From FT.com
Crude oil prices have drifted below $50 a barrel this year as the global recession has dented energy demand in the world’s biggest importers. As stockpiles build up, producers have cut capital expenditure on exploration and new production facilities.
But this could be sowing the seeds of the next bubble, some analysts say. Any failure to gear up output to meet the needs of a recovering economy, could create a gap between supply and demand similar to that which drove crude prices to $150 less than a year ago.
Francisco Blanch, head of global commodities research at Banc of America Securities-Merrill Lynch, answers readers’ questions on the impact of recession and recovery on oil prices.
Where will we see the increasing utilisation of alternative energy sources (such as electric powered cars) bring the price of oil to a permanent low, or will the continuous drainage of oil to a point where the resource is fast running out keep prices elevated?
This is the trillion dollar question. In my opinion, $50/bbl oil is not high enough to encourage a massive shift out of oil towards alternative energy. As an example, most biofuels plants around the world will lose money with oil prices below $60/bbl, while wind farms do not really make much sense in a low oil price world.
Will policymakers focus on energy efficiency when oil is a cheaper alternative and other political issues are more pressing?
We believe that continued upward pressure on energy prices will be needed to focus policy on energy efficiency. Limited spare capacity, strong underlying trend demand and the need for efficiency improvements all suggest that energy prices may have to increase again in the coming years relative to other prices in the economy. Our long-term WTI crude oil price forecast is $72/bbl in real terms.
In the midst of a global recession (depression?) with oil demand so low, one would expect prices to be low and remain low, and yet there still seems to be massive volatility in the price on a day to day and week to week basis. Why is this?
Fundamentally, price volatility in the commodity markets is linked to inventories. Commodity stocks, in effect, serve as a cushion to adjust supply and demand shocks in the physical market. In commodities such as oil and natural gas, where there storage constraints are a feature of the physical market, high levels of inventories can result in high levels of volatility.
Thus, we should not be surprised that the massive demand shock resulting from the global economic meltdown has pushed up oil price volatility. Similarly, low inventory levels can also drive volatility up in oil markets, as we saw last summer.
Technically, commodity price volatility is linked to volatility in other markets including equities, rates, credit or FX. I like to say that volatility is contagious. What will happen to oil price volatility going forward? In the second half of this year, we believe that the oil market will tighten and move from a very large surplus into a deficit, as demand stabilises and Opec maintains low output levels.
A tighter balance should mean that oil inventories could start drawing down in the coming months towards their 10 year average. In turn, a shift towards average inventory levels could help bring oil price volatility lower.
In 10 months, oil prices have decreased around 65 per cent. Do you see the recession as the one and only reason for this decrease?
Yes, we believe supply and demand fundamentals, and changes in the money supply and the velocity of money have been the key drivers of oil prices in the last five years. Industrial production across a broad range of developed and emerging economies came down very sharply in the fourth quarter last year and first quarter of 2009.
In the case of Japan, industrial output is now at the same level it was back in 1983, while German and American industrial activity has taken a step back of almost 10 years. These dramatic swings in economic activity are enough, in my judgement, to create such a large swing in prices.
Opec decided at its last meeting not to reduce output. After this decision, and coupled with poor demand and a move away from carbon fuels, can we seriously expect prices of $150+ ever again?
My simple answer to your question is yes, but a more important question perhaps is when. Due to their high exposure to the business cycle, oil prices have been seriously beaten by the current crises and are unlikely to stage a recovery until there are convincing signs that the global economy has turned the corner.
By then, another set of consecutive years of underinvestment in production capacity, coupled with a massive government debt overhang, will end up exacerbating the very same problems that created the most recent spike in energy prices, in my opinion. This situation could develop as soon as 2011 or 2012 and as late as 2015.
Another important factor that could push oil prices to $150/bbl in two to three years could be the tsunami of monetary and fiscal policy measures aiming to offset the recent private sector credit contraction. In our view, it is still uncertain how governments will be able to service the increased debt. In a world of fiat currencies and large government debts, higher inflation is not an unlikely scenario and a run-up in nominal commodity prices could develop.
In addition, with emerging markets poised to grow at a faster rate than OECD economies in the next decade and limited spare productive capacity, commodity markets could be among the first to experience inflationary pressures.
Is for example extraction of oil from the Alberta tar sands developments operationally economic at $50/barrel? What oil price is required to sanction capital expenditure on further tar sands projects?
It is important to differentiate between operational costs to maintain existing facilities and operational and incentive prices for new investments in productive capacity.
The current price level of $50/bbl will keep the existing tar sands projects in Alberta operational, but will not encourage new investment into the sector. As recently as 2008, our equity analysts estimated that new tar sands projects would only make sense financially at $90/bbl. Fortunately, improved labour productivity, lower steel and component pricing, and an end to the cost inflation environment of the 2006-2008 oil sands boom period are bringing incentive prices lower.
For oil sands projects, our equity analysts estimate that a cost reduction of 25 per cent in new projects is achievable over the next few years. If achieved, this could drive the required oil price to generate acceptable returns from $90/bbl back down to the $70-75/bbl range.
