation, meaning that the further you go into the future, the cheaper the price at which you can buy oil. To some, this is proof that the bullish sentiment is unsupported.

However, we also see two important differences:

• In February 2008, we crossed the hundred dollar barrier at a moment of solid economic growth in all parts of the world. This time, we cross it at a moment of fragile economic recovery in the Western world. The traditional medicine for curbing inflation is raising interest rates. Governments hope that this will inspire citizens to save more and spend less and companies to invest less. This would obviously reduce demand for commodities and can stop the bull run. But on the other hand, it would also kill off the beginning of a recovery that we have seen in recent months. Moreover, it’s not only governments in the West that fear inflation. Authoritarian regimes across the globe know that many revolutions have started with a middle class that reacts to a rising cost of life. It is therefore not surprising that the Chinese government is taking steps to reduce inflation. But it is clear that these steps will reduce growth in China, the growth that has been the engine of recovery in many other parts of the world, as far as Germany. The Chinese government can see good examples of the danger for the regime of inflation happening before their eyes in the Arab world. The people on the streets of Cairo quote rising food prices as one of the reasons for their anger.
• This brings us to the second danger. Geopolitical tensions have always been cited as a reason for oil price increases. But if you look back in history, you can find only two occasions of serious oil price inflation due to political conflict. The first one was in 1973 with the Yom Kippoer war and the ensuing blockade of the Suez Canal. The second one was in 1979 with the Islamic revolution in Iran. The Gulf Wars for example, had only a limited effect on oil prices as Saudi-Arabia stopped initial price increases by pumping up more oil. Opec is now claiming again that it will open the valves if the Egyptian crisis would cause restraints to the world’s oil supplies. However, the current situation bears some very uncomfortable analogies to the two previous occasions of politics leading to oil supply crunches. There is a danger that if Hosni Mubarak is ousted, he will be replaced with a regime that is much less friendly with Israel. It might even be an Islamic government. War between Egypt and Israel would disrupt supplies through the Suez Canal. Fear of this scenario was the reason most cited for yesterday’s push above 100 dollar.

Overall, and as always, the picture for the next months is complicated and unpredictable. Mister Mubarak might survive the crisis. He might be replaced by mister El Barradei who seems to be a peaceful figure (he has a Nobel prize on his desk to remind him of that). I have read in many books and articles that the Egyptian Muslim Brotherhood has developed more in the direction of Turkey’s moderate Islamic party than in the direction of radical Islamism. It is clear that no one can predict what will happen in Egypt. And even if Egypt becomes a broader conflict with ramifications for oil supplies, it is not clear whether oil prices can continue to rise. My best guess is that it will cause a new recession as governments raise interest rates and middle classes see higher commodity prices cutting into their buying power.

The economic picture of the past decade looks really bleak. A large part of this planet is growing towards a better future by growing their economies rapidly. This leads to spectacular boom phases. But the planet is unable to support that growth with sufficient commodities. The consequence is high inflation cutting into buying power which leads to spectacular busts. There is a shimmer of hope however and it lies in the third difference with the situation in February 2008. This time, many gas consumers in the West are not affected by the rising oil price. They buy gas in the Hub markets. In Europe, these prices haven’t risen much higher than 20 euro per MWh even in the coldest winter in decades. In the US, prices are half that thanks to the shale gas boom. The developments in the gas market show the way out of the boom and bust cycle. We have to reduce our dependence on scarce commodities such as oil.

Fuel for the dragon

Last month, figures were published that made clear that China has surpassed the US as the world’s largest consumer of energy.  Economic pessimists will probably interpret this as another sign that the Western economies are being surpassed by the Asian economies. It is true that for many years now, the economies of the east have grown faster than our economies. However, you are only surpassed when your competitor is becoming bigger than yours. And if we are discussing economic performance, you should watch for per capita figures rather than absolute figures. If you only watch absolute figures, the tiny country of Belgium that I live in, would never be good in anything. If you look at the energy consumption figures in that perspective, it still means that US energy consumption per capita is four times bigger than the Chinese. So, once again, we should remark that China is catching up rather than surpassing. In the past decades, this economic miracle has lifted 400 million Chinese out of poverty. Who can be against that?

