|Date||April 15, 2005|
|Speaker||Antoine HALFF(Director, Global Energy, Eurasia Group)|
|Moderator||TANABE Yasuo(Vice-President, RIETI)|
The dramatic price movements of recent months, and indeed the last two to three years, have attracted a lot of attention, not only in the oil industry itself but also among the public at large and in the press. Oil prices recently reached record highs, with WTI NYMEX soaring to $58 per barrel in New York and contracts for later delivery topping $60 a few weeks ago. Other benchmarks such as Brent in London or Dubai in the Middle East have also risen to record highs in recent weeks. This has started to raise concerns about the sustainability of the price increase and the effect on the economy, but there are many aspects to the price rally that are surprising and challenge our understanding of the way that the market functions.
During most of the last 15 years, whenever prices increased for crude oil or petroleum products, the price increase always corresponded to a decrease in inventory levels, to a tightening of so-called market fundamentals: supply and demand. It used to be that there was an increase in demand, a drop or slowdown in supply growth or disruption in supply, which caused tightening, which in turn caused prices to increase. That has been the case for much of the last decade and it was the case at the beginning of the current rally back in 2003 when the oil supply was disrupted on a number of occasions, starting with a general strike in Venezuela in December 2002, which completely disrupted Venezuelan production, and it continued with the war in Iraq in March that interrupted Iraqi supplies, and fighting in the Niger delta in Nigeria, which caused a major supply disruption there. When all these disruptions took place, stocks tightened dramatically, especially in the U.S. where inventory levels greatly suffered from the disruption in the Venezuelan supplies, and prices rose accordingly.
Since then, prices have continued to increase. In 2004 they rose to new levels and this price increase occurred without any noticeable tightening of inventories. This was very puzzling to many in the market as it fundamentally contradicted market conditions, where lower prices would have been justified. The price movement has been even more surprising in the past few months of 2005 as prices have continued to increase to record highs even though stocks not only did not contract any further but actually rebounded, according to OECD data. This has, in a way, challenged our understanding of how the market works and raises the question of whether the current price increase is a bubble that is about to burst or whether something happened to the market which has caused it to function differently.
This perplexing situation is heightened by the behavior of the futures curve. The differential between futures prices for prompt delivery and futures prices for delivery later on, when the market is tight, tends to be such that prompt barrels trade at a premium to later barrels, a situation known as backwardation. For much of the last three years, the market indeed has been in a situation of backwardation, which is consistent with an increase in prices as the cost of barrels today is higher than for tomorrow, resulting in a disincentive to buy and increase stock positions for fear that inventory positions will devalue over time.
Recently, in 2005, even as prices soared to new levels, the market shifted from a situation of backwardation to the reverse situation known as contango, when barrels for prompt delivery trade at a discount to barrels for delivery at a later time. That is true for the futures market and also for delivery at the back end of the curve. This means that the increase in prices has not only affected today's market but also the expectation of prices in the relatively distant future. There has been a dramatic surge in the price of WTI contracts for the end of 2006 and later on. This very new development seems to suggest that the market has started to accept the idea that we have moved to a sustainable high-price environment.
Nonetheless, it is also ammunition for those who think that the current market is abnormal and reflects a bubble situation, not a cyclical trend. Therefore, the question of what the current market conditions represent is key and deeply important in that it directs investment decisions by oil companies on which projects (upstream, exploration or development) are economical. My personal opinion is that it is a little bit of both, and both opinions have been very strongly and vocally represented in the industry and media.
Goldman Sachs recently came out with a report saying that prices could very easily exhibit a "super spike" to as high as $105 in the event of an unknown, unspecified geopolitical event that causes a supply disruption. On the other hand, Merrill Lynch has said that the commodity price movement is a big bubble that is about to burst and that prices will likely fall back to the $30-$35 range in the near future. This intense debate among bank analysts is also pervasive in the industry itself. The chairman of ChevronTexaco told the press that we have entered the beginning of a lasting energy crisis, with prices rising for the foreseeable future. At the same time, the chairman of ExxonMobil said that commodity prices are cyclical and that prices are very likely to fall back in the near future.
I would say that it is a bit of both. While there are bubble components in the current market situation, there are also structural shifts which will provide continued support to the market in the near future. I do not think that prices will continue rising in a straight line. I think the market remains cyclical in nature, but cyclical movements will still move, on average, in an upward curve in the next few years.
