The Summer Oil Slump

Instead of US consumers facing $5 gasoline this summer, as some analysts had predicted, we now find prices slipping well below $4 per gallon as oil prices respond to weakening demand, a stronger dollar, and steady supply growth.  Yet as welcome as this is, it's largely the result of a mountain of bad news: Not only does financial turmoil threaten the very existence of the European Monetary Union and its currency, the Euro, but economic growth in the large emerging economies is also slowing, at least partly in response to the weakness in the developed countries that constitute their primary export markets.  The engine of global growth for the next year or two just isn't obvious.  That's the backdrop for this week's OPEC meeting in Vienna.

Before we become too enthusiastic about the prospect of a period of cheaper oil, we should first put "cheap" in context.  Even ignoring West Texas Intermediate (WTI), the doldrums of which I've discussed at length, the world's most representative current crude oil price, for UK Brent, has fallen consistently below $100 per barrel for the first time since the beginning of the Arab Spring in 2011.  Yet even if it fell another $10/bbl, to about where WTI is currently trading, it would still exceed its annual average for every year save 2008 and 2011.  So while oil might be less of a drag on the economy at $90/bbl than at $120, that's still short of the kind of drop that would be necessary for it to provide a substantial positive stimulus, particularly when much of the drop reflects buyers around the world tightening their belts. 

The US is in a somewhat better position, thanks to surging production of "tight oil" in North Dakota and onshore Texas. This has more than made up for the inevitable slide in output from the deepwater Gulf of Mexico, two years after Deepwater Horizon and the ensuing drilling moratorium. With much of the new production trapped on the wrong side of some temporary pipeline bottlenecks, parts of the country are benefiting from oil prices that are $10-15/bbl below world prices, although short-term gains are a poor reason to perpetuate those bottlenecks, rather than resolving them and allowing North American production to reach its full potential.

Then there's the issue of speculation, which some politicians blamed for the recent spike in oil prices.  To whatever extent that was true--and I remain skeptical that the impact was nearly as large as claimed--we could be about to see what happens when the dominant direction of speculation flips from "long" to "short"--bullish to bearish--as noted in today's Wall St. Journal.  Since the main effect of speculation is to increase volatility, we could see oil prices temporarily drop even further than today's weak fundamentals would suggest they should.

All of this will be on the minds of the OPEC ministers meeting in Vienna Thursday, along with the usual dynamics between OPEC's price doves and hawks.  The pressures on the latter have intensified as Iran copes with tighter sanctions on its exports and Venezuela's ailing caudillo faces a serious election challenge.  OPEC meetings are rarely as dramatic as last June's session, but the global context ensures a keenly interested audience for this one.  Given the impact of gas prices on US voters, both presidential campaigns should be watching events in Vienna as closely as any traders.  $3.00 per gallon by November isn't beyond the realm of possibility.  It would only require a sustained dip below $80/bbl.

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Why Are Gasoline Prices So High in February?

US gasoline prices are setting records for this time of the year, with the current price apparently the highest ever for February, at least in nominal dollars. In fact, the monthly average US retail price for unleaded regular has set new records every month since last October. That isn't quite as dramatic as it might seem, because based on the Department of Energy's data, the previous records for those months were set just a year earlier. Yet it's still a significant drag on the economy--an anti-stimulus, as I've noted previously. Unfortunately, some of the explanations I've seen for these price levels, including the ones offered in last night's CBS Evening News, focus too much on minor factors such as refinery maintenance and commodity speculation, while ignoring the most basic influence: the price of oil. That's understandable if they're watching the wrong oil price.

If you've been reading this blog for a while, you know why the most-watched oil price in America, the one for West Texas Intermediate crude (WTI), is no longer representative of the broader US oil market, at least for now. The best domestic grade to follow at the moment is probably Louisiana Light Sweet (LLS), which is of similar quality to WTI but not subject to the persistent transportation bottleneck at Cushing, OK. It tracks closely to UK Brent crude, which has largely taken over the role of global oil price indicator. The "spot" price of LLS was $119 per barrel today, accounting for 94% of the price of prompt gasoline futures on the New York Mercantile Exchange (NYMEX) today. And the $16/bbl increase in LLS since February 9, 2011 explains nearly 80% of the increase in the wholesale gasoline price over that interval. So while refinery outages might be having some impact, particularly in the local and regional markets served by the affected facilities, they are not the main show, nor is speculation in gasoline futures, the effect of which beyond the New York area covered by the NYMEX contract should be rather attenuated.

