CRUDE AT $85. Oil has already toiled its way to. The $85 mark may be a reality soon. Strong Fundamentals Rising Geopolitical Tensions

Transcription

1 CRUDE AT $85 Oil has already toiled its way to $75. The $85 mark may be a reality soon. Strong Fundamentals Rising Geopolitical Tensions We have a serious problem. America is addicted to oil. - George Bush

2 Crude Oil at $ May 2006 Crude Oil: Crude Oil is Black Gold. It is one of the highest traded commodities across the globe. Unlike any other commodity, crude oil finds its importance at macroeconmic levels. Today, economics and politics are the key determinants of the functioning of any nation. Crude oil is one of the major determinants for inflation. Inflation in turn affects gold prices. Before really getting into the fundamentals of crude oil, let us look at the commodity crude oil. Crude oil is a mixture of hydrocarbons that exist in liquid state in natural underground reservoirs. Almost all industries are dependent on crude oil for their normal functioning. Be it the transportation industry which runs on gasoline and fuel distillate or be it crayons, bubble gum and heart valves, crude oil is indispensable. One US barrel of crude oil (which contains 42 gallons) when refined, produces the following: 20 gallons of motor gasoline 7 gallons of diesel Other petroleum products It is inte resting to note that a 42 gallon US barrel produces 44 gallons of petroleum products! Crude oil can be classified on the basis of various parameters. But from the futures market point of view, classification based on sulfur content and API (American Petroleum Institute) gravity is important. WTI (Western Texas Intermediate) type of crude oil is currently the benchmark for NYMEX crude oil futures. It has a low API gravity of 39.6 degrees which makes it light and a low sulfur content of 0.24% which makes it sweet. Brent crude oil is also traded on NYMEX but it is of relatively inferior quality. It has an API gravity of 38.3 degrees and a sulfur content of 0.37%. Before really getting into the study of crude oil prices proper, let us look at some basic fundamentals that govern the same. Crude oil being a fossil fuel is on its way to depletion. But enhanced oil recovery techniques, participation of more countries in oil production and leading producers move to tap untapped capacity have kept the supply condition relatively comfortable for now. However, the rate of discovery of oil fields has seen a decline, even though the recent Kuwait oilfield discovery deserves special mention. But the

3 recent rally and crude oil reaching above $75 1 does not definitely reflect such dynamics. The reason is called fear premium which is by virtue of geopolitical tensions. Fear premium is purely human in nature and manifests itself in the form of speculative decisions based on news, information and rumors. Crude Oil is a geopolitical commodity because it governs economies around the and the fundamentals of the same are in turn governed by energy events. The recent rally is due to apprehensions pertaining to possibilities of forthcoming nuclear strikes by US on Iran amidst the row over Iran s nuclear program. Iran has recently declared itself as a nuclear power but IAEA is not convinced of its peaceful intentions. Iran claims to develop nuclear technology for the purpose of energy and not for nuclear weapons. USA s insecurity saw President Bush s aggressive statements materializing into a spike in crude oil prices. The rally was also supported by the Nigerian oil crisis owing to repeated militant attacks which has cut down its production by nearly 500,000 barrels per day. USA recently has shifted its focus to greener gasoline. Initially US refineries used MTBE (Methyl Tertiary Butyl Ether) to produce gasoline but now the shift is to ethanol. The problem with ethanol is that, it is difficult to transport owing to its weight. As a result producers are finding it increasingly difficult to cater to the refiners needs. Gasoline inventories are witnessing a decline every week in the US coffers and this has added fuel to the crude oil rally as well. Declining gasoline inventories prior to the US summer driving season has raised fears of forthcoming supply shortages of gasoline. Keeping these fundamentals in view, it can be said that fear and geopolitics are by far the most important factors contributing to crude oil price movement. Crude oil unlike most commodities does not possess much seasonality. But if one had to attribute any seasonality to it, one can observe that demand for crude oil peaks every US driving season that stretches from end of May to early September. The actual peaking months are July and August when Americans take to driving during their vacations. Before arriving at a final price outlook, it is meaningful to look at the historical energy events that have governed crude oil price movements, followed by key fundamentals in terms of the demand supply dynamics on a country specific basis as well as on an overall basis. 1 Crude oil touched the $75 mark on

