Oil and the Middle Eastern security premium

 


By Kate Dourian and Ross McCracken 


February 4 - Extraneous shocks are a key part of the oil market, but as geopolitical events they lie outside the ambit of economic forecasts. 
The explosion of unrest in North Africa, and its significance for the wider Arab region, have brought political risk back to the fore for an industry otherwise in rude health. 
Despite the dip in 2009, oil company revenues remain buoyant. In 2010, the physical benchmark Dated Brent averaged $79.50/barrel. (See related chart: Top 10 oil companies by revenue). 
This should deliver for oil companies their second highest ever level of revenues unadjusted for inflation, following from a succession of record years. 
Dated Brent averaged $29.03/b from 2000-2004, but $70.22/b from 2005-2009. Prices were lower in 2009, but still averaged $61.67/b, enough to provide oil companies with their fourth ever highest level of revenues. 

The rise in revenues and asset values has been accompanied by higher costs. According to IHS CERA’s upstream capital costs index, by third-quarter 2008, a $1 billion dollar investment in 2000 would have cost $2.3 billion eight years later. Costs have since fallen, but have resumed an upward trend. 
The CERA upstream capital cost index stood at 207 in third-quarter 2010, while the upstream operating index was 174. 
The average oil price in 2000 was $28.50/b, almost a third of that in 2010. Oil prices -- and revenues -- have therefore kept ahead of rising costs over the last decade. 
The oil industry’s ability to weather the 2009 downturn is demonstrated in terms of capital expenditure. 
According to consultancy Wood Mackenzie, global upstream capital expenditure is thought to have risen by 5% in 2010 to $380 billion. 
In its World Energy Outlook 2010, the International Energy Agency said worldwide total upstream capital spending on oil and gas “is budgeted to rise in 2010 by around 9% to $470 billion, compared with a fall of 15% in 2009.” 
From 2000-2008, annual upstream investment more than quadrupled, while costs more than doubled, according to the IEA, which estimates a real terms increase in upstream capex of 4% over 2010. 
The impact of sustained high prices has been to expand the capacity of the oil industry as a whole -- as shown by the rising rig count. 
The worldwide tally of oil rigs in use compiled by oil service company Baker Hughes rose to 1,753 in October, split 925 in the United States and Canada and 828 in the rest of the world. This is 350 more than when the oil price hit its peak in the summer of 2008. 
The rig count for oil is exaggerated by US shale gas drillers targeting liquids rather than gas prospects, but the count for the rest of the world in September hit 850, a level not seen since the 1980s. 


Forecasts 


In November 2010, the IEA predicted that the world would need to find an additional 50 million b/d of crude oil by 2035, when total demand for oil would reach 99 million b/d. 
The IEA’s predictions are very long-term and thus highly uncertain. The degree of uncertainty is manifest in the changes in these forecasts from year to year. In 2007, the IEA predicted world oil demand of 116 million b/d in 2030 from a base of 84 million b/d in 2006. 
This shrank to 106 million b/d in its 2008 report and 105 million b/d in 2009, both by 2030. Now the forecast stands at 99 million b/d, but not until 2035, although this represents a change from a business as usual forecast scenario to one in which governments successfully implement new demand reducing policies. 
Over such a long period anything could happen -- abundant new subsalt reserves could be found, transport could be electrified, climate change science could be radically rethought, key oil producing countries could undergo significant social and political change. 
However, the IEA’s forecasts inform decision makers and investors in the present, while the predictions have to be seen in the light of both the absolute numbers and the trend in year-to-year estimates. One says the challenge remains great, the other that the challenge is shrinking and not just as a result of the financial crisis and its aftermath. 
Short-term forecasts naturally have a lower degree of uncertainty. Heading into 2011, the fundamental supply/demand balance looks largely neutral in terms of prices. 
Using IEA, OPEC and US Energy Information Administration forecasts, world oil demand is expected to increase by about 1.25 million b/d in 2011. 
OPEC Natural Gas Liquids, which are not constrained by OPEC output targets, are expected to rise by about 0.6 million b/d and non-OPEC supply by about 0.27 million b/d. 
Politics not fundamentals 
However, history amply demonstrates that it doesn’t take an actual shortage of crude oil to see prices rise (nor does a glut necessarily mean they will fall). The perception that there could be future tightness in the market is enough. There was no actual physical shortage of crude oil when oil prices hit their peak in 2008. 
Given the fairly balanced fundamentals picture, the key factors that could produce a price spike in 2011 are essentially political; firstly OPEC policy and secondly the ephemeral ‘security premium’. 
OPEC faces its age-old dilemma; that it must fear high prices as much as low ones. Low prices hit short-term revenues, while high prices encourage short-term demand destruction, loss of market share from emboldened non-OPEC production and, of most concern, long-term and permanent product substitution – represented by biofuels and the electrification of heating and transport. (See related chart: World crude production (%)). 
The threat of a loss of market share to conventional non-OPEC production is declining as OPEC holds the bulk of easily accessible remaining reserves. 
Neither electric cars nor biofuels are much of a threat to demand in 2011, but their development must be taken into consideration in OPEC’s policy decisions. 
Their evolution, dramatic or not, will inform investors perceptions about future oil demand, in particular the balance between non-OECD demand growth and OECD stagnation or contraction. 
However, OPEC has a tendency to get the long-term part of its strategy wrong. Its loss of control over rising prices in 2007/08 reflected insufficient earlier investment that would have created the spare capacity required to curb the increase in prices. 
The resulting price spike became a primary driver behind oil substitution policies, which has not been reversed. 
OPEC has little control over other substitution drivers like security of energy supply and climate change mitigation, but a high oil price makes alternative technologies commercial sooner. 
An oil price of $80-$90/b may be too high in that respect. OPEC’s optimal range in terms of volume multiplied by price is arguably much lower, given its on average low cost of production. 
But the budgetary pressure to maximize short-term revenues tends to mean that OPEC sets its sights too high. 
OPEC’s hawks are already arguing that the world economy can sustain an oil price of $100/b rather than the $70-$80/b range supposedly favored by Saudi Arabia. 
In this context, there is little reason to think that OPEC will deviate in policy terms from the general goal of keeping the oil price either side of $80-$90/b. 
In practice, this will mean a decrease in compliance with its existing output targets if prices rise and a bit more discipline if they fall. 
The trigger points for a formal change in output targets are likely to be $70 and $100/b. 
In the approach to $100/b there have already been signs that Saudi Arabia is willing to increase supply. 
Internally, OPEC needs demand growth to manage smoothly increases in its members’ reserves and output capacity, in particular beyond 2011 Iraq. 
A relatively low rather than high oil price would support this best. 