So with gas prices this high, this early in the year, how high might they be when the summer driving season arrives? That also comes down to crude oil, prompting questions about why oil prices are so high today, despite relatively weak demand. Many analysts attribute oil's strength to worries about Iran's threat to close the Strait of Hormuz as the sanctions noose tightens, along with rumors that Israel may be preparing to strike Iran's nuclear sites on its own this spring. But as with any such risks, they will either manifest or they won't, and the more time that goes by without these feared events occurring, the less influence they are likely to have in propping up oil markets, absent a surge in underlying demand due to a strengthening global economy. If none of that takes place, then oil prices could ease, resulting in summer gas prices not much worse than what we see today. However, I'd be wary of reversing that logic: Keeping gas prices low is not a sufficient reason to back away from addressing the risks posed by what the International Atomic Energy Agency refers to as the "military dimensions" of Iran's nuclear program.

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2011 in Energy: The Year of...

At the start of 2011, I thought the hallmark of the year's energy events and trends might involve regulation, with the White House seeking to implement measures that couldn't garner enough support in Congress to become laws. But for every major new regulation issued, such as last week's release of the new Mercury and Air Toxics Standards for power plants, others were delayed or deferred, including the EPA's effort to regulate greenhouse gases under the Clean Air Act and the agency's proposed ozone standard. Outside of the utilities and other industry groups directly affected by these rules, it seems likely that 2011 will instead be remembered for big, unpredictable events like the Fukushima nuclear accident and the Solyndra bankruptcy scandal, along with several major trends that reached critical mass this year. Anyone attempting to pick the energy story of the year is spoiled for choice.

In my search for a catchy title for this year's final posting, I toyed with "The Year of Solyndra", "The Year of Shale", "The Year of Fukushima", "The Year of Exports", and various other combinations of the energy buzzwords that percolated into our consciousness this year. In some ways, they'd all be apt choices. Here's a quick rundown on why they might merit that kind of recognition, with links to previous postings providing more details on each:

• If 2011 is the year of Solyndra, it's not because of the possibility that the government's $535 million loan to the firm was the result of political influence (cue Major Renault), or even that the Department of Energy is unlikely to recover more than pennies on the dollar in the firm's bankruptcy. Instead, it's because Solyndra highlighted the much broader and deeper problems of a global solar industry that, despite continued demand growth that other industries would kill for, now faces overcapacity and the fallout from the winding down of unsustainable government support. Germany's Solar Millennium is just the latest victim of this trend. Along with BP's exit from the solar business after 40 years, it provides a further reminder that renewable energy firms must succeed not just as technology providers, but as businesses that can earn consistent profits and continue to attract investors.



• Shale gas was hardly new to the scene in 2011; it has been expanding rapidly for several years and now accounts for up to a third of US natural gas production. However, the controversy surrounding drilling techniques like hydraulic fracturing that make its exploitation possible became much more widespread this year, while some scientists raised questions about its contribution to greenhouse gas emissions. Shale gas has the potential to transform nearly every aspect of our energy economy, and probably sooner than renewable energy sources could. That has some folks nervous, while others are eager for shale gas to displace coal from electricity generation, compete with oil in transportation, and revive the domestic petrochemical industry. I suspect we'll see all of those to some extent, provided we don't regulate shale out of the running.



• The aftermath of Fukushima could prove equally transformational, though it remains to be seen whether the ultimate result is safer nuclear power or a global retreat from one of our largest sources of low-emission energy. All but 8 of Japan's 54 nuclear power plants are currently idle, and that nation must shortly decide whether it will eventually restart those units that weren't critically damaged, or shut down the rest and attempt to run its manufacturing-intense economy on a combination of renewables and much larger imports of fossil fuels. The German government's post-Fukushima decision to phase out nuclear energy entirely could provide an even quicker test of the same proposition.



