Wednesday, June 27, 2012

Never so happy to see gas at $3.40 a gallon.

Gone are the days of driving across the vast expanse of the western U.S. in search of trout streams with complete disregard for travel expenses…as long one stuck to truck-stop coffee and doughnuts for sustenance. But this spring’s 13% drop in gasoline prices from near $4.00 per gallon to $3.41 does make travelers breathe a slight sigh of relief. Dipping pump prices have followed the path of crude oil, which has seen futures prices fall 28% from $110 per barrel in late February to $78.50 early this week. Accordingly, there has been much less griping from political circles about shady speculators rigging the oil market while socking it to the working Joe. Theoretically, prices for commodities such as crude should be determined by supply and demand dynamics in the marketplace. In many respects, the mouthpieces in D.C. are onto something. There are plenty of distortions rattling around commodities markets these days. Hmmm, I wonder what could be the source of those? Certainly not the myriad policies emanating from the nation’s capital? Before diving into that bees nest, it will first help to provide some general background on recent shifts in global oil market and America’s major, yet evolving, role in it.

The Big Dog
Most people are aware that the U.S. is the world’s largest consumer of crude oil, accounting for one-fifth of global demand. Few realize, though, that it is the third largest producer, behind Russia and Saudi Arabia. Not long ago, America held the top spot, with the U.S.S.R, overtaking it in 1976 followed by Saudi Arabia in 1980. In 2011, U.S. wells pumped roughly 10 million barrels of oil per day, or about 12% of global production. The same year the country consumed nearly 19 million barrels daily, meaning the balance had to be imported. So as a country, America produces a lot of crude, but given the energy-intensive society, it has, over the decades, become increasingly reliant upon foreign sources.  On a related note, the uptick in crude imports has coincided with the U.S. shifting from the world’s largest creditor nation to its largest debtor.
The Middle East, according to BP’s World Energy Review, accounts for 33% of global production (and 48% of proven reserves) while OPEC (including non-Middle Eastern members) pumps 42% of global supplies. That said, most of the largest sources for U.S. oil are in the western hemisphere with Canada leading the way, accounting for 29% of imports, a figure likely to grow in coming years, as elaborated upon below.

The Current Situation
As with any global market, one wildcard is political risk, and this was on display in early 2011 as the Arab Spring roiled the Middle East. After the initial burst subsided, U.S. benchmark prices (West Texas Intermediate) managed to average $95 for the year. BRENT prices, which is a contract more attuned to global risk, averaged $115, after spiking to $128 during the height of the uprisings. After a new wave of risk ricocheted through markets earlier in 2012, both benchmarks have dipped, with Brent now hovering around $91 and WTI near $80. Given the reliance of oil producers on the shipping lanes through the Strait of Hormuz, markets are only another dust-up away with players like Iran from triple digit prices.

Another factor in the lull in crude prices, as seen in the chart below, is lower demand. Mid-June demand is down 2.2% from the same period in 2011 and nearly 5% from 2010.  Compared to pre-crisis years, demand has been substantially curtailed, not a surprise being that over 30% of miles driven in the U.S. is work related. After all, unemployment remains elevated at 8.2% (and let’s not forget the millions who have dropped out of the labor force). Although the recent respite in crude prices is welcome, one only need to look back one decade when WTI averaged $22.74 for the year (2002) to gain perspective on how markets have changed. This four-fold increase is hard to stomach for the U.S. consumer, but the reality is that gasoline and other energy goods account for less than 4% of personal consumption expenditure. Although not a large piece of the consumption bucket, it is one of the most visible components with our eyeballs watching prices yo-yo at the corner filling station. That has a psychological effect, and what’s more, since gas purchases cannot be easily substituted or curtailed in our commuter culture, when prices do rise, we cut back on things that we can, such as lattes and the aforementioned boxes of doughnuts.

On a sunnier note, U.S. oil production increased 21% between 2006 and 2011. This increase, along with lower demand has caused the percentage of crude the country must import to fall from above 50% to below that threshold. This development has positive ramifications being that in 2011, 58% of the country’s trade deficit in goods and services was attributable to crude imports. Overall, imports have fallen 23% since their peak in June 2006.  Although renaissance, may be too strong of a word, this welcome uptick is partly due to the much ballyhooed increase in domestic production, including unconventional oil fields like North Dakota’s Bakken Formation. Only recently, for the first time since forever, the U.S. actually became a net exporter of refined products.

A Global Game
As with other commodities, like metals and agriculture goods, energy markets are being influenced by China’s voracious appetite for natural resources. Presently, Chinese oil consumption accounts for only 10% of the global total (compared to 20% for the U.S.). But over the past ten years its intake has grown at a 6.3% annual clip. During this time, consumption in the developed world has decreased, in part due to the recession, but also to increased efficiency. The latter reason is of import as emerging markets are notoriously inefficient energy consumers. Throw in a still low penetration of energy intensive products like cars (as of 2009, 4% of Chinese owned one) and one can see why going forward emerging Asia will be a pivotal factor in increasingly tighter energy markets.

