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By Gregor
McDonald
In the spring of 2011, when Libyan oil production --
over 1 million barrels a day (mpd) -- was suddenly
taken offline, the world received its first real-time test of the global
pricing system for oil since the crash lows of 2009.
Oil prices, already at the $85 level for WTIC,
bolted above $100, and eventually hit a high near $115 over the following two
months.
More importantly, however, is that -- save for a brief
eight week period in the autumn -- oil prices have stubbornly remained over
the $85 pre-Libya level ever since. Even as the debt crisis in Europe has
flared.
As usual, the mainstream view on the world’s
ability to make up for the loss has been wrong. How could the removal of
“only” 1.3% of total global production affect the oil price in
any prolonged way? was the universal
view of “experts.”
Answering that question requires that we modernize,
effectively, our understanding of how oil's numerous price discovery
mechanisms now operate. The past decade has seen a number of enormous shifts,
not only in supply and demand, but in market perceptions about spare
capacity. All these were very much at play last year.
And, they are at play right now as oil prices rise
once again as the global economy tries to strengthen.
The Subordination of Cushing
Through the dominant force of its own demand, the US
economy largely controlled the oil price for many decades. For years, it was
common practice therefore to gauge world demand through the weekly updates to
oil storage at Cushing, Oklahoma as well as total oil storage in the United
States. If the US was demanding more oil from the global market, and thus
either not adding to oil inventories or drawing them down, then a signal was
given, pointing to future oil price strength.
But this dynamic began to break down coming into
2005-2007. That was the period when US oil demand -- because of rising prices
-- began its current decline. Now that US oil demand is down over 12% from
its mid-decade peak, the fluctuation of oil inventories in the US no longer
drives prices.
The chart below shows that US inventories have been
on an upward trend since 2005, and are now near decadal highs above
300 million barrels even though oil prices are back above $100:
 
What we're now seeing is that US inventories and US
demand are now subordinate to numerous other factors, ranging from emerging
market demand, to market perception of spare capacity.
Lessons of Libya
A useful fact learned during last year's Libyan
civil war is that Saudi Arabia does not necessarily possess the 2-3 mbd of spare capacity which most have assumed for years.
Moreover, Saudi Arabia ceded the position of top world oil producer to Russia
over 5 years ago in 2006. Indeed, Saudi Arabia made no production response to
the loss of Libyan oil last spring. Producing near 9 mbd,
it was only by June that Saudi production was lifted by 600 thousand barrels
a day (kbd). That is a hefty production increase to
be sure, but it raised questions as to how quickly spare capacity in the
world can be brought online.
By the time Saudi Arabia had lifted production, the
OECD countries led by the IEA in Paris had already decided to release oil
from official inventories. But this, too, did little to calm oil prices --
and as I pointed out last June, only created further problems. In The
Dark Side of the OECD Oil Inventory Release, I explained that, by lowering OECD
inventories, the market would correctly deduce that safety buffers had been
reduced further. Combined with the Saudi increase in production, this only
reduced spare capacity further.
The result was even stronger prices as WTIC ran back
to $100 (until all global markets floundered on a flare-up in the EU
financial crisis). Indeed, it is no longer US inventories of crude oil but
the fluctuations in the emergency cushion of all inventories in the OECD (of
which the US is part) that is now the more important factor in oil prices:
The loss of Libyan production caused a dramatic
drawdown of OECD total oil stocks, which were already in a downward trend starting
the previous summer in 2010. OECD inventories fell on both an absolute basis
and on a comparative basis to the trailing 5-year average, as the above chart
shows. Taking these inventories from a high of 2800 mbd
to 2600 mbd onlysix
months later, combined with unrest across the entire Middle East, was more
than enough support to boost WTIC oil prices from $85 to above $100 last
spring. Additionally, as we can see in the chart, the decline in OECD oil
inventories was maintained into the end of 2011.
These are important conditions to consider when
trying to understand how oil prices now, in early
2012, are once again on the rise.
The Decline of Spare Production Capacity
The latest global production data shows that Saudi
Arabia was producing 9.4 mbd on average
during 2011, an increase of 500 kbd over 2010. To
accomplish this, The Saudis had to increase production from 9 mbd in 1H 2011 to 9.8 mbd
during 2H of 2011. But paradoxically, this production increase has only made
the global oil market even tighter, as spare capacity shrinks further.
Let's recall that nearly 60% of global oil supply
comes from outside of OPEC from countries like the US, Canada, Brazil,
Mexico, China, Australia, and the big producer, Russia. There is no spare
capacity in this non-OPEC grouping, and there hasn’t been for years.
Sure, there is oil to be developed in non-OPEC countries; but that is
not production capacity (meaning it is not supply that can be brought online
quickly).
Moreover, Russia, the country that single-handedly
saved non-OPEC production from going into steep decline, massively increased
its contribution to world supply in 2002. But in the past two years, it has
seen its production growth taper off and flatten, to just shy of 10 mbd.
