Category Archives: Energy

the influence of speculators in the crude oil market

July 11, 2011 By in Current Market Thoughts, Energy, Industry Analysis, Stock ideas, Strategy Tags: , , , , , , , , , , , , Leave a comment

The conventional view taught in business schools is that speculation is good.

Boiled down to its essentials, the argument supporting this view is a very simple one:  suppose there were no one to take the other side of the trade of, say, a farmer seeking to guarantee a minimum price for his corn crop that would ensure he’d cover his costs and have something left over to keep body and soul together.  There may not be enough cereal makers or animal feed producers who want to hedge their costs in the same amounts and at the same time as the farmer.  If not, who’s left to be the buyer of the commodity contracts the farmer wants to sell?  The answer:  speculators, who have purely financial motives and who will step in to stabilize a market by buying and selling commodity futures contracts before prices get too wacky.

In this picture, the main players are the producers and users of commodities; speculators play a minor role, though a convenient one for the theory.

 

I don’t know whether this was a solid description of the way commodities markets worked a generation or two ago,  or just a product of the many simplifications of the real world that academics need in order to have their mathematical models work more smoothly.  But even if they once were correct, do these ideas still work in a world where prop trading, hedge funds and commodity-based ETFs abound, and where brokers have made it much easier for ordinary investors to buy commodities futures directly?

the case of crude oil

In 2008, after an oil price spike that saw the price of crude nearly double from a starting point of $80, the Commodity Futures Trading Commission issued a report, based on the traditional thinking, which found that speculation played little role in the upward move.  The Baker Institute of Rice University is the most well-known of observers who criticized the CTFC findings.  It said the commission had ignored its own data, which showed a dramatic rise in the involvement of the proprietary trading desks of investment banks, of hedge funds, and of commodity funds in oil trading.  On the Baker Institute’s reckoning, these speculative entities made up half of the market (and they all wanted to bet that oil price would rise).

Apparently in response to this criticism, on July 5th,the CFTC published a relatively large set of data showing the relative importance of hedgers and speculators in various commodities markets, including crude oil.  What called my attention to the report was an article in the Financial Times that says speculators make up a majority of the trading in metals, agricultural and financial futures–but in crude oil, they comprise well over 90% of the trading volume!!  (I’ve cast my (unpracticed) eye over the figures.  I don’t see the 94.5% speculation the FT reports, but most categories of crude show hedgers make up less than 20% of the market.  Same difference.)

my thoughts

The CFTC is proposing that the government limit the number of positions a speculator can hold as a way of limiting their influence.  And the International Energy Agency has already organized a limited release of some of the crude oil stocks held by oil-consuming nations in an effort to cause speculators to liquidate.

CTFC action would just make speculators relocate, however.  The IEA has a worry, too –that speculators have deeper pockets than it does.  Both agencies are treating symptoms, not the root cause, of high oil prices.

In a lot of ways, the current oil situation reminds me of froeign exchange during the Bretton Woods era of fixed currency rates.  During Bretton Woods, countries periodically tried to defend a certain currency level, even though that level was ultimately being undermined by structural economic problems that at least one of the countries involved refused to address.  The banks speculating against the currency exchange rate were, in effect, betting that the structurally weak country didn’t have the political will to make needed changes.  Generally speaking, the banks were right.  They thought it was like shooting fish in a barrel.  Ultimately, the Bretton Woods arrangement collapsed.

The structural issue for petroleum in today’s world is the failure of Washington for more than a third of a century to fashion an effective energy policy that reduces the country’s dependence on crude oil.  In part, this has been a way of protecting a politically powerful but badly run domestic car industry–which is even now lobbying hard against proposed increases in fuel efficiency standards for cars and trucks that would bring the US into line with the rest of the developed world in ten years or so.

The massive speculative bet is that the current situation won’t change much–resulting in higher oil, a lower US dollar and slower economic growth in the US than would otherwise be the case.

investment implications

The straightforward bet on this issue would be for or against the stocks of oil producing companies.  Slow growth domestically and a weaker US$ would also favor US-listed companies with significant operations outside the US, however.  For anyone, like me, in the weak-$, slow-growth US camp, I think the latter group of stocks will do relatively well under most oil price scenarios, making them the better way to go.

