Tamer El Zayat
Published — Wednesday 16 January 2013
Last update 2 March 2014 11:08 pm
What was unique about the oil markets in 2012? What to expect in 2013? And how will OPEC and Saudi Arabia respond if demand weakens or new supply became readily available? Three paramount questions that need to be answered in order to illuminate the key forces acting in the oil markets especially that the global economy is still fraught with uncertainty.
To start with, an important facet to be mindful of while following oil markets is the inherent volatility that have been witnessed during the last five years, albeit the historically elevated year-end price levels, as demand downside risks and supply uncertainties from the unfolding sovereign debt crisis and geopolitics continue to lurk in the background.
In a similar fashion to 2008 when the price of the benchmark West Texas Intermediate (WTI) fell sharply in less than six months from $145 per barrel in early July to a mere $30 per barrel in December of that same year, 2012 was no different with Brent, the North Sea benchmark, fluctuating in a $88-125 per barrel range.
If such volatility is a new norm that stakeholders in the oil industry had to contend with since 2008, the increased irrelevancy of WTI as a benchmark for global prices became a reality last year.
The main reason behind the WTI crude losing its proxy status is the fact that it was dragged lower by a deepening supply glut from the shale boom across the US Midwest that led to transportation bottlenecks due to the limited capacity of the existing pipelines.
Accordingly, the US biggest production increase since 1950s and the rise in stockpiles at Cushing, Oklahoma, the largest storage hub in the US and the delivery point for the New York Mercantile Exchange futures, resulted in a record discount for WTI that averaged around $17.5 per barrel less than Brent in 2012 compared with an average premium of USD95 cents during 2000-2010.
It is no surprise, in my opinion, that the US Energy Information Administration have decided in July last year for the first time ever to drop the increasingly domestic benchmark for the Brent that is more indicative of global prices.
What does the future hold for oil prices in 2013? Definitely, it is a hard call to make, with expectations at both ends of the spectrum, with some analysts seeing the risks skewed to the upside due to the geopolitical tensions and fault lines in the Middle East while others believing that risks are overwhelmingly on the downside emanating from feeble global economic growth.
I, however, do subscribe to a “story of two halves” that views demand side factors as the driving force in 1H 2013 contrary to the second half of the year whereby supply factors will take the lead. On the demand side, the US debt ceiling, currently at $16.4 trillion, had already been breached by the end of last year and the Treasury department via its extraordinary measures will be able to borrow for January and February, which implies that another showdown a’ la fiscal cliff will raise uncertainty and weigh negatively on oil prices in the first quarter of 2013.
Central banks, however, have put a floor under the oil markets by filling the void left by the austerity measures adopted by most governments, as their unprecedented accommodative policies support economic growth.
The unlimited bond buying programs adopted by the European Central Bank (ECB) and the Federal Reserve (FED) starting September 2012 won’t be the last and there is a high probability that the People’s Bank of China (PBoC) and the Bank of Japan (BoJ) will revert to this infinite monetary policy mode in 1H 2013, especially with the once in a decade politburo shift in China and the sweeping election win by the Liberal Democratic Party in Japan.
Even though, as mentioned earlier fiscal policy is taking a back seat, the recent decision by the Chinese government to widen its budget gap by a staggering 50 percent to $192 billion, the first fiscal stimulus since 2008, will be pivotal in influencing oil market fundamentals on the back that the second-largest oil consumer is expected to generate 30 percent of total demand growth this year.
Accordingly, in my opinion, if China’s deficit spending materialized along with the PBoC’s monetary easing, the Energy Information Administration, International Energy Agency and OPEC have to revise up their projected increases that are in the range of 0.8-1.0 million barrels per day for global oil demand in 2013.
The takeaway is that demand will be supportive of oil prices next year unless the unlikely becomes a reality, a deadlock over the US debt ceiling due to partisan polarization.
On the supply front in 2013, it seems the geopolitical uncertainty in the Middle East and the North American oil bonanza will vie for the top spot.
The news early last year that Iran had begun enriching Uranium up to 20 percent, the threshold for making Uranium weapons-grade, deepened the rift between Tehran and the west, and I do believe that the confrontation will escalate especially that the European sanctions that took effect early July weighed heavily on Iran’s exports that fell by 50 percent to just 2.65 million barrels a day by the end of December.