• Another major shift that has been in the news recently involves exports. Although the US has long exported coal and various petroleum products, we could shortly become a bigger, more consistent exporter of many fuels, including liquefied natural gas (LNG), gasoline and diesel. As the reaction in a CBS news segment last week demonstrated, the US public doesn't know quite what to make of this, yet. Becoming a major energy exporter while still importing a net 9 million barrels per day of crude oil is very different than the picture of isolated self-sufficiency that four decades of "energy independence"rhetoric has evoked. We shouldn't be surprised that energy can provide a boost, and not just a drain on our trade balance. This topic requires more public discussion and education, before we see serious proposals to ban such exports--proposals that would make no more sense than banning exports of corn, tractors, or aircraft in an attempt to keep their US prices low.



• It's also tempting to call this the Year of Oil Price Confusion. The news media gradually woke up to the huge gap that had developed between global oil prices and the oil price that Americans tend to watch most closely, the one for West Texas Intermediate crude. Yet despite numerous stories on the storage and pipeline crunch and supply glut at Cushing, Oklahoma, few reporters and networks seemed able to follow through by breaking their old habit of treating the NYMEX WTI price and its gyrations as if it were still the best indicator of the overall oil market. Fortunately, the problem is in the process of being resolved, as pipelines are reversed and more tankage built.



• Finally, there was the administration's non-decision on the Keystone XL pipeline. Observers can read much into this, including the growing influence of citizen activists mobilized via social media. However, if it does nothing else, the Keystone controversy should put to rest the superficial fallacy that anything that improves greenhouse gas emissions is automatically good for energy security, instead of requiring difficult trade-offs. In that context, the prospect that the administration might ultimately turn down the permit for Keystone would be easier to stomach if the net greenhouse gas savings involved amounted to more than a paltry 0.3% of annual US emissions, based on the emissions from incremental oil sands production the pipeline might facilitate, compared to those from the conventional imported oil it would displace.

It was a busy year for energy, and if my short list of top stories missed something crucial, please let me know. 2012 promises to be just as interesting, with a Presidential election, in which energy issues could feature prominently, added to the mix. In the meantime, I'd like to wish my readers in the UK and Commonwealth a happy Boxing Day, and to all a Happy New Year.

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Why Haven't Gas Prices Fallen More?

With the US economy stuck in the doldrums, weakening the demand for oil and its products, and with the fall of at least portions of Tripoli foreshadowing the eventual return of Libyan oil exports to the market, it must seem puzzling that US gasoline prices haven't dropped farther in the last few weeks. As of Monday, the national average price for unleaded regular stood at $3.58 per gallon, only 3% lower than a month ago, when crude oil was just shy of $100 per barrel, compared to around $84 today. On Monday's evening news, CBS ran a segment attempting to explain this apparent disconnect. Unfortunately, they over-simplified the main explanation with a graphic showing cheaper domestic crude oil mixing with higher-priced imported oil. The "A" answer to this question is simpler but not well-understood, even though its elements have been fairly widely reported: Americans are simply looking at the wrong crude oil price, out of long habit. When you compare current gasoline prices and more representative crude oil prices, there isn't much of a disconnect about which to grumble.



The source of this confusion is the price of West Texas Intermediate crude oil (WTI), which for three decades has been the most watched and widely traded oil price in the world, and the basis of what most people mean when they talk about the price of "oil." In fact, there are numerous distinct grades of oil, each with its own price reflecting quality, location and availability. However, until recently most of these prices were based on the price of WTI, plus or minus a relatively narrow band of premiums or discounts, so using WTI as a barometer of all oil prices didn't cause much confusion or inaccuracy. The emergence of a pronounced and lengthy supply bottleneck at the Cushing, OK delivery location for the WTI futures contract has exploded this convenient set of relationships and assumptions.