4 History: The study of crude oil prices actually dates back to 1970s when OPEC started making its mark into the producers arena. The prices in question are nominal prices and have not been adjusted for inflation. The crests, troughs and peaks have been labeled serially and the corresponding events have been mentioned in the forthcoming table. World Crude Oil Nominal Prices ($ per barrel) Nominal Dollars per Barrel Official Price of Saudi Light Refiner Acquisition Cost of Imported Crude Oil (IRAC) Source: EIA Compiled from

5 Event No. Event 14 OPEC basket price by 14.5% 18 Saudi Arabia raises marker crude price from $19 to $26 per barrel 23 First major Iraq-Iran war 29 OPEC cuts prices by $5 a barrel and lowers output 30 Norway, UK, Nigeria cut prices 31 Saudi Arab Light crude oil prices cut to $28 32 OPEC output falls to 13.7 million bpd 35 Wide use of netback pricing ( 1986 price collapse) 40 Exxon s Valdez spills 11 million gallons of crude oil 41 OPEC raises production ceiling to 19.5 million barrels per day 42 Iraq invades Kuwait 44 Persian Gulf War ends 45 Dissolution of Soviet Union 51 Extreme cold winter in US and Europe 57 Increased Iraqi production coupled with no Asian demand due to Asian economic crisis 61 Economic recession in US and OPEC overproduction 62 Oil prices decline in fear of another economic recession after the September 11 terrorist attacks on WTC. Prices again went up after production cuts by OPEC and non OPEC producers and unrest in Middle East coupled with fears of renewed tensions with Iraq 67 Hurricane Ivan destroys oilfields in Gulf of Mexico 69 Hurricane Katrina s destruction Note: Only some of the important events have been mentioned.

6 Demand Supply Dynamics: OPEC: It is meaningful to look at the demand supply dynamics on a country specific basis and finally on a global basis. A country specific study would mean a comprehensive look at the leaders and the top players in terms of the producers and consumers. OPEC: Leading producers and Exporters: Current Scenario: Country Production Exports Proven Reserves Saudi Arabia Rising but at a Going down with Rising declining rate respect to 26% of 12% of production Iran Increasing but Going down with Rising share in OPEC respect to 12.76% of declining production 5.27% of Venezuela Declined sharply Constant Rising 3.42% of 3.42% of Nigeria Rising Rising (nearly Rising 3.09% of 100%) 3.31% of OPEC Rising Rising Rising 40% of 86% of

7 Forecasts: 2006: OPEC Pessimistic Most Likely Optimistic Production million bpd (-.5%) Exports bpd bpd (+1%) bpd Reserves million million million barrels barrels barrels (+2%) Observations: The average production in 2005 was million barrels per day. Keeping in view the geopolitical tensions surrounding Nigeria and Iran, a slight decrease in production is expected in Exports are expected to rise in 2006 but at a lower rate keeping in view the cartel s growing reserves to production ratio. Reserves are expected to grow in 2006 by nearly 2%, in contrast to 1.4% last year. USA: It has been observed that American production has been declining over the years, even though the country is the s third largest oil producer. The rising demand has been increasingly met by the country s growing imports. In 2005, the country s leading suppliers were the Persian Gulf, Canada, Mexico and OPEC. The country s reserves have been growing sharply over the years. This can be attributed to increasing geopolitical tensions. A study of only crude oil reserves is not enough. The major determinants are gasoline and fuel distillate reserves as they are the transportation fuels. Even though crude oil reserves have been piling, the same for gasoline and fuel distillate have been declining. This is one of the driving factors for the recent crude oil rally. Even though there is not much seasonality observed in crude oil, by and large,

