Sunday, May 21, 2006

Can oil provide a “shock” without OPEC withholding?

The oil shock of the 1970s had a clear and proximate cause: OPEC countries suddenly reduced the supply of available oil. The reduced supply led to an increase in price and, coupled with an ineffectual US Federal reserve and already burgeoning inflation, led to a US inflationary spiral that had serious repercussions on the economy. This historic backdrop provokes the question, "are current high oil prices precursors of another economic implosion or simply the ebb and flow of a healthy market?"

There has been no shortage of apparent excuses for the media to latch onto to explain the rise of oil prices: war in Iraq, the increase in Chinese oil consumption, Hurricane Katrina, and even an insurgency in Nigeria. All of these provided ample fuel for headlines that seem to imply an endlessly tight future for oil. Let’s put some numbers on these events and see how it really plays out. Obviously there would be serious investing ramifications of a long term oil shock, can we figure out how likely that might be and plan our investing accordingly?

Most people don’t realize it but the USA is actually one of the biggest oil producers on the planet. In 1999 the US was ranked third behind Saudi Arabia and the former Soviet Union (which is still considered an oil bloc). The reason that oil is still a problem in the US is that even though we had 2005 domestic production of 8.7 million barrels per day (abbreviated b/d from now on) the US total consumption was 21.9 million b/d, leaving 60% of the US market to be filled by imports. So where does the US get 13.2 million b/d from? Up to date data on imports by country are available from the department of energy and last weeks data showed the US’ main two sources of imported oil are Mexico and Canada at 1.7 million b/d each; after that come Saudi Arabia (1.3 million), Venezuela (1.2 million), Nigeria (1.1 million), Angola (0.5 million), Iraq (0.5 million) and so on. The first detail that jumps out of this data is that the US has a very broad supply base. Even if #4 supplier Venezuela suddenly decided to withhold all petroleum from the US (not an impossible turn of events) it would represent only about 5% of the US oil market. Hurricane Katrina caused a larger interruption than that for over a month and it only increased gasoline prices about $0.20 per gallon. At this moment Cambridge Energy Research Associates (CERA) estimates that four big oil producers are currently producing less than they used to for various reasons: Iraq (war and rebuilding), Venezuela (politics and government seizure of oil fields), the Gulf of Mexico (storm damage), and Nigeria (armed insurgence). Together these four disasters have taken about 2.2 million b/d off the world market. The world market is about 85 million b/d so we’re looking at a medium term 2.5% decrease in available oil worldwide. As that oil comes back online in the coming years it will provide a growth in supply.

What about consumption?

The typical argument du jour is that China’s massive oil consumption is growing quickly and that China will buy up so much supply that it will pinch world markets. It is worth a momentary aside to reconsider that the 1970s oil shock was due to decreased supply, typically you don’t see recessions triggered by increased demand – it just moves lots of prices around. Nonetheless the world media nearly went berserk in January when the first foreign trip of the new Saudi Arabian King Abdullah bin Abdul Aziz included a lengthy trip to China. Saudi Arabia knows as much as anybody else what a dramatic economic force China has become. Trade between the two countries reached $14 billion last year, half the amount between Saudi Arabia and the US. Trade (mostly oil) between the Saudis and China has increased at a compound yearly rate of 44% per year for the last six years! Meanwhile the US has been annoying business in both of those regions by blocking corporate investment attempts: first a Chinese company’s attempt to take over Unocal and then the attempted port purchase by a Dubai based company. From the Saudi and Chinese points of view the US is not such a great trade partner, so it’s natural that they are trading more with each other. On the oil consumption front China’s demand rose only 2% last year, however, as opposed to a more frightening 16% in 2004. In 2005 Chinese demand was 6.6 million b/d and the expected 2006 number is 7 million b/d for a projected rise of only 0.4 million b/d (or less than the US imports from a barely rebuilding Iraq).