The dragon economy of China has recovered more swiftly than that of any other country from the perils of the 2008 financial crisis. Moreover, it looks like they are managing to reduce the dependency on export (and American credit-based consumption) by stimulating inland demand. As the Chinese become richer (and wages are rising fastly), they buy more and more consumer goods. They also move into higher added value goods, which is a logic step. Being the world’s cheap labor workshop is not a source of sustainable economic growth. The counterside of that economic growth is of course the rise in energy consumption. And this gives rise to some important reflections:

1. Since hitting their lowest point in the beginning of 2009, oil prices have more than doubled again, fueled by the rapid recovery of Chinese oil demand growth. Coal prices didn’t grow as much, as increasing demand was matched by increasing supplies.  However, the evolution of oil prices shows that increasing Chinese demand has an important impact on commodities that are traded on a worldwide scale. This is also obvious in other commodity markets with tight supply such as copper.  What does this mean for natural gas markets, now that they are becoming more and more worldwide markets due to the LNG boom? Will China dash for gas and tap into the reserves of Russia, Southeast Asia and the worldwide LNG markets? And will the newly tapped reserves of shale gas be able to fuel an increase in worldwide gas demand? Will China itself be able to increase its production of gas due to the shale gas evolution?

2. Chinese energy demand growth has a big impact on the global carbon dioxide balance. China is growing fastly in renewable energy and for wind and solar power, it is a key market. But this renewable energy is unable to compensate for the even larger growth of coal-fired power plants. With its newly won status of being the world’s largest consumer of energy, the pressure on China for taking more responsibility in terms of reducing carbon dioxide emissions will be bigger than ever.

3. Even if China is obviously the most important factor in determining oil prices, the market is still looking mostly at the US for its analysis of prices. See this previous entry for more on that. This is due to the lack of good quality data on Chinese oil consumption. In the past two years we have seen the market surprised again and again by unexpected growth in Chinese oil demand. It is clear that an improvement in Chinese energy statistics would make the markets a lot more transparent.

We will have to see in the next years if the Chinese economy can continue its economic success story. Anyhow, it is clear that we will have to look East for information about the energy markets.

Could the BP oil spill move us beyond petroleum?

For more than three months, oil has been spilled in the Gulf of Mexico. In these three months the world has been presented with an unprecedented flow of images of the environmental impact of the oil industry. Birds and beaches drained in oil were not limited to some beaches like we see after the crash of an oil tanker but came on an unprecedented scale. I am not an environmental specialist, but I guess that in the next months, we’ll be reading a lot of reports about the damaging effects of the spill on the local environment. It takes some time before the exact impact of such a massive oil spill can be measured.

For BP, the impact can be measured in terms of billions of dollars already spent on the clean-up, and likely to be spent in the future on further clean-up, damage repair and fines. Today it was announced that the total sum of fines could run up to 13,4 billion euro. And what will be the longer term consequences of the reputational damage for BP after being involved in such a massive environmental disaster? The company once tried to be a front-runner of greening the oil business with its ‘beyond petroleum’ campaign and its green flower logo.  It is now bound to be the public enemy n°1 of environmentalists for many years to come. If you open the website of the UK branch of Greenpeace, you get a pop-up that attacks BP (www.greenpeace.co.uk). The many parodies on BP’s beyond petroleum slogan that we currently see, make clear that as a company you have to be very careful when you launch a ‘look how green we are’-campaign. You have to make sure that you can live up to the expectations that you create.

For buyers of energy, the interesting question is: will the Gulf of Mexico spill help us to really move ‘beyond petroleum’? Could it be the big cathartic event that helps mankind to get rid of its petroleum addiction? And by what energy will petroleum be replaced? Energy not consumed due to energy savings programs? Renewable energy? Natural gas, of which we have recently found out that we may have more available than we thought? Nuclear energy?

I am not too hopeful about individual action. One of the television reports on the oil spill showed a woman from Louisiana who was railing against the government for not doing enough to stop the tragedy. The camera zoomed out and showed that she was speaking from the window of a giant SUV car. Usage of energy-rapacious equipment such as SUV’s have caused petroleum consumption in the US to continue to grow in the past decades. This consumption growth makes it necessary to drill for oil in difficult circumstances such as the deeper parts of the Gulf. However, most people prefer to blame the government rather than questioning their own energy-consuming behavior. ‘BP’ or ‘Obama’ are more likely scapegoats than ‘me’. So far, I have met with very few people that argued: ‘have you seen what happened in the Gulf of Mexico? I am considering to buy a more fuel-efficient car and reduce how much I use it by using my bike, the train or my feet more often’. Is there anybody out there that has cancelled the flight to his summer holiday resort because of the oil spill?