 

 

thoughts on the International Energy Agency release of strategic oil reserves

June 24, 2011 By in Current Market Thoughts, economics, emerging markets, Energy, Industry Analysis, Recent Market Action, Stock ideas Tags: , , , , , , , , , , Leave a comment

the IEA action

Yesterday, the International Energy Agency (IEA), an organization of oil consuming countries, announced its 28 member nations have agreed to release 60 million barrels of their collective emergency oil supplies, at the rate of 2 million barrels daily for thirty days starting early in July.  The idea is to offset upward pressure on the oil price that might arise during the summer high point in demand.

The extra oil, which represents a bit less than 4% of the total government reserves of the IEA, is ostensibly to replace crude lost to world markets by fighting in Libya.

The agency has done this twice before.  The first time was when Iraq invaded Kuwait in 1990; the second was after Hurricane Katrina.

Of the 60 million barrels, North America (read, the US) will supply half, Europe 30% and Asia the rest.  Each country will decide for itself how it will achieve its goal.  The US intends to release crude oil from the Strategic Petroleum Reserve.  Japan, in contrast, is simply going to reduce by three days the amount of refined petroleum products that refiner/marketers are legally mandated to maintain.  This presumably will ultimately lead to decreased purchases of crude by Japanese oil companies.

a stop-gap measure

The release of petroleum reserves is a stop-gap measure.  It appears to have been well-timed enough to be shaking some speculators out of their long positions in oil futures, and may therefore get the world through the summer months with lower gasoline prices.  But the move is also reminiscent of the ultimately futile attempts of the signatories to the Bretton Woods currency agreements to defend fixed exchange rates.

structural issues

In the case of oil, two structural issues stand out:

–the increasing affluence of the developing world means ever higher demand from these countries for fossil fuels for power generation and for transportation, and

–the US, the only developed country without a sensible energy conservation policy, consumes almost a quarter of the petroleum the world produces, even though it  represents just over 4% of the population of the globe.

effect on stocks

The initial reaction from financial markets is that the IEA action is bad for oil stocks and good for consumer names, especially in the US.  To some degree, I think this is the right response.  But production-sharing agreements signed between the big international oil companies and producing nations over the past twenty years call for progressively increasing percentages of oil sales revenue to go to the nation rather than the oil company as prices rise.  So the negative effect of the current price fall will likely be less than markets expect.  Also, the IEA move is more a temporary reprieve than a problem solution for hard-pressed consumers.

As a result, I think that, as it unfolds in the coming weeks, the IEA move will prove a better occasion for selling US retail stocks whose customers are ordinary Americans and buying oil names that it is to do the opposite.

 

crude oil production contracts: a simple overview

April 26, 2011 By in Current Market Thoughts, economics, Energy, Industry Analysis, Recent Market Action Tags: , , , , , , , , , , 2 Comments

Financial commentators have been pointing out recently that neither the large international integrated oil companies’ profits nor their stock prices are rising in line with the upwardly spiking price of oil.  This has to do with the changing nature of production-sharing agreements in the development of sovereign oil deposits.

There’s a ton of jargon in the oil business used to describe the often complex process of deciding how revenues and costs from a project are split up among the parties involved.  This is a highly simplified outline (but still good enough, I think, for a stock market investor) of how it works:

Generally speaking, an oil company (or group of companies) leases oil and gas rights to a specified block of acreage owned by a government through a competitive auction (in the past, colonial-style political or military coercion could easily have been the real key, however) .  In some cases, the winner will pay a large up-front fee.  In all cases, he is obliged to pay for and drill a specified number of exploratory wells over a specified time period, or else forfeit the lease.

If economically viable quantities of hydrocarbons are found, the oil firm must begin commercial development, again within a certain period of time.  The company “carries” the government, that is, it pays all development expenses.  Typically it can gradually recover these costs once production begins by being allocated an extra share of output until it has been recompensed.

Sometimes, the oil company takes physical possession of some or all of the oil and can do what it wants with it, sometimes not.  This can be a big deal in times of shortage.  For companies designated as “national champions” in nations like China or Japan, and asked to find supplies that can be sent back home in a pinch, it’s always a big deal.

three frameworks

I’ve seen three major contract frameworks, one following after the other, since I began watching the international oil industry in 1978:

1.  When I became an oil analyst, the typical arrangement called for the ol company to pay a fixed fee, say, $.50 or $1 a barrel, to the government that leased the mineral rights to a major international oil firm.  The oil company owned the oil, and might resell the crude immediately or refine and market it.  Such a firm made a good profit even when oil sold for under $2 a barrel.  But when prices rose in the early Seventies and again later in that decade, reaching as high as $35, the oil companies enjoyed the entire windfall.