Our calculations suggest that the oil industry’s marginal source of supply will fall to US$70-75/bbl. However, we still expect to see continued price volatility around marginal costs particularly in periods of significant positive or negative divergence from trend levels of growth.
How much of the $150 per barrel oil do you feel was the result of institutional investors buying oil futures instead of, for example, asset backed securities as the crisis unfolded? If the impact of such speculation was significant then do you believe that speculators will continue to play a large role in a potential future oil bubble? Or have we learned our lessons for now?
The influx of investment in commodities sparked an intense and politically charged debate last year on whether speculation somehow caused the price of commodities to become disconnected from the fundamentals of supply and demand. Having analysed the available data in detail, we believe there is simply no evidence for that assertion.
Instead, we can find a clear link from sharp changes in monetary policy to abrupt commodity price movements. Looking back thirty years, our analysis concludes that a 1 per cent reduction in real interest rates results in a 17.5 per cent increase in spot commodity prices 10 months later. Our estimate thus suggests that loose monetary policy played a much more important role than speculators in the commodity price rally in the first half of 2008.
If the prospect of a future price bubble is so obvious why are not speculators already driving up the price, which in turn would encourage investment in oil exploration, extraction and refining?
The short answer is that long-dated oil prices are already on the rise. ICE Brent crude oil contracts for delivery in December 2017 closed last Friday at $78.71/bbl, a 60 per cent premium to current spot prices. The oil futures curve is currently pricing in nominal price appreciation of around 6 per cent per annum for the next 8 years.
I would like to clarify, however, that long-dated oil prices are not just driven by ”speculators”. Key participants in the oil markets include consumers, refiners, producers, inflation hedgers and speculators, defined here as investors that have the ability to go long or short any given contract to take advantage of market conditions). At the moment, a number of consumers have re-entered the market to take advantage of relatively low prices to hedge forward consumption.
Is it possible for the world to exceed more than 90 million barrels of oil production per day? If not, what alternatives is Merrill Lynch investing in to fill the demand gap of 10, 15, 20 years from now?
Perhaps 90 million barrels a day is a reachable target, but the chance of world oil production ever exceeding 95 million barrels a day is very low, in my view. On our estimates, if global GDP grows by 3.6 per cent every year over the next decade, annual energy demand will increase by 4 million b/d of energy in oil equivalent terms.
For oil, this figure could mean an annual net increase in global demand of 1 million b/d. Given the natural limits to supply, policymakers will have to shift their attention to energy efficiency. I can not really comment on what Merrill Lynch is investing, but I certainly see the need to increase global energy supply by 1.7 per cent per annum and global energy efficiency by 1.8 per cent per annum every year over the next decade.
What does that mean for investors? I think sectors such as energy productivity, alternative fuels, renewable electricity generation, but also conventional fuels such as coal or natural gas, will all provide very good opportunities over the next decade as we struggle to fill the ”demand gap” left by oil.
Is the persistent contango structure of the future oil market a sign of increasing dislocations in the oil market or is it just the result of normal market expectations? When do you think the curve will go back to its prevailing backwardation structure?
The persistent contango structure is primarily a function of the extremely high level of inventories, and the ongoing supply/demand imbalance. Keep in mind, however, that the second quarter of the year is the seasonally low point in demand. Thus, we should see a sequential improvement in global oil demand based both on seasonal factors as well as on a slight improvement in underlying economic demand.
In my opinion, with the oil market turning more balanced and Opec keeping over 3.5 million b/d off the market, inventories are heading for a draw in the second half of 2009. Thus, we believe that oil prices will likely continue to strengthen in the next six months.
However, long-dated prices are unlikely to follow suit, as the demand recovery will likely be very shallow in 2010. In a market with abundant spare capacity and a tightening balance, the pronounced crude contango should lead to a flatter curve or even to backwardation. Thus, we believe that the term structure of WTI crude oil prices will continue to flatten from here.
Given that some oil resources are uneconomic to exploit at current prices, what price does oil need to reach for post recession demand to be met?
We believe that two forces will need to be at work over the next decade to prevent further oil price spikes: (1) increased investment into the oil sector and (2) increased energy efficiency and substitution. Thus, oil prices need to be high enough to encourage a relatively slow oil demand growth path going forward and oil prices need to be high enough to encourage investment in marginal sources of supply, which we believe are Canadian oil sands and biofuels.
Keep in mind that commodity production utilisation rates are still high compared to other sectors, so any rebound in economic activity will likely have an impact on commodity prices before it hits other parts of the economy.
Low spare capacity availability on a relative basis, strong underlying trend demand and the need for energy efficiency all suggest that WTI crude oil prices may have to average $72/bbl in the long-term in real terms. In turn, a high oil price will keep energy’s share of global GDP above historical averages.
Did Peak Oil get it wrong and now it’s Peak Demand?