An Israeli attack similar to the one undertaken against the Iraqi Osirak nuclear reactor in 1981 is not a farfetched scenario, especially that the Jewish state is adamant in maintaining superiority not only in terms of nuclear capability, but also nuclear deterrence. This cloudy geopolitical specter has obviously added between $10-$20 per barrel in the form of risk premium to oil prices and will continue to be factored in 2013 given the importance of the Strait of Hormuz, where 17-18 million barrels a day pass through the 50 km waterway, representing around 40 percent of seaborne oil and 18 percent of globally traded oil.
However, the shale boom in the US will offset part of the geopolitical risk premium especially that one of the aforementioned constrains pertaining to pipelines will start to relatively ease, with the extra domestic supply finding its way to domestic markets, thus, reducing the US demand for imports.
As many as twenty pipelines could come on stream transporting 1 million barrels per day to the gulf coast that accounts for 50 percent of US refining capacity.
The two most important pipelines are the 400 thousand barrels Seaway pipeline that will commence operations early 2013 and the 700 thousand barrels Keystone XL pipeline that will be operational late 2013, both from Cushing to the Gulf Coast.
The Canadian tar sands from Alberta will also be able to make use of these pipelines, which will augment the positive impact from a logistics basis.
Thus, North America is expected to account for 60 percent of the 900 thousand barrels a day increase in non-OPEC supply next year.
The aforementioned supply dynamics can act as a drag on prices, but in my opinion OPEC, and in particular Saudi Arabia as a swing producer will play a pivotal role in balancing the oil markets. When supply concerns were escalating in 2011, the Kingdom spearheaded a new quota for OPEC members in December 2011 to 30 million barrels, the first change in three years, and pumped oil at the highest rate in three decades.
It also ensured that its overseas storage tanks in Rotterdam, Okinawa, and Sidi Kerir are full. However, the recent buildup in inventory in the US and the OECD’s forward demand cover that stands at 59.1 days have certainly been on the radar of the OPEC that enhanced compliance as evident from the reduced production to 30.62 million barrels a day in November, a 12-month low. The Kingdom has also recently been unilaterally decreasing its supply, curbing output to a 14-month low of 9.5 million barrels a day in December.
Will 2013 be a repeat of the 1986? A question that many analysts pose to compare the North Sea substantial increase in output that eventually led to more than 50 percent decline in oil prices between December 1985 and July 1986, from $23 to $9.8 per barrel, with shale oil discoveries.
The International Energy Agency had even subscribed to such theme predicting that by 2020 the US will surpass Saudi Arabia to become the largest producer of oil and that by 2030 it will be net exporter.
Nevertheless, I do believe that comparing tight oil reserves from shale oil and conventional oil from the North Sea ignores three aspects, notably the high marginal cost of extraction, the technological challenges and the rapid aging of the fields.
Another important aspect that will prevent a repeat of the 1986 saga is the relative solidarity among OPEC members and the financial strength of the Gulf members that will enable them to counter any abrupt surge in global supply with a reduced supply quota of their own.
On the short-run, it is clear that OPEC will likely consider supply cuts next year to prevent prices from falling and to ensure market balance.
On a longer-term supply perspective, the unfolding Iranian standoff had raised concerns about disruptions to the Strait of Hormuz and the lack of alternative routes for oil transportation.
The world’s spare capacity, mostly located in Saudi Arabia, UAE and Kuwait will be constrained in case of closure.
Currently, there are alternatives that are either under construction or in need of maintenance. For instance, in the UAE a 1.8 million barrels a day pipeline from Abu Dhabi to Fujairah on the Gulf of Oman is almost operational.
Another alternative is a northern pipeline in Iraq that has 1.6 million barrels a day, but requires major repairs that can last for more than 2 years.
Most importantly, in Saudi Arabia, a pipeline from the Eastern province to Yanbu can transport around 5 million barrels a day in crude oil instead of refined products.
Looking ahead, the issue of midstream projects that bypass the Strait of Hormuz will be of prime importance to the GCC to enhance their shock response.
There is little doubt that OPEC and Saudi Arabia will be instrumental in mitigating concerns and ensuring market balance in the oil markets, which leads me to believe in a range-bound oil price that will end 2013 at an annual average of $110 per barrel for Brent, with Saudi curbing its production to an annual average of 9.5 million barrels per day.
To conclude, if some people believe that the only constant thing in life is change, I do believe that the only thing constant in the world economy these days is uncertainty.
— Tamer El Zayat is a senior economist at the National Commercial Bank, Jeddah.