Because more oil has been going into tankage at Cushing than was leaving those tanks over the last year or so, the price of WTI--itself a category, rather than a single stream of oil--has become massively depressed relative other types of crude oil, not just imported oil but also oil in other locations in the US that aren't affected by the bottleneck. Consider some important examples. While oil produced in Kansas, New Mexico and Oklahoma is all cheaper due to the Cushing effect, Louisiana Light Sweet, which historically traded within a dollar of WTI, is now worth nearly $20/bbl more, putting it much closer to the price of UK Brent crude--the best current gauge of global oil prices--than to WTI. Meanwhile, Bloomberg reports Alaskan North Slope crude (ANS) for delivery on the West Coast at nearly $107/bbl, or $24 over WTI. That's surprising, considering that ANS is heavier and higher in sulfur than WTI, and thus requires more processing. Just as remarkably, California heavy crude at Midway-Sunset is quoted at more than $10/bbl above WTI, when based on history and quality I would expect to see a discount of at least that magnitude. In other words, for now at least, the price of WTI is simply no longer representative of the crude that many US refineries are processing, from either foreign or domestic sources.



When you compare the wholesale price of gasoline from US refineries near the East, West and Gulf coasts to the cost of their crude inputs at around $100 or more, the difference of $15-17/bbl isn't historically unusual. Meanwhile, refineries in the middle of the country have recently been experiencing much stronger margins. This disparity is evident in the second quarter earnings reported by various US refining companies. East coast refiner Sunoco, which hasn't benefited much from cheap WTI, reported a net loss for the quarter, while Valero, with a bigger and more geographically dispersed refining system that includes facilities processing large quantities of WTI-related crude, saw refining segment earnings increase by 39% compared to the second quarter of 2010. The Cushing effect was even more pronounced for the recently merged HollyFrontier Corp., which apparently runs little crude that isn't priced near WTI and saw second-quarter net income almost triple versus 2Q2010. Even after that extra profit margin, gas prices in Tulsa, OK are currently as low as $3.30/gal., or about 15 cents per gallon less than the national average after adjusting for differences in state gas taxes.



Gasoline prices are determined by more than just crude oil prices, though in the long run the two must move together, because the latter represents the largest component of the cost of the former. At least until the bottleneck in Cushing is resolved by new pipeline capacity to the Gulf Coast, one option for which was just canceled, we will need to look beyond our old reliable WTI price indicator in order to compare gasoline and crude prices on a representative basis. I've been paying a lot more attention to the Brent market, and the Wall St. Journal still publishes daily prices for Louisiana Light Sweet and ANS. When and if those indices drop significantly, then it will be time to start looking for a commensurate drop in retail gasoline prices at the pump.

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Oil Price Hangover

The price of oil is an odd thing. It's watched by millions of people every day, especially when it reaches uncomfortable levels, yet no two observers agree on all the details of how it's determined. Having traded the stuff professionally, I've always given a lot more credence to the fundamentals of supply and demand than to the influence of speculators as the main driver of day-to-day price movements, though it's clear that both supply and demand are pretty complex constructs in their own right these days. For some time, however, I've also been intrigued by the extent to which current oil prices seem to be affected by their own history, something more in keeping with behavioral economics than the kind I learned in grad school. When I consider all the factors converging to yield this morning's price for the prompt (April 2010 delivery) West Texas Intermediate crude oil futures contract, it's hard to rationalize a value just over $80 per barrel any other way, without taking into account that less than two years ago it was nearly $150 per barrel-- though just a year ago it stood at $40, after a dip into the mid-$30s.

Over the weekend I happened to look back at some scenario work I did almost six years ago, when oil prices were rising steadily but before they had passed the $50 per barrel mark for the first time. Though it seems hard to credit now, at the time even that milestone seemed nearly unimaginable for the group of energy industry managers participating in the workshop I was leading. WTI had just broken through $40/bbl, which represented the highest nominal oil price any of us had seen in our careers, a record set in the lead-up to the first Gulf War. Although the prices in the early 1980s, after the Iranian Revolution, were higher on an inflation-adjusted basis, we had just lived through a couple of decades in which oil had notably failed to keep up with general inflation. Of course from our current vantage point $40 or $50 now seems cheap, and that's precisely the point. With an all-time high of $145 still relatively fresh in memory for "anchoring" purposes, $80 might not seem low, but it hardly provokes the kind of anxious political pronouncements that flavored the 2008 US presidential campaign.