The most important reaction to look out for, will be the political reaction. US as well as EU officials have already responded to the disaster by imposing moratoriums on deep-sea drilling for oil. Now that the hole has been plugged will these bans be reversed in a ‘back to business-as-usual’ scenario? I don’t think so. By plugging the hole, BP has avoided that the problem will become worse. But there is still a lot of rubbish in the sea and on the shores, and the negative consequences of the oil spill will continue to be in the news for quite some time to come. It is likely that any license for deep-sea oil drilling will at least be seriously challenged in the next years.

There is a danger, however, that a more critical approach of drilling licenses could create a worldwide Nimby, or ‘not in my backyard’ syndrome. We don’t drill for oil near our own shores, but we buy the oil drilled in countries where governments are less environmentally sensitive. This would mean that the West becomes even more dependent on importing oil from underdeveloped or developing countries. This could increase the risk of more conflict in the style of Iraq …

The only way of avoiding that is by having the drilling bans flanked by a policy for investment in renewable energy and fuel efficiency improvement. Blocking BP from drilling for petroleum in the Gulf of Mexico, Alaska or North-Sea will not move us ‘beyond petroleum’. A new vision on energy policy is necessary. And maybe, the Gulf of Mexico oil spill might help president Obama to sell such a policy to its countrymen. If this succeeds, BP will indeed have helped the world to move beyond petroleum. However, not in the way that it once imagined.

Iraq: the next oil bonanza?

The oil market is buzzing with whispers over the future oil supply from Iraq. The Iraqi government is granting licenses for the giant Iraqi oil fields. The numbers are impressive: Zubair: 4 billion barrels, Majnoon: 12,8 billion barrels, West Qurna 12,9, Halfaya: another 4 billion barrels. As a comparison, Ghawar in Saudi-Arabia, the world’s largest oilfield, is said to have already produced 60 billion barrels. Still, the Iraqi government hopes that the production in these oilfields will allow the country to surpass Saudi-Arabia as the world’s largest producer of oil. They project Iraqi oil production to grow to 11 million barrels per day, five times its current production. Western analysts are more prudent and say that they would be happy if Iraq could grow to 5 million barrels per day.

The most important feature of these oilfields is that they are giant, conventional on-land oilfields at a normal depth and with satisfying pressure and water levels and that they are close to existing oil export infrastructure. This means that production from these oilfields will be cheap. Occidental Petroleum (US), Eni (Italy) and Korea Gas Corp, the three companies that team up for production at Zubair are happy to earn 2 dollars per barrel. They will invest 20 billion dollars in Zubair over the 20 years for which they have won a license. This is a completely different story than the tar sand or deep-sea off-shore oil fields of Canada, Venezuela or Brazil. Oil can be economically produced from these fields only at oil prices far over 50 dollars per barrel.

If the Western oil companies that have now been invited into Iraq manage to produce the oil bonanza for which the Iraqi government is yearning so much, this could mean a huge glut of cheap oil in the markets. The combination of increasing demand and diminishing supply from traditional cheap oil fields like Ghawar or China’s Daqing has produced the peak in oil prices of recent years. The fact that these large cheap oil fields were being replaced by much smaller and more expensive oil fields also caused the extreme volatility of oil prices which made oil prices double again in 2009. Will a glut of cheap Iraqi oil produce more stability and lower prices in the oil market?

The first question is of course whether they are indeed the bonanza that both the Iraqi government and Western oil companies clearly believe they are. After all, these are not newly discovered oilfields. Was it just the crookedness of the Saddam regime that made large-scale oil production from these fields impossible? Or are unexpected technical difficulties awaiting? And if oil production is technically possible, will the political climate in Iraq finally find the stability necessary to allow a stable flow of the oil out and the money in? Will the Sunnis, Shiites and Kurds find peaceful agreement over how to share the booty? Today, the US Marines are leaving Iraq. Is this signaling a final step for the country into a peaceful, prosperous future?

If Iraq could finally come to peace with itself and its oil riches, the question is of course what happens in the rest of the world. The combination of growing oil demand (in China) and declining oil production in other parts of the world like Saudi-Arabia could outstrip the increase in production in Iraq. This is what James DiGeorgia, author of “The global war for oil” believes. If that would happen, that would be excellent news for the Iraqi government. They would cash in the extra dollars between the low price paid to the producers and the much higher price that they would get in a world market characterized by tightness. It’s cynical, but it would be a huge payback for Iraq for all the blood and tears of the past decades. That is, if the oil bonanza doesn’t cause another period of war and terror.

Impossible to see who will prove right, skeptics like mr. DiGeorgia or the Iraqi government. Anyway, with the Iraqi oil bounty looking for its way to the market, a future of rising oil prices looks less certain. In your energy buying strategy, you shouldn’t neglect the possibility of a future of cheaper oil.