This was a mixed blessing.  The contracts were seen as so unfair and one-sided that many oil-producing countries nationalized their oilfields and threw the majors out.

2.  In the 1980s, new contracts retained the general form of their predecessors but were renames production sharing agreements.  They called for a sharing of production revenues in specified percentages, say 70/30, with the oil company receiving the smaller portion.  That worked for a while.  But as prices rose from $12-$15 a barrel to $25-$30, and the majors began to make huge profits relative to their invested capital once more, the same problem of perceived onesidedness arose again.  Producing nations reacted in a somewhat similar vein as earlier, but either levying new taxes or simply unilaterally mandating more favorable terms to contracts.

3.  During the past decade or so, a new type of contract has emerged.  Again, the general form of the original contract has been retained.  But the production sharing arrangements call now for the oil producing country to receive an escalating percentage of revenues as the oil price rises.  While the contract terms tend to be expressed in this manner, the intention, I think, is to cap the returns to the oil major from a given project at, say, 25%-30% yearly.  The producing country basically retains everything above that.

Are the oil companies okay with this latest development?  Well, they continue to drill.  Of course, a lot depends on the riskiness of a specific project, but I think the oil company investment conclusion is that getting a 25% annual return for the life of a twenty- or thirty-year project is better than getting a 100% return for two years and then losing the project entirely.

stock market implications

For individual stock market investors, though, it’s important to realize that professional portfolio managers, or at least the oil analysts who work for them, understand the rules of the new order.  So they won’t chase after the stocks of companies that they know have large proportions of newer contracts.

why are the Saudis raising oil output?

March 10, 2011 By in emerging markets, Energy, Industry Analysis, Refining Tags: , , , , Leave a comment

Saudi Arabia to the rescue

Saudi Arabia announced recently that it is upping the amount of oil it produces.  It’s doing so to replace the portion of Libya’s normal output of 1.6 million barrels a day being lost during the current political struggle there.  The Saudis will doubtless be joined by other OPEC nations who will increase their production as well, although these other countries may not choose to identify themselves.

Even assuming the total number of barrels reaching the market is unchanged, the world faces a short-term logistics issue.  The Saudi crude needs more processing than Libyan oil.  It has extra sulfur (corrosive and a pollutant) that needs to be removed, for one thing.  And it contains more large molecules that need to be “cracked,” or broken down chemically to yield higher value-added products like gasoline or jet fuel.  The quality difference is a particular problem for Italy, the traditional buyer much of Libya’s oil.  (Italy seized Libya from Turkey in a war about a century ago and held it as a colony until after World War II.)  The country’s refineries haven’t seen the need to spend money on the expensive equipment required to process lower-quality Saudi crude into stuff customers can use. Nevertheless, they’re under severe political and market pressure to deliver refined products.  The resulting scramble for easy-to-refine crude is one reason the price of high-quality North Sea oil has risen so much.

Provided governments don’t decide to “help” the process along with new regulations, oil companies should readjust the world’s refining and distribution networks to restore the flow of gasoline, naphtha and jet fuel to something akin to the pre-Libyan-revolution normal within a few months.  I think there’s a very good chance of this happening.

why add production?

That doesn’t mean I don’t see a secular upward trend in the price of oil, because I do.  In this post, however, I only want to address the narrow question of why Saudi Arabia is acting to hold down oil prices, even though a $1 a barrel rise in the cost of crude puts an extra $3 billion a year into the royal treasury.

the iron law of macroeconomics: substitutes determine pricing

The answer is pure microeconomics.  Saudi Arabia, like many OPEC countries, has enough oil underground to last for well over fifty years at its current production rate.  It could easily have a hundred years’ worth.