That leaves the oil market, tasked with the job of
pricing, to figure out the ongoing mystery that is the "true" spare
production capacity in OPEC. That it took 4-5 months for Saudi Arabia to
increase production is a concern. Such delays should seriously give pause to
those analysts who’ve regurgitated the belief over years that Saudi has
2-3 mbd that can be brought on quickly.
Although EIA Washington currently judges OPEC
spare capacity to be
higher than during the lows of 2003-2008, its historic figures show that
spare capacity has been declining since a 2009 high.
Moreover, the failure of non-OPEC production to
increase within last decade counts as a true surprise to the global oil
market. The faith in non-OPEC supply over the last decade helped to keep
prices subdued, until that faith was shattered by 2007's wild spike.
The problem now is that the oil market has been
re-educated. Faith in the non-OPEC countries' ability to increase supply is
no more. Meanwhile, the great deceleration in Russian oil supply growth
has spooked the market. Combined, a market with 74 mbd
of production and a theoretical spare capacity of 3 mbd
simply creates too much uncertainty.
And consider this: the amount of total spare
capacity is now equal to the 3 mbpd of demand
that’s been taken offline in Europe, Japan, and the United States over
the past 7 years, as oil prices have risen from $40 to the $100 level. Thus
the oil market has quite correctly rationed supply, at higher prices. If
prices were to fall to $50 or $60, the world’s lost demand could be
rebuilt rather quickly.
Killing discretionary demand is now the proper
function of the oil market in an age of flat supply growth.
Quantitative Easing and Granger Causality
We should also remember that the global economy
would be mired in a textbook deflationary depression were it not for the
continual and gargantuan US$ trillions that have been provided by central
banks since 2008.
Early 2009 saw oil prices slip briefly below $40.
But, of course, that's the price level appropriate to a world during an
industrial crash -- with reduced shipping, halted economies, and dislocated
consumer demand. The world can have those prices again, if it chooses. But it
must also be willing to accept a global recession to achieve such low oil
prices.
Thus, there is a misconception that currency debasement is the main driver of
oil prices. However, given the new supply realities, that simply isn't true
any longer.
The chart below is helpful in explaining why. There
is no question that coming out of 2000, the decline of the US Dollar as
expressed by the USD Index was a true component of the rising oil price.
During that period, as the USD was falling, global oil supply was still
increasing. The descent of the US Dollar was unquestionably part of the repricing process, as the USD Index fell from a high of
120.00 in 2002 to 80.00 in 2005:
But see how the most ferocious part of oil’s
price advance started to unfold after 2005, when, as the USD continued
falling, the global supply of oil stopped growing.
If we think of this comprehensively, we have to conclude
that the debasement of currencies is no longer the primary factor in the
price of oil on a valuation basis. Rather, it is that quantitative
easing prevents a deflationary industrial collapse, thus keeping the global
economy alive and able to consume more energy.
We can therefore say that in our post-credit bubble
collapse era, and with global oil supply now flat, that quantitative easing
causes higher oil prices (through Granger
causality). It keeps
economies from collapsing (for now) and thus brings demand up against very
tight supply. As we can see from the chart above, the USD Index has for 3
years now been bouncing off the bottom it first reached in 2008. In a way,
this is helpful because it brings to light the new dominant factor in global
oil prices: supply.
Supply
is Now Primary
Supply and the recognition of supply are now the
dominant factor in the oil price -- a point so obvious, it hardly seems worth
making. However, the developed world is still largely operating on the
classical economic view that higher prices will make new oil resources
available.
That is true. But, it’s just not true in the
way most anticipate.
While higher prices have brought on new supply,
these resources have been slow to develop, are more difficult to extract, and
generally flow at lower rates of production. As the older oil fields
of the world decline, the price of oil must reflect the economics of this new
tranche of oil resources. There are no vast new supplies of oil that will come
online in 2013, 2014, and 2015 at the scale to negate existing global
declines.
During the entire time that global oil supply has
been held at a ceiling of 74 mbd, since 2005, a lot
of new production in the Americas and Africa especially has come online. But
it has not been enough to increase total world supply. And the price of oil
has finally started to price in that new reality.
Here Comes Volatility in Oil Prices
The pricing dynamic discussed above is accentuated
by the crisis cycle: the repetitive oscillation between acute and chronic
phases of the ongoing debt crisis, mitigated by central bank reflationary
policies.
In Part II: Get Ready for Oil Price Volatility to Kill the 'Recovery', we forecast how today's protractedly
high recent oil prices are already sending a signal that a new hit to global
demand is underway.
Generally, it appears that the oil price is making
its move too early in the year -- which will likely serve as a sucker punch
to the fragile world economy -- thus making spectacularly high prices before
year end less likely, and a sharp market correction and return to economic
recession more so.
Investors will be wise to take prudent precautions
before this nasty wake-up call arrives.
Click here to access Part II of this report (free executive summary; enrollment required for
full access).
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