Things couldn't be more different than the first time we passed $80/bbl in September 2007, when there was much talk of the risk premium on oil prices due to tensions with Iran, as well as the impact of a weakening US dollar. Most importantly, the global economy was still booming and OPEC was having trouble keeping up with growing demand, particularly from the developing economies of China and the Middle East oil producers themselves, along with the US at the tail end of the bubble. By contrast, despite expectations for a recovery in 2010, today's oil market is dominated by weak demand, with average US demand for oil and its products in 2009 down by 10%, or 2 million barrels per day (MBD) from '07. The global appetite for oil fell by 1.5% in 2009, with only Asia and the Middle East registering any growth. Inventories are ample, refineries are running at extremely low rates of utilization--partly due to some ill-timed capacity increases--and OPEC has as much spare oil production capacity as it did in 2003, when WTI was in the $30s.

So why isn't oil back in the $30s or $40s, rather than the $70s and $80s, particularly with the dollar having strengthened by almost 6% since the beginning of the year? Certainly a big part of the credit or blame, depending on your perspective, belongs to OPEC, which has managed to take 2-3 MBD of production off the market and keep it there, with minimal cheating and without triggering a price war driven by members whose national budgets needed significantly higher oil prices or sales to balance. It's also clear that since the beginning of the last decade the marginal cost of incremental non-OPEC production has gone up significantly, whether from Canadian oil sands or deepwater Gulf of Mexico platforms. Part of that is due to the fact that these are intrinsically costlier barrels to produce, but it also owes a lot to the costs of raw materials and construction involved. Those soared during the last decade, weakening subsequently but not returning to their former levels. That means that the much lower oil prices we saw briefly at the end of 2008 and beginning of 2009 aren't sustainable for any length of time, though precisely where a realistic floor now lies is anyone's guess.

Arriving at a price of $80/bbl despite slack demand, ample global supply and a refining sector that's losing money doesn't require nefarious speculation, but it probably depends on two crucial factors: Most oil deals today are negotiated as a stated premium or discount relative to a handful of grades like WTI and Brent that involve as many financial players as refiners who must process the stuff and try to make a profit on it. And for those few, correspondingly more influential markets in which traders must negotiate an actual price and not just a differential, traders' price expectations are anchored by the history of the last couple of years. Once you've seen oil above $100 without the world ending--though it came close--you simply can't look at the market the same way you did before. If the range of possible prices is now seen as $40-$150, rather than $15-$35, today's circumstances understandably yield a mid-range interpretation, backed by an expectation that OPEC would intervene even more strongly if prices began falling towards that uncertain floor--a threat the credibility of which is greatly enhanced by OPEC's remarkable cohesion and discipline over the last year or so, perhaps providing more psychological anchoring in the form of availability bias.

So in a strange sort of way, we may still be experiencing the consequences of the extraordinary oil price spike of 2007-8, which was itself either an outgrowth of the global financial bubble, or a major, independent contributor to the ensuing collapse, in classic oil-shock fashion. While the extreme prices of that period have receded, they haven't vanished from the market's memory, and so they may continue to influence prices for some time to come, until the next spike or oil-price collapse resets them again.

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Indexing Crude Prices

Although oil trading hasn't been my primary focus for many years, the recent announcement by Saudi Aramco that it is switching its price mechanism for oil delivered to the US caught my attention. Instead of basing its formula for deliveries here on the price of West Texas Intermediate crude oil, it will apparently reference the new Argus Sour Crude Index (ASCI.) While that lends substantial credibility to this new index and may gain Argus more than a few new subscribers, the implications for the widely-traded NYMEX WTI contract and the dynamics of the broader international oil market seem much less clear. In particular, I am skeptical of suggestions that this move could ultimately reduce whatever influence non-commercial financial participants--speculators, in common parlance--have on oil prices.

