King oil is not dead (again...)

|The King is not dead. Why Oil is rallying, and what might come next.

So we are at it again. Oil broke the 80 $ per barrel mark and everyone and their cousin are making predictions on where is going to go next? what OPEC will do? how about shale oil?

Could the 100 dollar mark be next by the end of the year?

The answer is as usual, no one really knows. Why? Because the factors at play are many and their interaction fairly complex.

Anyone betting on a specific price might lose their shirt exactly like someone betting on horse-racing.

Back in 2001, during the Bush II administration, the dynamic on the market looked remarkably similar to what we are seeing now. Trump is, at least vocally, trying to push around OPEC countries to increase production, while the countries are keeping steady or making rumors about potential uplift in production without committing to any specific targets.

The issue is that the producing countries have on one side, learned their lesson 18 years ago: in 2001, the answer of the markets to each increase in production was always the same: an increase in prices.

Why? Because of expectations. The markets were basically pricing in the growing demand and betting on a scarce remaining spare capacity. A bit the same scenarios present itself now, with Iran essentially cut off by sanctions and tensions in other producing countries such as Venezuela and Libya.

Another elephant in the room, that the average journalist happily ignores in the Western media, is how much spare capacity might be really brought online.

Both Saudi Arabia and Russia might have substantial constraints, albeit for different reasons:

• Saudi Arabia has already increased the production substantially and might find it harder than in the past to play the role of the Swing producer
• Russia has serious difficulties due to under-investment because of a short term management of its resources (see the likes of Lukoil asking for additional tax breaks, that the federal government is reluctant to concede) and due to the sanctions that are depriving Russia of access to knowledge and spare parts;

Also, even though the ignorant press was essentially hailing the end of oil as a major factor in the energy markets, reality is itself very different: Oil demand is fast approaching the threshold of 100 million barrels per day,with a growth that has not even slowed down marginally in the last 5 years.

Maintaining a production big enough to satisfy such a demand, even imagining a reduction in the growth, will require financial commitment that is not trivial, and the volatility both in the oil and other financial markets, together with a general reduction in money supply due to the roll-back of QE programs and a general trend for interest rates to inch upwards, are not going to make capital commitments any easier to sustain.

And to the believers that fracking in the USA will pick up the slack of other countries, the rosiest forecasts indicate that the USA will not become a net exporter of oil (if ever...) before 2022. Which is a questionable assumption by itself, considering the general delicate financial health of most players in shale-fracking.

(As the graphic shows, there is an obvious correlation between oil and gasoline consumption, except that much of the gasoline produced in the US relies on imported refined products...ie the US is far from being self sufficient, let alone a net exporter of energy products)

So much for peak oil demand, really. Lest we forget that, failing a technological revolution that still has to materialize, oil demand is not really elastic.

So to summarize, hoping that the OPEC will use its magic wand to dig us out (pun intended) of the hole in which we are finding ourselves, is like keep on smoking and hoping that cancer or other ailments will not attack us: It is wishful thinking.

On top of this issue, we need to remember what oil is used for. Crude itself is fairly useless, unless it is refined.

The problem is that refining has been neglected in the last quarter of a century to a point where it can barely satisfy the growing appetite for quality fuels.

Sacrosanct tightening of environmental regulations, together with the aforementioned under-investment, has created a dependency of oil consuming countries on import of distillates from the gulf and from other emerging countries, the production of which is then used in blending fuels that correspond to the local regulations.

This means that international oil trading has allowed the consumers to avoid the problem for the last 20 years, however the competition on the markets, with the growth in demand, is getting stronger by the year and is based on a delicate web of international shipping routes, which require a seamless flow of trade.

In a political scenario, mostly driven by the Trump White House, where trade is getting stifled to drive (idiotically, I add) political agendas, the risk of a supply shock becomes more and more of a reality.

The current mechanism of market balancing through paper trading, will not, in this case, allow the consumers to hedge the risk of a shock on the physical market.

Why? because paper trading is essentially a way to protect, partially, from price swings. But the reliability of supply and quality of physical fuel requires big volumes of different refined products that are not listed on paper markets and that require physical delivery, blending and hence infrastructure and refining capabilities. To top this off, the ever stringent regulations require fuels to be cleaner and cleaner, forcing refiner to reach even further, and competing at even higher prices, for high quality distillates. All of which does not contribute to a stable operating environment. And even admitting that refiners might be able, or even willing, to start the investments that are necessary, the time needed before such complicated projects receive the green light from government agency and are finalized might yet be too long to solve tight supply conditions now.

And here there is a lesson, a political lesson for the press and for economic nationalists: the oil market is a complicated beast which is much more than just the price of a marker (be it Brent, WTI or similar).

The livelihood and economic well-being of literally billions of people depend on a well functioning, unimpeded markets that allows for the optimum supply.

Another lesson is that for how depressing it might sound, oil is still, and will be for many years to come, a vital part of the energy mix, and investments will be needed in order to improve the quality of air, and life for the whole population, and to avoid imbalance an already precarious equilibrium.

As for many cases in life, by looking at the general discourse on the matter, comes to the mind the adage “complex problems have simple solutions. But they are usually wrong.”

King Oil is indeed not dead, Again.