In looking at some of the factors that have driven prices up, I am not suggesting that there are no fundamental factors behind the current rise in prices. Demand rose dramatically in 2004. Contrary to the trend a few years ago, when demand was falling and prices contracting, demand began to surge in late 2003 with the strongest increase in 2004 since 1976. At the same time, there has been a supply increase as well with more than three million barrels per day of incremental supply last year, which includes both OPEC and non-OPEC crude and OPEC liquids (NGLs). However, a string of disruptions has taken the market by surprise, and there has also been steep depletion in mature producing areas such as the North Sea and damage to underground pipelines caused by hurricanes in the Gulf of Mexico. Perhaps an even more important factor recently on the supply side has been the slowdown in Russian production.
As for components of demand growth, China really emerged as the major driver of demand growth in 2004 and late 2003. For much of the 1990s, Chinese demand increased substantially in line with its economic growth, but by and large traded below the robust pace of economic growth. The Chinese economy was very coal-intensive with comparatively modest oil consumption, which grew quite slowly compared to the broader economy. To everyone's surprise, the Chinese economy took off in late 2003 and growth in oil demand far outpaced the underlying economic growth. China's demand last year was very significant and accounted for more than 40% of the total.
Many people have said that this surge in Chinese demand is sustainable and some of the arguments behind the theory of the new era of rising prices and demand are based on the assumption of continued dramatic growth in Chinese demand. I subscribe to that view to some extent, and for various reasons think that Chinese oil demand will continue to grow quite rapidly in the next few years; and I also think Indian demand will soon take off. However, some of the factors behind last year's increase in Chinese demand were cyclical, one-off factors, that will not be sustained nor replicated, and might actually be reversed initially and cause a temporary slowdown in Chinese demand growth.
The permanent structural factors behind Chinese demand growth have to do with the offshoring of manufacturing capacity to China because of lower production and labor costs there. That is going to continue even though it might slow a bit as there is quite a bit of overcapacity in Chinese manufacturing, especially in the car industry. An even stronger structural factor has been the emergence of a significant domestic consumer market in conjunction with the growth of the middle class. When GDP per capita reaches a certain point, demand tends to increase more rapidly to an inflection point, and there follows a sustained temporary period of rapid demand growth, as seen in China.
The more cyclical, one-off factors have to do with a shortfall in electric power generation capacity. In China there has been a lack of production and transmission capacity, leading many end users to import backup generators and build up storage capacity in the event of a blackout. This was a major factor last year but will eventually fade as Chinese power generation capacity catches up with demand. A similar cycle of demand growth occurred in the early 1990s in China, but demand growth has been comparatively lower this year than last, demonstrating a significant albeit temporary slowdown that might cause demand for 2005 to be less robust than it was in 2004.
On the supply side, the key element is the slowdown in production growth in the former Soviet Union over the last few years, particularly in Russian production growth. There has been a steady downgrading of expectations of non-OPEC supply recently among forecasters in that most of the growth in non-OPEC supply in recent years has come from Russia. This has to do with the crackdown on Yukos and the nationalization of Yuganskneftegas, with Yukos production expected to continue slowing down this year. Nonetheless, supply has been adequate over the last year and a half and has more than met demand growth. With stocks in the OECD having been rebuilt from 2003 levels and more or less in the midrange all over the world, there seems to be no concern about a crisis. In truth, if stocks are calculated not in absolute levels but in terms of forward demand coverage, they are significantly tighter because of the increase in demand, but not to a point as to reflect a crisis.
Therefore, there must be factors other than demand growth and supply constraints that explain the current prices. Among them are the role of investors and new institutional investors that have moved money from equities to commodities markets. An additional, more potent factor is concerns about infrastructure capacity limits all across the supply chain. There have been concerns that capacity is scarce at the wellhead/production level focusing on tightening in Saudi spare capacity, but also about lack of transportation capacity and saturation of the pipeline network in Russia. Also, despite expectations of a rebound in the tanker industry, tanker rates have soared, recently reflecting the scarcity of available tankers.
Finally, there are significant constraints on the refining side. A few years ago, when refining was considered a money-losing industry, refining capacity was being reduced to a point now where refinery capacity has suddenly become lacking, insufficient and stretched. However, concerns about refining capacity, though real, are being addressed and are not expected to be permanent. Investments have been committed to the refining and transportation sectors. Active drilling is taking place, particularly in Saudi Arabia to expand capacity and rebuild spare capacity, but such projects will take time.
Additionally, there has been increased concern in the market about the perception of political risks in producing countries. This, in part, reflects reality as many of the disruptions in recent years have propped up prices and supported the market. It appears though the political risks currently are overstated by the market, and in fact high prices seem to have reduced political risks in many producing countries. For example, despite several terrorist attacks over the last two years in Saudi Arabia, in fact, stability there has increased. The same can be said about Venezuela. It might be argued that just as political risks are alleviated in the short term, they might be heightened for the longer term because the same factors that solidify regimes in the short term might postpone necessary reforms, hinder steps to diversify the economy, and cause more problems to appear later on. In the short term, however, it is a more stabilizing factor.