8 demand for the same is seen to peak during the US summer driving season that is from May to September. The peaking months are July and August when Americans hit the road for vacation. Prior to the driving season, refineries close down for maintenance and crude prices are seen to rally during this time. Moreover the hurricane season also clashes with this time period. The killer Katrina that devastated US oilfields last year deserves special mention. It is during this time that the country resorts to draw down. Capacity Utilization in the US has seen an overall increase, even though the production has seen a decline. The anomaly can be explained by the fact that many US refineries have been shutting down owing to the country s increasing dependence on imports. It is meaningful to have a brief look at the transportation sector exclusively as it is one of the key driving forces behind crude oil demand. Transportation fuel: Transportation accounts for 87% of increase in fuel consumption in the United States every year. The transportation sector is a booming one and it is expected to see healthy growth in motors and aviation. Ply of freight trucks is expected to grow by more than 2% this year and this is the fastest rate of growth for any means of transport. Growth in the transportation industry can be attributed to growing technology and growing economies. This has a direct impact on infrastructural growth, a major component of which is transportation. The rising demand in the transportation industry manifests itself in the form of rising gasoline and fuel distillate demand. The latter is used in the manufacturing of diesel that is used by heavy vehicles and automobiles. Gasoline demand is expected to grow by 2.5% in 2006 and the same for fuel distillate is expected to grow by 2%.

9 US Motor Gasoline Consumption 3,500,000 3,000,000 2,500,000 2,000,000 1,500,000 1,000, , thousand barrels US Motor gasoline Consumption thousand barrels US Fuel Distillate Supplied

10 Forecasts: 2006: Variable Production 3rd largest 10.26% of Optimistic Most Likely ( 000 barrels) ( 000 barrels) % Pessimistic ( 000 barrels) Net imports Crude oil Reserves 3% of Motor Gasoline Reserves Aviation Gasoline Reserves Fuel Distillate Reserves Consumption 26% of per day per day +1.4% % % % % % per day The big question arises: Will USA be able to cope with its rising demand? It is expected that the US production in 2006 will be thousand barrels and its net imports will be around thousand barrels per day in the same year. At the same time it is expected to maintain its crude oil reserves at thousand barrels. It is expected that the consumption in the same year is thousand barrels. The supply position looks definitely comfortable. That is, even if USA has net imports of thousand barrels per day and imports only on 47 days at this rate in 2006, it will just be able to meet its consumption, the same being met by its production and imports.

11 Other Non OPEC Countries: Non OPEC countries, i.e., countries that are not members of the Organization of Petroleum Exporting Countries (OPEC) produce around 60% of the s oil. The same was 62% in 2003 and 71% in Most Non OPEC countries are net oil importers. Majority of the oil producers in non OPEC countries are private companies. As a result the governments hardly have any control over production levels. Another significant difference between OPEC and Non OPEC countries is that, since most producers are private companies, they maintain very little spare capacity in order to capitalize on profitable production. As a result, during global oil crises, OPEC is a better option to fall back upon in order to cater to oil demand. Again, non OPEC countries have a higher cost of production which makes them more vulnerable to price collapses. There are 204 Non OPEC countries. However the major players are United States, Russia, Mexico, China, Canada and few others. However, Russia, Norway, Mexico and Kazakhstan are the s largest net oil exporters. United States and China are net oil importers whereas Canada and UK are marginal net oil exporters. The forthcoming discussions aim to explore the oil industries in each of these countries below and hence study the fundamentals in terms of demand and supply. Russia: Russia is important to energy markets because it holds the 's largest natural gas reserves, the second largest coal reserves, and the eighth largest oil reserves. Russia is also the 's largest exporter of natural gas, the second largest oil exporter, and the third largest energy consumer. 2 Russia s economic growth for the pat few years has been mainly due to its energy exports due to a rise in its production levels and high oil prices. EIA sources reveal that a $1 change in price per barrel of oil results in $1.4 billion change in Russian revenues in the same direction. Owing to its extremely volatile oil market, the Russian government introduced a stabilization fund in

12 Production: Prior to 1992, which is during the time of the existence of U.S.S.R, production in the Soviet used to be on an average 8.7 million barrels per day, the peak being around million barrels per day in The average share of U.S.S.R in total Non OPEC production apart from USA was nearly 50% and the same in entire production was nearly 18%. But after the formation of Russia, production declined and currently Russia produces around 21% of the entire Non OPEC production and 12.14% of the entire production. But in 2005 it has remained the s second largest oil producer next to Saudi Arabia Russian Production as % of NonOPEC Russia as a % of Non OPEC less USA Graph based on data from The Russian production front can be studied in two phases: during existence of former U.S.S.R and after formation of Russia. Prior to 1992, that is before Russia came into being the correlation between productions of total Non OPEC and the Soviet was as high as.96. The same fell to.62 from 1992.