The question of how best to price crude oil for buyers and sellers is a perennial problem, particularly for oil that differs significantly in quality from the light, sweet grades behind the extremely liquid WTI and ICE Brent futures contracts. US refiners, in particular, have invested many billions of dollars in the hardware required to turn lower-quality oil into high-quality petroleum products. Any time the peculiarities of these contracts drag up the prices of the grades of oil they prefer to run, they grumble about basing deals on WTI. Likewise for sellers of sour crude, foreign and domestic, who suffer when the WTI price moves out of sync with world prices, such as when storage at its nexus at Cushing, OK fills up, as it did earlier this year. However, after listening to the Q&A podcast concerning the ASCI on Argus's website and reading the background document there, I'm skeptical that this index will settle the sour crude market's discontent, because it won't change the way this oil is traded by nearly as much as it might appear.

Without getting into all of its details, as I understand it the ASCI is effectively a composite daily report of the deals done for three specific streams of offshore Gulf of Mexico crude oil, all of which trade at a differential to WTI. In calculating a daily price, Argus will add the average daily discount or premium vs. WTI from the transactions it learns of to the daily price for WTI to come up with a single price in dollars per barrel. The Argus podcast was very clear that NYMEX WTI is still as the heart of the new index, not just because this reflects the way deals are done with reference to WTI, but also because WTI remains the highly-liquid futures contract that the buyers and sellers of the ASCI oil streams use to hedge their market risk. In other words, the new ASCI index is not a substitute for WTI-based pricing, but merely a more transparent gauge of the relationship between WTI and the sour crude market--though an index you have to pay to read falls a bit short of the kind of transparency currently provided by WTI itself.

What would happen if speculators drove up the price of WTI by $30/bbl? In theory, ASCI would reflect any disconnection between the fundamentals-based pricing of its included sour crude streams and the financially-driven WTI market by remaining more or less unchanged, after summing the combination of correspondingly wider discounts for the ASCI grades to the inflated daily WTI prices. Only by looking at the differentials themselves would we see any indication of distortion of the market by non-commercial players. But is that realistic? Consider that between January 2007 and July 2008, when the price of WTI rose more or less steadily from the mid-$50s to nearly $150/bbl, the discount between WTI and the monthly average refiner acquisition price for imported crude only widened from around $4.75/bbl to roughly $9/bbl. If WTI was being driven by speculation in that interval, differentials-based trading of the kind that ASCI will measure hardly insulated refiners from its effects.

That historical result might merely indicate that speculation had little real effect on the market in that period--a view to which I'm sympathetic--but it might just reflect the inertia of negotiated crude differentials. Either way, if you're Saudi Aramco and you're selling crude into the US based on ASCI, I'd conclude that your prices would still go up more or less in tandem with the NYMEX, despite the superficial "arms-length" mechanism flowing through ASCI. Perhaps I've missed some subtlety in the mechanism.

From what I can tell, neither ASCI nor the prospect of new futures contracts based on it addresses the underlying concerns I have had since the industry migrated to pricing based on differentials against the WTI and Brent futures contracts, and away from negotiating actual "fixed and flat" prices for each cargo or pipeline deal, back when I was trading oil in the 1980s and early 1990s. While that shift made life much easier for risk managers and took a lot of heat off traders to strike the best deal on any given day, it also opened the door to a host of other influences on pricing that I still don't think we entirely understand.

The market will pass its own judgment on ASCI and other new tools like it. If it proves useful to traders and risk managers, it could become the new industry standard, as Argus must hope, having made such a big splash over its launch. If it's not useful, it will fade into the background, becoming just another dataset in an already bewildering sea of energy-related information. With Gulf of Mexico output booming and more discoveries yet to be made, it looks like a reasonable bet to join other useful physical crude indices around the world. But anyone hoping it will shine a beacon on speculators in the next oil price spike is likely to be disappointed by the core of a system still rooted in WTI, the speculative influences over which remain uncertain and possibly unprovable.

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