The flipside of that is the strengthening of the link between oil and politics. There is a tendency among producers to be more assertive about their use of oil as a political tool to achieve foreign policy goals or geopolitical ambitions. That is certainly the case in Venezuela and President Chavez's actions to sever ties with the United States - to explore alternative, non-traditional markets. While many producing countries have explicitly rejected oil as a political weapon, oil has the potential to reappear as a political weapon in other parts of the world. If you look at trade flows, it is quite clear, for instance in Russia, that exports to Europe have decreased recently as exports to China have increased. This does not just reflect the search for new outlets for incremental production, but a redirection of trade flows away from traditional markets.
On the question of whether the strength of prices and the current rally is sustainable, my answer is yes and no. Some of the constraints on the supply side will remain for some time and it will take time to expand refining capacity enough so that there is more flexibility in the system, but I think also that many forecasts of demand growth perhaps overstate the strength of demand in the near term. One reason that there were no price effects on demand last year was the strength of economic growth and the role of subsidies in many of the economies where demand expanded at the fastest pace.
Those two factors are now receding, with growth slowing down and countries now realizing the burden of price subsidies and cutting back on them. With a decrease in subsidies, there will be an increase in prices, which may marginally affect demand, although it will be mostly offset by economic growth. For example, in Thailand, where gasoline subsidies were removed sooner than diesel subsidies, looking at the pace of demand growth in comparison to the role of subsidies as a percentage of product prices, demand increased quite rapidly when gasoline subsidies were high, but slowed when they were reduced, and finally contracted when they were removed. Prices in emerging and developing economies do have an impact when the public is allowed to feel the full effect of international price increases.
Some factors will nevertheless sustain demand growth in 2005. In the U.S., unlike in Thailand or other developing economies, gasoline demand is not sensitive to prices, but is linked to the pace of GDP growth. This means that even though prices for gasoline are at record highs, those prices are not expected to have an immediate impact on demand. Gasoline demand is however expected to slow compared to 2004, and the same is expected of GDP growth in the U.S. There will be some later impact, with SUV sales falling dramatically in the U.S., and consumers now increasingly preferring cars with a higher fuel efficiency, but that will not have an immediate impact since it takes a very long time to change the fuel efficiency of a car fleet as large as that of the U.S.
Another factor that will sustain demand this year is the connection between demand for diesel in the U.S. and gas oil in China. Comparing U.S. diesel consumption with the container trade on the West Coast, there is a very strong correlation between the two. Diesel in the U.S. is used mostly for trucking and as imports from China and the rest of Asia increase, more trucks are needed to unload the vessels, which in turn rapidly increases gas oil and diesel demand. Comparing U.S. diesel demand with the U.S. trade deficit, the connection again appears to be very striking, with the pace of demand growth fairly parallel to the increase in the trade deficit. Similarly, gas oil demand in China increases as manufacturing increases and exports increase. This situation will only slow when GDP slows enough to reduce export demand in China, or when the Chinese increase the value of the renminbi to such an extent that their exports become less competitive and demand is reduced.
In summary, the factors supporting the current price rally to some extent reflect a secular trend. We are facing a period of rapid demand growth from Asia in particular, as well as from other economies. There are problems accessing supplies, not a lack of supply, but to actually translate reserves into supply. Therefore, supply will continue to be constrained for the next few years. Although demand is expected to slow in 2005, it may pick up afterward and there is no sense of crisis. For the medium term, until significant additional capacity is developed, the market is likely to continue in a broadly upward trend, but there is clearly room for significant cycles in the market. Prices will not go up in a straight line; there is potential for significant dips followed by rebounds. One factor that will likely continue to sustain prices over the next few months is concerns about the relationship between the U.S. and Iran, and the perceived likelihood of a pinpoint attack targeting Iranian nuclear facilities.
Questions and Answers
Q: How would you explain what you described as the shift in Russian oil from Europe to China? Is that because it is a more secure market or because of higher prices? Or does it reflect concerns about using the Eastern European pipelines through Belarus and Ukraine?
A: It is a combination of factors. It is not pipeline constraints per se because Russian companies have so far been able to circumvent some of the pipeline infrastructure constraints to Europe. Exports to Europe have fallen marginally recently, but not because of loss of pipeline capacity. There are several factors at play. The first is political in nature in that as relations between Russia and the West appear to be undergoing a period of stress, there might be a strategic preference for developing or maintaining ties with alternate markets. There is also a perception that China is an essential market to be positioned in because of its spectacular growth. For instance, Saudi Arabia realized early on that China was a growth market which had to be captured, and indeed Saudi exports to China have been steadily increasing despite various ups and downs overall. Other countries are catching on and despite seemingly higher transportation costs and decreasing margin, if it is done right, as long as exports remain marginal, it is a rational decision. Venezuela has been following this course to move away from the U.S. and retain influence in OPEC.