13 Russia vs. Total Non OPEC ( million bpd) During the 1980s Russian production made hay with the Western Siberian region (Russian Core) pumping at almost full capacity. The production declined after the collapse of Soviet Union in 1991 but production saw its recovery from 1999 when the privatization boom started in Russia. In 2004, Russia produced around 8.8 million barrels of crude oil. Recently, in March 2006, Russian oil production saw a double digit growth rate owing to its growing economy. It is expected that the Russian crude oil production by the end of 2006 will be around 11 million barrels per day. The rationale behind the slightly more than usual rate of increase in Russian production is justified by the following: New field developments in Lukoil s Middle Caspian project Sakhalin Island projects Shell Joint Venture s West Salymskoye project Many other projects Viable export routes Russia Former U.S.S.R Total Non OPEC Russia Exports and Reserves: It is seen that approximately 70% of Russian production is exported and the remaining 30% is refined locally. The export destinations are mostly Central and Eastern European countries like Belarus, Ukraine, Germany, Poland, Hungary, Slovakia and others. Currently the country holds around 60 billion barrels of proven reserves. Lukoil holds the maximum reserves followed by Rosneft and others. EIA sources reveal that Russia exports around 4 million barrels per day of crude oil. It is expected that owing to its enhanced capacities to produce and establishment of more viable oil routes in Europe, Russian exports will touch the

14 5 million barrels per day mark by the end of An increase in exports is also expected because of the current tension between USA and Iran on the latter s nuclear program. Supply cuts from Iran are likely to follow and USA is expected to shift its focus to Russia. Currently American imports from Russia are too little and it is not an exaggeration to expect that Russia will be a significant supplier for USA in the near future. Mexico: Mexico is one of the leading Non OPEC producers of crude oil. After Russia which accounts for 11% of entire production of crude oil, Mexico ranks second among the Non OPEC countries apart from USA in crude oil production. Mexico is also the 5 th largest oil producer in the. Mexico accounts for 4.6 of entire global production of crude oil which is equal to 9.16% of entire Non OPEC production (less USA) in According to EIA sources, oil accounts for 10% of Mexico s export earnings and 33.33% of government revenues. An important aspect of studying oil sector in Mexico is the Maquiladora sector which is actually a sector of manufacturing plants along the border of USA. These plants import raw materials from USA which are then re exported in the form of finished products to USA free of any duty. 83% of Mexican crude oil production is along the Gulf of Campeche. Mexico is also home to one of the biggest oil companies of the, Pemex. The production is poised for a rise in forthcoming years owing to increased investment % share of Mexico in Non OPEC less USA % share of Mexico in Non OPEC less USA

15 The percentage share of Mexico in Non OPEC production has been seeing a gradual increase over the past twenty years. In 2004, Mexican production was around 3.38 million barrels per day. It is expected that the same in 2006 will be around 3.9 million barrels per day, a jump of nearly 11% with respect to predicted 2005 production. Mexican production has a correlation of.96 with entire Non OPEC reserves. Both the productions move more or less in tandem but not to the extent of such a high correlation. The high correlation is probably due to an overpowering effect of trend component. Mexico vs. Total Non OPEC less USA ( million bpd) Mexico Non OPEC less USA Exports and Reserves: The largest consumer of Mexican crude oil is USA. In 2005, Mexico exported around 1.79 million barrels per day. Of this 88% went to USA and the rest went to Europe. In 2005 Mexico held 1.75% of the s proven reserves of crude oil which was around 180 billion barrels of crude oil. It is expected that proven reserves will go up this year. China: China is the s second largest consumer of oil next to USA. It overtook Japan for the first time as the s second largest consumer in Production: China accounts for 4.46% of the s oil production. The major oil producers in China are Sinopec, CNPC and CNOOC. Despite being a large producer, China is a net oil importer and most of its oil goes to satisfy domestic demand. The