So let us assume for a moment that China’s increase comes directly out of the Saudi shipments to the US (which I consider an overly pessimistic assumption – the Saudi’s are constantly increasing production). That works out to 0.4 million b/d, or about 2% of the US oil supply. Five times that amount is already off the market due to various disasters and political fluctuations. Pull some oil out of the market in one place and the buyers just buy elsewhere, and over the next few years there should be at least as much oil becoming available as is required by the growing economies of Asia. Looking straight at the numbers it looks like repairs and some political progress plus the usual growth rate in supply would generate more oil than the projected growth rates of the top 10 oil importers with no problems at all.

So what is going on in oil prices?

At the moment the world is suffering from the aforementioned 2.5% decrease in available oil, but there is also a collective worry element. Psychologists have long known about “availability bias”, the phenomena in which people worry most about the matters they have most recently and most prominently heard mentioned. My American readers may remember a few years back when it was “the summer of the shark” and it seemed like there were shark attacks on the news constantly. It all started with widespread coverage of a surfer girl in Hawaii losing an arm and after that no TV station would skip a chance to report on sharks. Shark repellent showed up in beach stores and people stayed out of the water. A later study concluded that “the summer of the shark” actually had FEWER shark attacks than average and consumer advocates complained that the money spent on shark repellent could have saved a large number of lives if spent on simple household fixes that rarely make the news (like non-slip shower mats and baby-proofing). CERA estimates that at least $10 of the current $70 per barrel oil price is worry and hysteria. With the possibility of hostilities in Iran, this is completely understandable, but it is not based on a current economic situation. Another solid indicator of the worry element of prices is that several times in recent months the future price of a barrel of oil (purchased through the futures market by speculators) has gone ABOVE the spot price of a barrel of oil (the price for immediate delivery). This inversion rarely happens: it means that you could simply buy real oil now and sell a future option, then sit on the oil for a few months and deliver it back having made a nice profit – and because of the way deliveries on spot markets work you could even do it without the oil ever having to move physically. When this inversion happens it means people aren’t so much buying oil as they are betting on the direction of worry in the market.

Meanwhile various world figures have been happy to give the media ominous sound bites to further their own agendas. Huga Chavez in Venezuela has been using oil as a pulpit to rail against George Bush, and during the Saudi Royal visit to China Saudi tycoon Abdullah Al Zamil commented on George Bush's statements that the US is sadly addicted to oil, saying it "is a message to us that this region does not need to trade with you... I would rather produce 9 million [b/d] at $90 a barrel than 12 million at $55 a barrel." The quote flashed across news boards worldwide and oil rose in price. (As a side note the tycoon's Zamil group does not work in oil.)

But these press accounts don't add any new quantitative information. We already know how much oil is off the market and we know what impact level is possible from various players. In the long term it seems as if the oil “shock” is likely to fizzle.

But what about difficulties with Iran? How bad could the market get in the short term?

Iran produces about 4 million b/d, although only about 2.5 million b/d goes onto the international market. If Iran wanted to produce an oil shock it would strike ships in the Strait of Hormuz, the biggest oil chokepoint in the world. 15.4 million b/d go through the Strait of Hormuz, which is in the Persian Gulf right near Iran. Any such strikes, however, would have the effect of generating chaos in the entire world oil market and would turn almost all oil importing countries (including Japan, China, the EU, and the US) against Iran. It’s hard to imagine they would take such a suicidal strategic action but the mere possibility would be sure to drive up oil prices if armed conflict were to break out in Iran. It is interesting to note that Iran almost certainly couldn’t maintain a blockade on the strait longer than the US strategic oil reserve could handle the loss, so actual oil available for consumption would probably not be affected, but the prices would certainly gyrate.

There are a lot of numbers here, so feel free to play around with them and let me know your thoughts. I have looked at them from a number of angles and can’t come up with a reasonable sounding long term shortage scenario so I don’t foresee an oil shock like we had in the US during the 1970s. Prices will bound around, and I think a lot of things are pushing for the US to have some inflation, but I don’t think there will be an extended oil shock.

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