Feature Stories | Feb 15 2012
By Greg Peel
The US consumes over one fifth of global petroleum production, notes Standard Bank, more than twice that of the second largest consumer – China. For decades the strength of the US oil market has been the barometer of the health of the global oil market but that economic indicator has begun to lose its emphasis. While it may yet take a while for China to catch the US in terms of oil product consumption there is a lot more going on in the world than just America's obsession with oil.
For more than a year now the West Texas Intermediate futures contract has lost its significance as a global oil price indicator and focus has shifted to UK-delivered Brent crude contracts instead. Most Americans seem unable to accept that the global price of oil is anything other than the WTI price, but the smarter money has realised for a while now Brent, another actively traded futures contract, is the more realistic price indicator. It might seem anathema to Americans to use the Brits' oil price indicator but the reality is that of all the crude oils available in the world nearly all of them trade in a close price band with Brent and, since mid last year, a substantial margin away from WTI. This includes Gulf of Mexico oil – Louisiana Light Sweet crude – which one might suggest is the “real” price of US oil.
The price spread between Brent and WTI blew out to above US$25/bbl in 2011 before squeezing back to around US$12 late in the year, but recent weeks have seen the spread widening again. The shut-down of Libyan oil production last year was the main excuse for the big price blow-out, but Libyan oil is flowing again yet the spread has begun to widen once more. Realistically the Brent price is not “blowing out” to the upside as much as the WTI price is hampered to the downside. The WTI price reflects oil in storage in Oklahoma and that facility is straining under the volume of oil flowing steadily not only from the vast pipelines connecting Canadian production but also now from accelerating shale oil production in the US mid west.
Once at Oklahoma, that oil is somewhat stranded. There is as yet no pipeline to take WTI a step further down to the Gulf coast refineries and ports. Expensive rail and truck transport is the only option. Such a cost thus brings the cost of WTI at the refinery gate closer to the price of all other oils as compared to its price in storage. Indeed, the growing cost of limited storage in Oklahoma forces down the price of the actual oil in the Oklahoma tanks, and hence the related futures price.
The price of energy is arguably the most significant “cost” for the global economy. Hence the price of oil is a closely watched indicator. The price of crude is nevertheless only a proxy, because oil has to be refined into its various products (gasoline, diesel, heating oil, jet fuel etc) in order to be consumed and refined products come with their own price margin. Hence the end-cost of energy to the economy is dependent not just on global crude demand and supply but also on refinery capacity and efficiency.
Every week the US Energy Information Administration releases inventory data for crude oil and its products stored in the US and for decades the ebb and flow of US inventories has been a major determinant of “the oil price”. It's still the case today, with sharp movements in the WTI price still being blamed on weekly US inventory surprises. Yet Barclays Capital notes, “The overall state of global oil market fundamentals appears to be tighter than implied by recent US oil data releases, the latter of which also appear to be out of line with US macroeconomic data releases”.
US economic data may have improved in recent months but indications of US oil demand remain very weak. Such weakness can be explained both by short-term seasonal factors – North America has experienced its mildest winter in about 50 years – but also a longer-term trend away from profligate oil consumption – falling petrol demand through smaller cars, general fuel efficiency gains, switching to diesel, simple family budgeting and so forth. Once upon a time natural US population and income growth would lead to naturally rising oil prices but falling petrol demand is now offsetting this typical trend, JP Morgan notes.
Europe had also been experiencing a mild winter, up until a week or so ago when the weather changed dramatically. Clearly such a disparity has helped the Brent-WTI spread widen at the same time but again we must look at end-use, being in fuel and heating products rather than actual crude consumption, and that brings in the issue of refining.
Global refiner Petroplus has recently closed three refineries in Europe and the St Croix refinery in the US Virgin Islands has also shut down, sending the Atlantic Basin oil products market into deficit despite aforementioned weak US demand. When the global recession hit in 2009, notes JP Morgan, 21 refineries closed down across Europe, North America and the Caribbean representing 2.2 million barrels per day of refining capacity. In the ensuing fragile recovery, only two have restarted.
In Australia, we note that local refiner Caltex ((CTX)) is in the process of ending its refinery operations and is expected to convert its plants into storage facilities for refined products imported from Singapore. The bottom line is that while oil producers can make a killing in a rising oil price environment, refiners have to balance out the cost of crude against demand for different products which makes refining margins very volatile. Crude has to be ordered long ahead of refining and product demand must be forecast and it's quite easy to get it all very wrong. To that end, listed companies across the globe electing to shut down refinery operations have been seeing share price appreciation as a result.