16 correlation between Chinese production and Non OPEC production is as high as.98 and both productions move more or less in tandem China vs. Total Non OPEC(except USA) in million bpd China Total Non OPEC less USA In 2004 China produced around 3.49 million barrels per day of crude oil. It is expected that the same will be up by 2% in Consumption: China accounts for around 7% of the entire s petroleum consumption. It is the s second largest consumer of crude oil next to USA. Consumption has been sharply increasing for the past one decade and like USA its consumption is being catered by its increasing dependence on imports. 6, , , , , , Chinese consumption of petroleum in 000 bpd Chinese consumption of petroleum in 000 bpd

17 In 2003, China consumed around 5550 thousand barrels per day. The same is expected to go up to 6692 thousand barrels per day by the end of Recently China has been in news because of its move to enhance its Strategic Petroleum Reserves. These are emergency reserves. Apart from China, India and Russia have also declared their decision to enhance their SPR. This has been one of the driving factors for the crude oil rally. China has targeted an SPR of 100 million barrels, which is around 14.21% of the SPR for USA. USA has around 50% of the s SPR. Canada: Canada is the s ninth largest producer of crude oil. Canada produced around 3.1 million barrels per day of crude oil in It accounts for approximately 4.09% of the entire production. Canada is the major Non OPEC supplier of crude oil to USA. Source:

18 Source: Canada s production has been witnessing an increase in production since 1999 because of its enhanced recovery techniques, its new oil sands and offshore projects. According to Oil and Gas journal, Canada had reported billion barrels of proven reserves in 2005 which is the second largest only next to Saudi Arabia. This is equal to 17.45% of the entire proven reserves of the. Saudi Arabia holds around 25.5% of the same. The key reason to Canada s growing production is its privatization which has led to considerable consolidation of the Canadian oil industry. The key sources of Canadian oil are Western Sedimentary Basin, Northern Alberta and offshore fields. Canada also has good pipeline coverage both on domestic basis and international basis. The domestic system apart from ensuring internal supply also transports oil to the Petroleum Administrative Districts of USA. It is expected that Canadian oil production will grow owing to increasing investments by oil companies both domestic and American and the extensive pipeline coverage coupled with the new offshore projects. Japan: Japan is the s third largest consumer of crude oil next to USA and China. In 2003 it accounted for nearly 7% of the entire consumption of crude oil. It was however displaced by China which occupied the second rank after USA. An interesting fact about Japan is that it contains almost no oil reserves of its own. It

19 has only 30 million barrels of proven reserves which is less than 0.003% of the s proven reserves. Japans oil consumption has seen a decline recently. Japanese consumption of crude oil in 000 bpd 7, , , , , , , This is mainly due to the country s recovery of nuclear power industry which had seen a series of shut downs in Japan s key oil suppliers lie in OPEC, particularly Persian Gulf countries like UAE, Saudi Arabia, Kuwait, Qatar and Iran. Recently Japan has seen an increase in its imports from the Russian front too. It is expected that Japanese consumption will grow by 1% in Germany: Germany is the s third largest importer of crude oil next to United States and Japan. The country lacks sufficient production and owing to its size, it has to depend on imports. The key suppliers of crude oil for Germany are Russia, Norway and United Kingdom. 90% of German consumption is satisfied by imports. But the consumption level has been witnessing a decline since the last few years.

20 German Consumption of Crude oil in 000 bpd 2, , , , , , , , , German Consumption of Crude oil in 000 bpd This is probably due to the country s shift towards natural gas. Source: It is expected that German consumption will decrease by 1% in India: India does not figure as a significant player in the production arena. But it is the s sixth largest consumer of crude oil. It is also the ninth largest net importer of crude oil. India consumed around 2.3 million barrels per day of crude

21 oil in Recently, India announced its target of achieving 40 million barrels of strategic petroleum reserves. Source: India consumed around thousand barrels per day of crude oil in 2005 which was around 3% of the entire consumption in the same year. It is expected that the demand for petroleum from India in 2006 will grow by 1% to 2700 thousand barrels per day. Non OPEC Summary: Forecasts: Country Production Consumption Russia +11% +2% Mexico +11% +4% China +2% +10% Canada +4% +5.4% Japan +1% Germany -1% India - +1% Now that the country specific study is over, let us have a look at the top producers and consumers: 3 Please note that due to insufficient data on some Non OPEC countries, the accuracy of some of the forecasts may have been compromised.