Security premium and spare capacity

The wild card is the ephemeral ‘security premium’, which is impossible to quantify accurately in money terms. It is an expression of the level of risk of a major supply-side shock as the result of geopolitical developments.

The security premium declined in 2010 to a point close to non-existence, for the simple reason that shocks on the supply side have much less of an impact when spare capacity is high. They can easily be absorbed.

The premium, or security risk, increases as spare capacity falls.

Extraneous shocks are a key part of the oil market, but as geopolitical events they lie outside the ambit of economic forecasts.

Real shortages of crude oil -- as opposed to financial ones -- are caused by politics, wars, invasions and revolutions.

The oil market in 2011 has some important flashpoints, such as Sudan’s 2011 referendum on independence for the south, Nigeria’s upcoming presidential election, or the rising tensions between North and South Korea.

However, it has been the unexpected explosion of unrest in North Africa that has reinforced the political risk inherent in a market as global as oil. January saw the relatively swift fall of Tunisian president Ben Ali in the face of popular protest.

This soon spread to Egypt, where the country’s urban centers have seen persistent rioting and mass demonstrations aimed at ousting President Hosni Mubarak.

Neither Egypt nor Tunisia are hugely important in terms of oil production. (See related chart: World crude production (%)).

Egypt produced 742,000 b/d of crude in 2009 and consumed about the same amount. Tunisian crude output is less than 100,000 b/d. Even if upstream operations were badly impacted, it is a storm the market could weather.

In North Africa, Algeria and Libya are far more important in crude oil terms, both exporting more than 1 million b/d, while the Middle East is a league of its own, supplying almost 35% of the world’s oil exports.

Egypt’s significance lies firstly in its control of the Suez canal that links the Mediterranean with the Red Sea, and secondly in its role as regional power broker and its military, economic and cultural influence within the Arab world.

The International Energy Agency estimates that in 2009, an estimated 1 million b/d of crude and refined products moved north through the Suez Canal to the Mediterranean, while 800,000 b/d moved south into the Red Sea.

The alternative, around the Cape of Good Hope, would add 6,000 miles and additional charges to a tanker’s journey westward from the Middle East.

Nevertheless, while the closure of the canal would cause major disruption to oil markets, it would not represent a loss of output.

The significance of the Jasmine revolution, the unrest in Egypt and similar demonstrations elsewhere in the region is the potential for wider instability.

While many of the causes of the disturbances are common to North African and Middle Eastern countries, there are as many dissimilarities.

Nevertheless, it is an oft repeated mantra in the region that if Egypt goes, other Arab countries will follow, which explains the virtual blanket coverage of events unfolding in Cairo and other major cities on all Middle Eastern television channels.

For the region as a whole, Egypt is hugely important. Mubarak, 82, is a former air force pilot who has ruled Egypt since 1981 under emergency laws imposed following the assassination of Anwar Sadat.

Sadat unilaterally broke Arab ranks and concluded a peace treaty with Israel, which has held despite opposition from Egyptian Islamists and other factions who saw it as a betrayal of the Arab and Palestinian cause.

Mubarak has since been re-elected in polls widely seen as fixed. Islamist parties are banned from participation in elections, despite enjoying a large degree of popular sympathy.

Should the balance of power shift in Egypt, the rest of the Arab world will have cause to fear the potential stirring of Islamist tendencies.

In Saudi Arabia, the monarchy now directed by King Abdullah's regent, has been actively suppressing al-Qaeda-inspired terrorists for nearly a decade, while Kuwait and Bahrain have had to cope with a rising threat from disgruntled Shi'ite Muslim constituents who have become more vocal in recent years.

Sudan is on the verge of splitting into two, Yemen is grappling with secessionists and separatists, while Iraq is only just trying to find its democratic feet in an environment riven by sectarianism.

Should the protests in Egypt result in the fall of one-party rule and lead to a leadership void in this Sunni Muslim bastion, Shi'ite Iran would stand to benefit by expanding its influence in the region beyond Iraq.

As sAs such, the unrest in Egypt could herald a reconfiguration of the politics and balance of power in the Middle East, the most important oil producing region in the world.

For the oil market, that represents political risk of a new order.