No doubt, global industrial production and economic activity has fallen sharply, with OECD economies contracting at an unprecedented rate in recent quarters. However, this extraordinary ”demand vacuum” created by the collapse of the credit bubble could be filled up quickly by demand for durables in Emerging Markets, in our opinion. We estimate that about 1.7 billion consumers sit on an annual GDP per head of $5,000 to $20,000, mostly in Emerging Markets and mostly unlevered.
This bracket of income is a sweet spot for the consumption of durable goods and for taking on leverage, as appetite for washing machines, freezers or cars rises rapidly when per capita income hits $5,000. As a reference point, Americans had a real GDP per capita of $12,000 in 1980 as the multi-decade long credit bubble began, while Portugal did not cross the GDP per capita mark of $10,000 until 1990.
Thus, as a higher consumption of durables comes with a substantial increase in energy use, supply constraints could soon resurface. As a reference point, global energy demand in oil equivalent terms increased by 6 million b/d in 2007. For China, India and other Emerging Markets to drive and fly, we need all the oil we can get, or a viable alternative to the existing transportation technology.
Given that the fall of oil prices have revealed that countries like Russia and Venezuela have failed to diversify their economies outside of commodities; do you see any oil producing economies making progress to diversify their economy in this climate?
Broadly speaking, I think commodity producers have been more cautious with their spending in the past business cycle than during the oil and commodity boom of the 1970s. In Latin America, Mexico, Brazil or Chile are good examples of oil price hedging, economic diversification, and precautionary savings ahead of the commodity price downturn.
In the Middle East, emerging trading centres in the United Arab Emirates or Qatar could well gain increasing traction in sectors such as finance with global taxation on the rise, partly thanks to heavy investment in infrastructure. Similarly, a broad range of commodity producers sit on large Sovereign Wealth Funds that should allow them to endure the oil price downturn.
There is a long-lasting dispute on the impact of speculation on oil prices. Has the relation between fundamental (physical) and financial (speculative) factors changed after the financial crisis, and are oil bourses (ICE, Nymex) gaining influence compared to OTC deals?
In our view, a global misallocation of capital sits at the heart of the current economic crisis. In simple terms, capital markets failed in recent years and channelled too much money into real estate, too little into energy. Having analysed the available data in detail a few months ago, we found no link between speculative activity and systematic price increases in commodity markets.
As part of a general growth in derivatives across all asset classes trading volumes and open interest in commodity derivatives surely increased, but only some commodities experienced significant price swings in the last two years. What has changed after the credit crisis?
Naturally, listed products are gaining ground across all asset classes, not just commodities, as regulators and market participants press for greater transparency and lower credit risk. Still, activity in the over-the-counter market continues unabated because it offers a customized angle that listed markets can’t provide. Having said that, market participants will now choose to clear trades on the exchange to limit counterparty credit risk, when possible.
Opec regularly states that they require an oil price around 70$/bbl to sustain projects. Where do you see Opec production cost at the moment and do you have an estimate of how many projects have already been postponed or cancelled?
Opec production cutbacks have been very significant. From a peak of 30.3 million b/d in July last year, Opec-11 crude oil production has come down to about 26 million b/d, helping create a floor to global crude oil prices. However, actual oil production costs for most Opec members are substantially lower than $70/bbl, perhaps as low as $10-20/bbl.
Similarly, social oil costs for Opec, or the oil price required to balance the member governments’ budgets, differ by country. For Saudi Arabia, Kuwait, Qatar or the Emirates, we estimate that $50/bbl would suffice to roughly bring government budgets into balance, while members such as Iran or Venezuela probably require higher prices of $70/bbl to break even. Then again, we are talking about social costs, not production costs or incentive prices for new supply.
Having said that, new investments in Canadian oil sands and biofuels production require a $70/bbl price tag, but these projects sit mostly outside Opec. So far, over half of all planned oil sands-related projects in Canada have been delayed or cancelled, while many biofuels producers have cut back on their investment plans.
With collapsing global oil prices and the rapidly increasing cost of funding, we expect delays on expensive development projects like Canadian oil sands to continue. Within Opec, we have also seen significant cutbacks in capital expenditures, as financial resources are being diverted to other sectors of the economy.
Currently there is well over 100 million bbls of crude and 25 millions barrels of products in floating storage. This, combined with record shore stocks will surely provide a buffer until production increases to meet any increase in demand and therefore prevent a price bubble?
I agree that there are very low chances of an oil price spike in the next 12 to 18 months, but I also believe the market could start to tighten again in 2011. Remember that 125 million barrels in floating storage is only 1.5 days of global oil demand, so this cushion is not as large as it seems if economic activity ticks up.
However, given the shallow demand recovery ahead, the high inventory levels, and the increased spare capacity in refining and crude oil supply within Opec, I do not see much upside to oil prices until the end of next year.
Our current forecast for WTI crude oil prices in 2010 is $62/bbl. Beyond next year, the limited growth prospects in rich OECD economies stand in stark contrast to the middle income emerging economies.
As I have pointed out in another question, we estimate that 1.7 billion consumers sit on annual GDP per head of $5k to $20k, a sweet spot for the consumption of durables and for taking on leverage. Thus, the medium-term energy demand prospects are a lot brighter as EM economies start to recover.
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