22 Producers Saudi Arabia Russia United States Mexico China Norway Canada Consumers United States China Japan Germany Russia India Canada World Demand Supply Balance: Can we cope with the rising demand? The World Oil Balance Sheet: 2005 (Million barrels per day): Particulars 1 st quarter 2 nd 3 rd 4 th Annual Quarter Quarter Quarter Average Oil Supply OECD USA Other OECD Total OECD Non OECD OPEC Former USSR Other Non OECD Total Non OECD Total World Supply Oil Demand

23 OECD USA Other OECD Total OECD Non OECD China Former USSR Other Non OECD Total Non OECD Total World Demand Source: The demand is clearly higher than the supply in 2005.The expected demand for crude oil in 2006 is around thousand barrels per day and the expected supply is around thousand barrels per day which is short by 924 thousand barrels per day. But supply conditions for some countries like Saudi Arabia and USA are quite comfortable. On the whole the crude oil market looks under supplied. This leads us to the hint of a bull run for crude. Now where can we see crude oil prices by the end of 2006? And how high can they really be? 80 NYMEX Crude Oil Futures Prices (in $ per barrel) /28/1986 8/31/1987 5/31/1988 2/28/ /30/1989 8/31/1990 5/31/1991 2/28/ /30/1992 8/31/1993 5/31/1994 2/28/ /30/1995 8/30/1996 5/30/1997 2/27/ /30/1998 8/31/1999 5/31/2000 2/28/ /30/2001 8/30/2002 5/30/2003 2/27/ /30/2004 8/31/2005

24 Crude Price Forecast MAPE: MAD: 8 MSD: Actual Predicted Forecast Actual Predicted Forecast Smoothing Constants Alpha (level): Gamma (trend): The forecasting tool used is called Double Exponential Smoothing which gives more weights to recent events as compared to past events. The weights are chosen in such a way that the Mean Square Error (MSE) is minimum. MSE is a measure of the error.

25 Geopolitics seems to be reigning supreme and they are the most important fundamentals for crude oil. It is probably not an exaggeration to believe that geopolitical tensions are CRUDE AT $85 only expected to continue. Moreover though the OPEC countries have decided to operate at full capacity, it will take quite sometime to reach that level of production. The Nigerian oil crisis situation substantiates the fact as the 500,000 barrels per day loss has not yet been compensated in a period of three months. Moreover, with no new oilfield discoveries and permanent damage caused to some major fields along the Gulf Coast in USA by Hurricane Katrina in 2005, crude oil production seems to be a bit pressured. Gasoline again is a major cause of concern for US oil refineries. The s largest consumer has been heavily dependent on Nigeria s gasoline rich light end crude oil. Moreover the shifting gasoline specifications have been posing a major challenge to the American producer. However, Americans have managed to take up the challenge and production has seen a boost since the last couple of weeks. Capacity utilization is also on its way up. But the Iran issue is probably the major determining factor for crude oil price movement. Iran has blatantly turned down IAEA s call for a halt of its nuclear program. The forthcoming weeks are likely to see a tussle between Iran and USA. Moreover, the approaching hurricane season in the United States will see some destruction along the Gulf Coast. The crude oil rally is expected to take its way up to the $85 mark by the end of July 2006 if not earlier. KARVY Comtrade Ltd is engaged in commodities broking business in India. For opening a commodities trading account contact , or any of the nearby Karvy branches. Mail us at commodity@karvy.com Disclaimer The report contains the opinions of the author, which are not to be construed as investment advices. The author, directors and other employees of Karvy and its affiliates cannot be held responsible for the accuracy of the information presented herein or for the results of the positions taken based on the opinions expressed above. The above mentioned opinions are based on the information which are believed to be accurate and no assurance can be given for the accuracy of these information. There is risk of loss in trading in derivatives. The author, directors and other employees of Karvy and its affiliates cannot be held responsible for any losses in trading.