Bottlenecks and rising prices

Dr Dalton Garris looks at the reasons for high oil prices and asks whether or not the current levels can continue.

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By  Dr Dalton Garris Published  July 4, 2005

|~||~||~|At its Vienna headquarters on June 15, OPEC’s president, Sheikh Ahmad Al Fahd Al Sabah, announced a formal increase in its output quota of 500,000 bpd, with an additional 500,000 bpd promised in the near future if crude prices fail to moderate. It was also announced that the OPEC basket of crudes is to become slightly lighter and more sour.

Since this announcement only legitimises what OPEC members had been producing, the crude price on the New York Mercantile Exchange (NYMEX) promptly rose by US $1.50. By June 21, it had increased to an all-time high in current dollar terms of over $59.50/bbl, close to the new and higher psychological resistance point of $60.00/bbl.

As explanation for the continuing high crude prices in the face of increasing crude storage supplies in the US and elsewhere, OPEC offered that the real reason was the lack of downstream refining capacity, and not crude supply worries. If this is true, the explanation needed further explaining.

It is not immediately clear why a downstream bottleneck could be causing an upstream resource to experience a price increase. Would you expect iron ore prices to increase if steel mills had all the ore they could handle and didn’t need any more because they lacked the physical capacity to utilise it? Certainly not; and that is why the OPEC explanation of downstream bottlenecks causing crude price increases seems illogical.

The logic of the explanation is in there being different crudes, and different refining capacities to handle them. The crudes that have been rising in price are the light sweet benchmark crudes of West Texas Intermediate (WTI) and North Sea Brent. The OPEC basket, the one increasing in production volume, is generally heavier, and becoming more sour, as the specifications of the new basket indicate.

Refining capacity for the light sweet crudes exists, but these crudes are not the crudes OPEC generally supplies, while the OPEC crudes that are being made available are not economically refined using most existing world refining capacity. What is needed is greater capacity to refine heavier, sour crudes.

Thus, OPEC’s increases do not increase the quantity of crudes that refiners want, and it is those crudes, WTI and Brent, that are rising in price. True, the OPEC basket and other heavier crudes are also experiencing price increases, but as Sheikh Ahmad observed at the June 15 meeting, OPEC crudes are selling at a deep discount, making them “bargains,” with good crack spread potential, that is, if you have heavy crude refining capacity at hand.

Sheikh Ahmad strongly encouraged expanding downstream refining capacity for the heavier, and increasingly sour, crudes. Asked why, when firms are finally showing a profit in refining operations after more than two decades in the economic doldrums, they would increase refining capacity and thereby reduce those new-found profits, he offered that the future was in the heavier crudes, which, presently, the world lacked the capacity to refine.

In other words, it would be in their long-term revenue interest to develop this capacity.

Heavier crudes require more complex processes to release enough of the most valuable commercially demanded grades, such as gasoline, heating oil, jet fuel and diesel fuels. “Hydro cracking” and “catalytic cracking” methods are employed. These refineries experience higher per unit operating costs, all else being equal, compared to atmospheric refining of light crudes, which can produce the same, or similar, quantities of the most demanded refined products at lower unit costs.

This explains some of the reluctance of companies to aggressively invest in hydro and cat cracking refineries. The other part of their reluctance is in the 3-5 year time frame required to bring a new refinery on line.

Everyone is utilising the same information and everyone sees that presently there is profit potential in cat and hydro crackers if they had this capacity operating today. But, what about in 3-5 years? All see the profit potential: if they all start building these expensive refineries, it is more than likely that when they begin operations, the competition has reduced operating profits to near zero. Thus, each potential refiner-investor decides to do nothing now, and await future developments.

And future developments could see more increases in the benchmark crudes of Brent and WTI. Although predicting nearby prices in crude is risky, $70.00/bbl by August is certainly possible. Recall that Goldman Sachs predicted crude would reach $105.00/bbl within a few years, which, in constant dollar terms, is higher than the price spike of 1979-80 at the commencement of the Iran-Iraq war. As T. Boone Pickens, the famous Texas oilman and hedge fund manager, stated last month, “I wouldn’t advise shorting these markets right now.”

One reason he could say that with confidence is the macroeconomic environment in which crude prices are rising. Macro indicators, such as GDP increases, bond spreads, central bank interest changes and pronouncements, point to a possible slowdown in world economic output, and hence, world demand for oil.

As of June 22, the spread between US and UK bonds had shrunk to about 35 basis points. It has not been this low since before the 2001 recession. Additionally, the UK is lowering interest rates. This signals that the monetary authorities are not worrying about inflation, which also means that they are now more worried about an economic slowdown rather than an overheating economy. With one of my country’s major trading partners slowing down, it is likely that the US economy will also slow down. Yields on US 10-year treasuries are falling (move inversely to the price), which is another indicator that the US economy may be heading for a slowdown near-term.

This is in addition to the recent anemic growth of Japan and Germany, two of our other major trading partners and the two historic growth engines in their respective regions. China’s growth is also not certain. While somewhere around 9%, that is less than the 14%+ of 2004, the growth rate that caused such widespread price increases in commodities like copper, steel, cement, and, of course, crude oil.

Recent rates for very large crude carriers (VLCC) transporting crude from the Gulf States to the Far East, have fallen in the last six months from over 240 Worldscale to less than 60 Worldscale, a precipitous drop in tanker leasing rates. In fact, only a few routes are still holding out good profits for crude transport, such as the Africa to North America route. Increased tanker numbers plus decreased demand would be required in combination to cause such a rapid erosion in transport revenues.

These are strong indications that crude might be overbought. And yet, its price continues to rise, even with these facts known to all the market players. Either they don’t believe the bearish indicators, which might move crude prices lower, even sharply lower, or they are staring at other variables not captured in posted data commonly quoted by the business media.

One of those ‘latent’ variables being focused on by the markets is the long-term outlook for crude supply increases being unable to cover crude demand increases as time goes by. Consequently, current prices must rise to reflect the future inventory replacement value for crude oil. Futures contracts for crude delivery in December of 2010 traded for $54.80/bbl on June 22 on the NYMEX. That is the price the best players, those who think with their own wallets, judge crude to be worth in five years.

These contracts are being traded by hedgers and speculators who wish to lock in that price today, because they see the price only going higher over time, and they believe $54.80/bbl a good price in that case.

A look at the daily oil balance — the difference between production and consumption per day — shows that it has fallen from 6 million bpd to less than 2 million bpd in the last few years. That means even a minor disruption in supply chains, not an unlikely prospect given increased international terrorism targeting supply infrastructures, could result in spot shortages for crude.

If what is fascinating traders are these long term calculations that show increasing difficulties in supply covering expected demand at current prices, then prices can certainly be expected to continue rising, even to $70.00/bbl by August. However, it is always about what is “the best game in town.”

That is, a lot of the crude and energy stock trading is the result of other market sectors, such as technologies, big pharma, retail, etc., not holding out significant profit opportunities for investors, especially hedge funds. If that changes for any reason, expect money to be pulled out of the energy sector and reinvested in the next hot sector. For crude, that could equal an $8.00-$12.00/bbl drop in the current price.

Dalton H. Garis, Ph.D. is Associate Professor of Economics at The Petroleum Institute in Abu Dhabi, UAE.||**||

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