Most of those barrels will only have value if petroleum remains the world’s fuel of choice in 2060…and in 2100.  So Saudi Arabia certainly doesn’t want world governments worrying about the dependability of oil supply and starting programs of serious research on possible replacement fuels.  Nor does it want dramatic real (that is, inflation plus) increases in the price of oil that might cause consumers to start to conserve.  Saudi Arabia doesn’t want to make waves.  It just wants to keep taking its $800 million + check to the bank every day.

conservation potential

Conservation could be a serious threat to OPEC revenues.  Look to the United States, which is the low-hanging fruit in the conservation department.  We have 4% of the world’s population but use about a quarter of the world’s oil (we consume about 3.7 tons of the stuff yearly for each man, woman and child in the country).  We’re the only developed country without a coherent national energy policy.  We’re practically alone in not taxing oil heavily to discourage use.  True, we no longer artificially depress the price of oil as we did in the Seventies.  Nor do we have quotas that limit imports of fuel-efficient cars, as we did in the Eighties.  But that’s not much.  The Saudis have a strong economic interest in us not waking up.

history shows what sharp price increases do

We’ve seen during the oil shocks of the 1970s what happens when oil price skyrocket.  Crude oil prices, which were under $2 a barrel in the 1960s, quadrupled in the early 1970s, declined somewhat and then more than doubled during 1978-80 in the wake of the Iranian revolution.

What followed was a period of global economic stagnation and then–crucially from an oil producer’s point of view–a twenty-year period of oil price decline.  At its nadir, crude had given back in real terms virtually all its gains from the 1970s.  So OPEC had a few years of riches, followed by two decades of budget deficits.

Conditions could actually have been worse for oil producers, had it not been for Saudi Arabia.  Had the Saudis acted unilaterally to temper price increases by adding to output, prices might have otherwise stayed high enough for long enough during the late Seventies-early Eighties to force permanent changes in consumption. Those billions of barrels of oil still in the ground might have become worthless.

As it turned out, however, and especially in the US, governments quickly lost interest in substitute fuels and in conservation measures as oil prices began to slide.

Today, Saudi Arabia is just doing what it has been doing for the past thirty years +, taking the role of the “swing producer” to keep real increases in prices under control.  This behavior may have its altruistic aspects, but, given its vast amounts of untapped oil, Saudi Arabia is clearly acting in its own economic interest.

oil refining basics: why countries like Libya are important to the world economy–plus a thought on the markets

February 24, 2011 By in Capital-intensive firms, Current Market Thoughts, Energy, Industry Analysis, Refining, Trading Tags: , , , , , Leave a comment

Political upheaval in Libya is causing much more turmoil in world stock markets than the popular overthrow of the government in Egypt–even though Egypt is a much larger country with much more influence in Middle East politics.  The obvious difference between the two is that Libya is an oil producer and Egypt is not.  But when we look at the amount of oil Libya brings to the surface every day, it’s pretty small–1.6 million barrels, or less than 2% of the world’s daily usage.  How can that be so important?

The answer is that a lot depends on two factors:  the kind of oil Libya has (light, sweet crude) and the ability of the world’s processing capacity to turn different types of oil into usable products.

refinery basics

Wikipedia has a chart that diagrams the structure of a typical oil refinery.  It’s complicated.  Luckily, six years as an oil analyst taught me that you don’t need to know all the ins and outs. The Cliffnotes version:

1.  The primary refining process consists in putting the crude oil in a big metal cylinder and boiling it.  Heat causes the crude to break up into three parts:

—the lightest molecules, basically gasoline, that rise to the top of the tube

—medium-weight molecules, jet fuel, diesel fuel, home heating oil, naphtha, that settle in the middle

—the heaviest, industrial boiler fuel or “residual” oil, tar, asphalt and other junk, at the bottom.

The top two parts, or “fractions,” contain most of the value.  The third might be hard to give away.

2.   An increasing proportion of the oil available for refining is what industry jargon calls “sour” instead of “sweet. ”  That is, it contains sulfur, a corrosive element and a pollutant.  So most refineries have expensive desulfurization machinery that remove the sulfur from refined products.

3.  An increasing proportion of the available oil is also “heavy” instead of “light.” That is, it’s rich in bigger molecules and contains few small ones.  Therefore, the primary heating process yields large amounts of the junky stuff at the bottom of the column and very little of the more valuable gasoline and middle distillates.

As a result, most modern refineries also have (again, very expensive) machinery to “crack,” or break up, the large molecules at the bottom of the distilling column into smaller-molecule, more valuable output, like diesel or gasoline.