On the supply side, there too has been a sea change. While apocalyptic theories on Peak Oil may be reserved for survivalists in their Idaho bomb shelters, the fact remains that most of the easy oil has been gotten. Going forward, additions to global production will increasingly come from so-called unconventional plays. These include the oil shale of the Bakken, the heavy oil (bitumen) of Canada’s oil sands, and the deep water finds such as Brazil’s massive pre-salt formation. In each of these cases, the cost of extraction is much greater than in the past.
It is important to point out that the number worth paying attention to is the marginal cost of production. This is the cost of the next barrel of oil, wherever in the world it may be, to get sucked out of the ground to meet future demand. We know where the easy oil is, and in the case of Saudi Arabia, extraction is dirt cheap, in the neighborhood of $30 per barrel. But those barrels have been accounted for. With oil markets close to being balanced, meeting future demand depends upon new finds, and these sources are not cheap to develop. Figures vary, but the marginal cost of a barrel of Canadian heavy oil is around $85. The Bakken’s marginal cost is anywhere between $55 and $70, as labor costs and drilling supplies have surged during the boom. One study showed that between 2000 and 2009, the cost of crude extraction increased globally by 200%. These figures effectively act is a floor to prices. Should demand weaken, say due to another global slowdown, and crude prices fall below the marginal cost of these unconventional fields, drillers will simply turn off their rigs thus leading to lower output and an eventual rebalancing of supply and demand. So yes, petroleum prices may decline for short periods in the future, but as global GDP…and accompanying energy consumption….rises, these marginal sources of oil will set the price.
Tossing a Wrench into the Textbook

Enough about market fundamentals. As with most putatively free markets, the energy complex is rife with distortions that cloud price discovery based solely on supply/demand dynamics. One such clog in the plumbing is an infrastructure that inhibits the efficient delivery of product to buyers. For the past year an example has been on display with the divergence in prices between WTI and BRENT contracts. The U.S. contract has historically been considered the global benchmark given the country’s position as the world’s largest oil consumer. The liquidity of its financial exchanges further tilted the deck in favor of the New York (NYMEX) traded contracts. Due to this (and differences in quality), Europe-focused BRENT contracts historically traded at a slight discount to WTI. This relationship reversed over the past few years in a very large way, with BRENT contracts often trading at a $17 or more premium to WTI. One reason is the fact that BRENT has become a proxy of global…that is non-U.S….market conditions (including political risk). Another reason has been the bottleneck of crude supplies in the central U.S. (Cushing, OK) hub upon which WTI is priced. Inadequate pipelines have inhibited the ability to get this excess inventory onto global markets or even to other parts of the United States.  As a consequence, U.S. markets have appeared sufficiently supplied while global markets have signaled future…if not immediate…pressure on crude supplies. The shifting of preeminence from the WTI contract to BRENT is symbolic of the growing influence of emerging energy consumers such as China, as well as the fact that at present, much of global spare production capacity remains with OPEC, and Saudi Arabia more specifically.
Insufficient North American energy infrastructure further made news with opposite sides of the Keystone XL Pipeline debate endlessly bludgeoning each other during the government’s approval process.  No need to rehash the argument here, but it does highlight the issue of fuel delivery and the globalization of markets. Should Canada, which has seen crude reserves and production explode as it develops its oil sands, not be able to ship the stuff to its southern neighbor, chances are it can find plenty of willing buyers in emerging Asia.  Then again, as pipeline flows between Oklahoma and the Gulf Coast are reversed, inventory previously socked away for American use can find its way onto global markets as well. At current production levels this could negatively impact U.S. consumers, but should domestic production continue to rise, it could be a boon to the industry, especially with regard to refined products.

Some Bigger Wrenches…Well Sledgehammers Actually

If the major distortions could all be fixed by a few extra tankers and miles of pipeline, then markets could happily get back to their primary function of price discovery.  However, there are other phenomena clouding markets; these are less tangible and can be placed under the ominous category of unintended consequences. As has been the case of late, any time energy prices spike, there is a corresponding rise in rhetoric about sly speculators jobbing the market. In normal times, the evidence has shown that financial investors looking to make a buck by trading commodities do not influence prices over the mid-term. Fundamentals do. But these are not normal times. Instead the world (and markets) has been inundated by a series of initiatives to catalyze growth, which, as inferred, have unforeseen knock-off effects. By the Fed’s own admission, one of the goals of the QE programs is to crowd investors out of safer assets such as Treasuries and force them out along the risk spectrum. Well, what asset class, among others, is sitting out there? Commodities.  It should shock no one that investors starving for satisfactory yields will dial up their allocation to energy and metals. Rock bottom short-term interest rates, anchored to the Fed Funds rate (at 0.25% for eons), also enable financial investors to afford to enter into highly levered commodities contracts that would otherwise be cost-prohibitive. A normalization of interest rates would raise the cost of funding of such positions and most likely see many investors cut back on their energy exposure.

Low rates also cause reverberations in physical markets. Historically foreign producers such as the Saudis have invested their oil profits into safe, but respectably yielding U.S. government and mortgage bonds. With yields on the 10-Year at 1.6% and the 30-Year at 2.7% (we won’t even discuss the stigma hanging over mortgage investing), foreign producers are more inclined to leave the product in the ground and only monetize it when crude prices are higher or investments in which they can park their profits return something other than a pittance. Such tactics only tighten oil supply further. Lastly, low interest rates, along with the Federal Government’s wanting fiscal position, will continue to diminish the outlook for the Dollar. As most commodities are priced in the greenback, a lower value will make oil, metals, et. al., more affordable to countries whose currencies are appreciating vis-a-vis the USD. Similarly, foreign producers, less than pleased that their Dollar-denominated profits convert back to a lower amount of their home currency, may curtail production to boost crude’s price. So yes, there are actors out there monkeying with oil market, and if the powers-that-be want to get a good look at them, I’m pretty sure both the West Wing of the White House and the headquarters of the Federal Reserve have plenty of mirrors.

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