A particular issue with refining is that of refined product variety. One cannot just turn a dial on the cracker to shift from light distillate (such as petrol) production to middle distillate (such as diesel) production in a trice. Specific refineries are set up to produce specific products and altering the product mix is a very expensive operation. Hence refiners have to get their mix of petrol, diesel, heating oil, jet fuel etc production right or they end up not being able to sell stuff they don't have while being stuck with stuff they can't sell. Such an issue is apparent as US petrol demand weakens (and obviously seasonal risks are significant such as knowing exactly how much heating oil to produce) but it also brings China into an ever more complex equation. The bottom line is China likes diesel.
In the shorter scheme of things, Chinese oil demand rose in 2011 by 6%, notes Deutsche Bank, which is only half the rate of growth of 2010. This clearly reflects a Chinese economy being forcibly slowed by Beijing if nothing else. In the longer scheme of things, emerging markets are now providing the growth engine of energy demand.
Having investigated why current global oil market fundamentals appear to be a lot tighter than recent US oil data releases suggest, Barclays Capital offers, “In our view, there appears at this moment to be a sharp and unexpected demand surge from both Asia and the Former Soviet Union, to which a severe European cold snap has added to create tighter prompt market conditions than either expected, or is implied by the US oil data”.
JP Morgan has also noted the discrepancy between strong global demand and weak US weekly data, from robust crude prices to strong refining margins. Aside from a modest rebound in industrial activity and the sudden cold weather JP Morgan also points to the aforementioned refinery closures and indications that importers of Iranian oil, which include China, are looking for alternative suppliers ahead of any escalation in geopolitical tension.
Further to Chinese demand influences, Deutsche Bank's Chinese industrial production forecasts imply a moderation of diesel demand in 2012 but the swing factor is always that of sudden Chinese power shortages, which seem now to happen every year. China has been increasing its own refining capacity, however, which suggests to Deutsche that actual diesel (as opposed to crude) imports should not be necessary unless the power shortages are extreme.
Another factor to consider is that of Chinese government fuel subsidies which to date have only been marginally reduced. If Chinese inflation continues a downward trend Beijing may feel comfortable in raising fuel prices which could impact on demand from the masses. However we must also consider Beijing's historical preference for stockpiling its future commodity needs at times of cheaper pricing. Oil is not in a cheaper pricing phase but we may be looking at further price rises if geopolitical tensions escalate not just in the Middle East but also in Africa (Nigeria, for example, suffers from constant disruptions).
Speaking of African oil production, Deutsche Bank notes further that the new nation of South Sudan shut down its 350,000bpd production at the end of January due to disputes with former adversary Sudan. South Sudan is landlocked and oil exports rely on a pipeline through Sudan to the Sudanese port. Arguments relate to transit fees and revenue sharing. China is the biggest buyer of Sudanese oil and Japan is not far behind since it shut down most of its nuclear energy capacity.
Japan's recent need to supplement lost nuclear power capacity with fossil fuel alternatives has added another source of pressure on the global oil supply.
On the supply side, deep water drilling has recommenced a-pace in the Gulf of Mexico and US shale oil production is accelerating at an “exceptional” rate, notes JP Morgan, notwithstanding the aforementioned delivery problems. Libyan oil production is back up and running but JP Morgan is wary of output actually being as high as the 1.3mbpd indicated by the state oil company at the end of January. OPEC producers stepped up production to supplement the loss of Libyan oil but the Middle East producers will likely remain competitive, JP Morgan suggests, as they seek to meet increasing demand from Asian customers.
JP Morgan is concerned, nevertheless, at news that Iraqi officials have announced the indefinite postponement of the commissioning of a vital export terminal at the port of Basra. The terminal was meant to start up early this year and without it supplies of oil out of Iraq will struggle to materially rise.
Barclays Capital is also of the belief a key source of upside surprise on the demand side could come from China and India. Both went through a strong destocking phase in 2011 and Barclays sees that reversing in 2012. The analysts note upside surprise from Asia in general is “coming through perhaps earlier than even we had anticipated”.
As emerging market energy demand rises, the global refining sector is struggling to meet demand for middle distillates such as diesel while US demand for light distillates such as petrol stalls. This could translate into elevated costs for the transport sector and thus create broader issues for the economy as a whole, JP Morgan warns.
JP Morgan's economists have been expecting the global economy to follow a bumpy path in the first half of 2012, struggling along to 2% growth. However global data releases in January, such as global manufacturing purchases managers' indices (PMI), suggest there is broader growth momentum at play than previously envisioned. The risk is thus to the upside for global growth and any increase impacts directly on global oil demand. A percentage point shift up in global growth can add 400,000 to 600,000bpd to oil demand growth, the economists note.
To conclude, Barclays Capital provides a concise summary of all of the above:
“The problem with judging the global pace of demand growth is that the epicentre of that growth has most definitely moved away from the US to Asia, and China in particular. The scale of Chinese demand, and the degree to which it can swing, has meant that US-focussed views of fundamentals have not provided much explanation of the market for most of the past two years, and insufficient attention to Chinese demand is no longer an Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.
