Speculation pervades the oil market, with fear of a supply outage pushing oil prices to $46 a barrel — a record level. This price reflects a premium of $18 to $22 above what supply-and-demand fundamentals can satisfy.
Historically, the relationship between oil prices and industry-held oil inventories explained more than 90 percent of the moves in oil prices: Whenever inventories rose, oil prices fell (and vice versa). However, the relationship broke down this year. Even though inventories have built strongly, oil prices have soared.
In the past, inventory levels of 295 million barrels — the current level — have dictated an oil price in the range of $24 to $28 a barrel. The difference between this price range and the current price represents a fear premium that supply with be insufficient to meet demand.
Fear worked its way into oil prices beginning with production outages in Iraq last year. But fear is now incited by something as routine as the announcement of maintenance downtime at a small oil field.
Are we running out of spare capacity? Is oil demand about to exceed supply? What will happen if terrorists take control of the Saudi oil fields? What if Russian oil companies stop exporting oil? The oil market is climbing a wall of worry.
As you might imagine, it is difficult to assess a market that is driven by fear and speculation. There is no telling how high prices can go. Analysis is made more difficult by the fact that — in addition to exogenous factors influencing perceptions about oil supplies — there have been changes in fundamentals.
Many arguments about today’s high barrel price may sound convincing, but they have no causal link to their conclusions. For example, some say that strong demand is responsible for high prices. True, rapid economic expansion has sparked strong demand for oil, particularly in China, India, and the U.S. However, oil supply has still been stronger than demand, as evidenced by the large build in inventories worldwide.
Although the current oil price has surpassed expectations, much of the fear that belies the upward move in the oil price seems exaggerated. Of course, it is impossible to know if a significant supply outage will actually occur. But many of the drivers behind the rally in oil prices seem to be at odds with the facts and probabilities.
So let’s weigh fear against fact.
Fear: There is no spare oil-production capacity. Any supply outage means we will run out of oil.
Fact: Non-OPEC production usually operates at full capacity while OPEC acts as the swing producer. While no one knows how much OPEC can produce, output by most member countries has surpassed the capacity estimates of analysts. Even countries that were thought to be tapped out — such as Algeria, Libya, Iran, and Nigeria — have shown steady growth in output in the past year.
Interestingly, the “call” on OPEC oil — or the amount that OPEC must produce to balance the oil market — has not changed in the past eight years as non-OPEC production has increased and higher output of natural-gas liquids have largely kept pace with world demand growth. Over this time period, however, lower production in Iraq, Indonesia, and Venezuela have required other OPEC producers to take up the slack. And they have: In total, the eight remaining OPEC members have increased production by more than 3 million barrels a day since 1998, or about 2 million barrels a day more than the decline in production from Iraq, Indonesia, and Venezuela.
Fear: Oil producers are experiencing a high level of operational outages.
Fact: Media coverage makes it seem like outages are more frequent. But it is because news organizations are more focused on the industry today that oil prices are so high. Labor strikes, mechanical problems, weather-related shutdowns, and strife in lesser-developed nations are constant challenges that confront the petroleum industry. But in actuality, non-OPEC supply has reached record levels this year, and production has been steadier than in any of the past five years. At the same time, OPEC production has increased by more than 800,000 barrels a day, even with the outages in Iraq.
Fear: Strong demand, driven by China, India, and the U.S., is responsible for the rise in oil prices.
Fact: Oil demand appears to be strong this year. However, supply looks to be stronger. In the U.S., for example, stocks have built at a record pace, suggesting that the increase in supply has even overwhelmed the growth in demand.
More, while strong economic growth has been the primary driver for the pickup in oil demand, unreported inventory builds have resulted in demand being overstated. There is also a tendency for forecasters to extrapolate demand growth, despite indications that demand will slow. In China, for instance, the government has taken steps to curtail the rise in petroleum product imports. In the U.S. and elsewhere, high oil prices are likely to slow petroleum consumption. Across the globe, credit tightening by central banks is likely to inhibit oil demand.
Fear: Terrorist activity is bound to disrupt supplies.
Fact: Since well before September 11, 2001, the world has not lost a meaningful quantity of oil production due to terrorist acts. Major oil production and refining facilities in most countries are thought to be potential terrorist targets, and so they are fortified. Security might be violated at these facilities, but they are not easy targets.
Overall, the chance of a major, prolonged disruption in oil supplies from terrorism is low. Even if a disruption were to happen and lost volumes could not be made up from alternative sources, the strategic petroleum reserves that many countries manage are perfectly capable of maintaining oil flows. Even OPEC’s strategic reserves could cover a loss of 2 million barrels a day for two years.
Fear: The U.S. and other governments must be aware that a terrorist attack on oil installations will take place or they wouldn’t be buying oil at $45 a barrel for strategic reserves.
Fact: The U.S. Strategic Petroleum Reserve (SPRo) was established in 1977 to create an emergency stockpile of oil to be used in the event of an oil-supply emergency. Congress has authorized the president to build that reserve to a maximum level of 700 million barrels, at his discretion. The SPRo currently holds about 666 million barrels.
Over the years, purchases for the SPRo have started and stopped. Oil has been released five times — once under former President Bush during the first Gulf War and four times under President Clinton. Starts, stops, and releases have been influenced by budgetary and political issues as well as by confidence and insecurity surrounding oil supplies. President George W. Bush ordered the SPRo be filled after the 9/11 attacks as a security measure. For the most part, the government has been a steady buyer for the reserve ever since.
In the past, the SPRo fill was viewed by oil traders simply as an inventory build. A large build in SPRo reserves usually was viewed as a negative for oil prices. But in the past year purchases have fuelled terrorist speculation — “the government must know something is going to happen or they wouldn’t be buying oil at these prices” — and allowed traders to front-run purchases, since the program is transparent and reasonably steady.
Today, a release of SPRo reserves in a non-emergency situation under President Bush seems unlikely. So, traders view the SPRo more as consumption than inventory. But the more oil we have in inventory, the more secure markets should feel about the available oil supply. For the moment, the market seems to be reading this differently.
Fear: New, large oil discoveries have been few. Oil companies are having trouble replacing production.
Fact: The perception is false. Dozens of giant oil fields have been discovered in the past few years in the deep-water Gulf of Mexico and offshore Angola, Nigeria, Brazil, and Malaysia; in shallow water in Kazakhstan, Azerbaijan, and Equatorial Guinea; and onshore in Russia, Trinidad, Chad, and Canada.
These are the fears and the facts. Taken together, the only conclusion can be that oil prices will fall hard — perhaps to $25 a barrel in 2005. But two conditions are necessary for this to happen: Inventory levels need to rise further and there must be no major supply interruption. As inventories rise, speculators will shift their focus from fear to fundamentals.
– Frederick P. Leuffer, CFA, is senior managing director and senior energy analyst for Bear, Stearns & Co. Inc.