That’s all you need to know.  Light, sweet crude:  boil it and you’re done.  Heavy, sour crude:  spend billions on a “back end” to your refinery so you can make it into stuff people will buy.  Why do this?  …heavy, sour crude is a lot cheaper.

world refinery capacity:  a mixed bag

Building, or even upgrading, a refinery is a pain in the neck.  It’s a multi-billion dollar, several year project.  It requires educated guesses about what kinds of crude oil, sweet or sour, light or heavy, will be available on the market when the refinery is finished, as well as whether there will be more or less demand from competing refineries for the kinds of crude your plant is optimized for. In addition, in most developed countries, it may be next to impossible to get local government permission for any kind of building.  Do you want a refinery in your back yard?

As a result of all this, there’s still a substantial amount of refining capacity, particularly in Europe, where the owners have opted to do nothing.  So these plants can’t process anything else except the lightest, sweetest crude.

why Libya matters

That’s where Libya comes in.  Yes, Libya is only a small factor in the world oil market (the country may have huge reserves, but that’s irrelevant if they’re not being developed).  And it has a reputation as an unreliable supplier.  But the 1.6 million barrels it churns out is all easy/cheap to refine light, sweet crude that’s rich in the gasoline and diesel fuel that the US and Europe consume.

There may be lots of “extra” crude oil available on the market.  But that’s predominantly heavier and sulfur-laden.  These are only substitutes if the refineries that have contracted for Libyan crude can process these lower grade oils as well.  The frantic bidding we’re seeing in the market for similar light sweet crude argues that they can’t.

The refiners affected are in a no-win situation.  They can scramble to get the crude they need, so they can produce fuel for their retail outlets, in which case they get blamed for higher prices.  Or they can simply shut down until Libyan crude is available again, in which case they’d take the political heat for supply shortages.

In the short term, then, the mismatch between the capabilities of the world’s oil refining plants and the “slate” of crudes available to refiners will translate into higher retail prices.  Because of the unusually pure nature of Libyan crude, withdrawal of even that country’s small contribution to world crude production can cause this.

stock market effects

I don’t have any idea how the Libyan situation will play out politically.  My guess is that virtually none of the “experts” talking or writing about Libya do either.  The least favorable outcome for the world ex Libya would be a years-long cessation of that country’s oil production–sort of a mini-Iraq.  World refined products prices might be, say, 5% higher than they would otherwise be.  Consumers in the US, where taxes on gasoline are very low by world standards, would be disproportionately hurt.

Even in this case, though, I think there are much more powerful currents affecting the US economy–like the pace of recovery, mobile broadband, internet-enabled erosion of brick-and-mortar retailing.  Yes, the US would be hurt, yet again, by Washington’s failure to have a coherent energy policy.  But we deliberately haven’t had one for thirty-five years, so that’s not real news.  And somewhat higher oil prices could get lost in the welter of other, structural things going on.

To my mind, the current downdraft in world stock markets has very little to do with Libya. It has more to do with how high the markets have gone in the past six months.

The S&P 500, for example, has been steadily rising since September and is up by 28% since then.  Time for a correction?

Looking at the market from another perspective, the S&P was up more than 7% year to date as of mid-day last Friday.  Assume we could have closed out the month that way.  If 7% were an average two-month return on stocks, then the yearly return would be 42%–or 4x what history tells us is the norm for stocks.  In year one of a bull market, this might be possible.  But approaching year three?   …no way.

To my mind, Libya is more a trigger than a cause for investors to take profits after this run.  If it hadn’t been Libya, it would have been something else.

One interesting characteristic of world equities over the past few months has been–until this week–the unwillingness of stocks to go down.  I’ve been reading this as being the result of an asset allocation shift to equities and away from cash and bonds.  If so, it will be important to watch for how deep this correction is and how long it goes on. Continuation of flows into stocks would argue that the correction will be shallow and brief.  Looking at the charts, the first line of defense for the S&P is around 1300.

In short, I’m reading this downdraft as a natural part of the two-steps- forward, one-step-back character of equity markets.

Most investors simply don’t look at prices during a period like this.  That’s ok with me.  I’ve always found these times to be good for upgrading your portfolio.  Stocks that have done poorly over the past year probably won’t go down much in a correction (after all, they didn’t go up), while strong-performing stocks can be hurt badly as nervous investors “lock in” profits.  So you may be able to switch to better companies at a 10%-20% cheaper price than you would have been able to last week.  The fewer investors doing this, the better bargains for those who are.