Q: Given the historical correlation between inventory level and price, and the incentive to companies to increase inventories based on the contango of the futures market, can I expect this cycle to continue with increasing inventories and decreasing prices?
A: We would expect that if markets behave the way they did in the past, but there might be other factors conflicting with those traditional relationships. We have seen a bit of retrenchment in the past week, so the steep drop in prices over the last few days shows that price is not fully justified by fundamentals and there are other factors at play. Prices may fall back again, but the drop should not be too significant.
It might be that the way stocks are measured is no longer completely adequate. On the one hand, demand has increased dramatically so that if stocks are measured in terms of forward demand coverage as opposed to absolute levels, stocks might not look as abundant as they would appear otherwise. Additionally, we measure stocks in OECD countries only. Non-OECD markets used to be less important since their consumption was much less. But the share of non-OECD countries in global demand has increased and now weighs quite heavily in the global market. In order to understand the market better, it is necessary to know about stocks in those countries, and statistical collection efforts are under way.
There has also been a very significant increase in storage capacity, particularly in China but also other countries, to reach minimum operating levels. Stored oil cannot be used as stock and cannot be relied upon to meet demand. It has been a draw on supply and was a big factor last year interfering with the supply and demand balance.
Q: Three questions: First, you appear to be confident that supply will be sufficient to meet increased demand, such as in China. Where do you expect the additional supply to come from? Second, what kind of price range do you expect for the oil price in the medium term? Third, will the entry of heavily state-influenced Chinese companies entering the market as big buyers affect the way the market functions?
A: I am not really confident that supply will be there, but I am hopeful and cautious. I am not alarmist because I do not believe that we are facing a shortage, but the balance remains fairly tight. I think there is supply coming down the pipeline with two key areas of supply growth being West Africa (Angola) and Brazil, two countries in which a lot of investment has been made. Projects there should come to fruition soon. Combined with isolated growth in China and Russia, these should help balance demand over the next year.
In terms of the price band, it is especially difficult to forecast prices today because of the breaking of this historical relationship between OECD inventory levels and prices. With that relationship having gone by the wayside for now, it makes it all the more difficult to forecast prices. You have to take into account much more intangible factors, whose effect on prices is much less verified by a long record of historical data. However, it would be fair to say that there will be significant volatility in the market based on the constraints of spare capacity on transportation, refining and production. The market will likely respond quite dramatically to news on the down- as well as the upside.
On the issue of Chinese companies, it is true that they behave differently from other companies. Typically, they would go into countries shunned by Western companies because of political risks (Sudan) or go after assets deemed unattractive. The industry has frequently sneered at Chinese companies, but there has been a reassessment of the market perception and in retrospect, the seemingly high prices that Chinese companies paid for reserves now appear quite reasonable. While some view China's aggressive search for supply as a threat, I believe that it is a positive development to help balance the market.
Q: Could you talk a little bit about the political risk of Chinese policy as a driver in the oil rally?
A: China is grasping for a coherent and clear energy policy at the moment. At the latest meeting of the People's Congress there was a decision to set up an energy task force and implement an efficient energy policy. The key is to have a pricing policy or pricing adjustment mechanism, as opposed to price controls as currently implemented in China.
Q: So you mean energy policy and not security or foreign policy?
A: That is a separate question and a new development, which may have an impact. If the current tension in China continues to rise, it will undoubtedly have a chilling effect on foreign direct investment, some of which will be redirected to other emerging markets. This will slow down Chinese growth and probably increase FDI to India with the rise in demand there.
Q: How do you see the situation in the East China Sea as an outside expert?
A: It is a heated question but at the end of the day, agreement needs to be reached on these issues. If reserves are developed in the East China Sea, for the market as a whole, as long as it adds supply to meet demand it is perhaps less relevant who develops the reserves than for the countries themselves.
Q: Others might certainly think that ownership of the oil is important. Looking at geopolitical developments, which school of thought do you consider more appropriate?
A: I think that the school of thought that oil is a fungible market is a more appropriate view. It is an oversimplified view because there are different grades of oil. Thus, it is not a completely fungible market, but it is fungible in the sense that it is global. Therefore, whoever develops oil is less relevant because the more oil is produced the greater the chance that global needs will be met. National oil companies have recently become more flexible not only in the marketing of their crude but also in the approach to the development of reserves.
*This summary was compiled by RIETI Editorial staff.