The Oil Supply Constriction Is Fast Approaching
Shortly I'll be off to Victoria Station, the train to Gatwick, and a welcome flight home to Pittsburgh. However, there is an accelerating development I need to tell you about before getting on the plane.
As you know, last month, the Paris-based International Energy Agency (IEA) and the U.S. government announced they were releasing 60 million barrels of crude oil into the international market, 30 million of which coming from the U.S. Strategic Petroleum Reserve (SPR).
I said at the time that this would only make matters worse (“Releasing the Strategic Petroleum Reserve Will Make Volatility Surge,” June 24, 2011). The market has already confirmed my conclusion.
The move hit an unprepared market while I was in Athens on the first leg of this five-week trip. And from the outset, neither the rationale provided by Paris nor Washington rang true.
Less Than A Day's Worth of Oil
To begin with, this was never a significant move.
The volume they released represents only about 16 hours worth of global demand.
And when all was said and done, neither the IEA in Paris or the Obama administration in D.C. could find actual customers for the full complement.
Traders have easily incorporated the additional volume into their calculations. The West Texas Intermediate (WTI) price in New York is again approaching $100 a barrel, while Brent here in London is now testing $120 a barrel.
In short, any assertion that such a supply-side move was meant to assuage prices is unwarranted.
Plus, the IEA and Washington are now in the position of having to release continuous volume from strategic reserves, merely in reaction to what will be increasing prices, anyway. If this additional volume is not continuously injected into the market, the volatility will be even greater moving forward.
In other words, the price spike may be more intense because of the distortion caused by temporary reserve releases – worse than it they were not attempted at all.
It's much like painting oneself into a policy corner… without a way out.
I also noted in the June 24 Oil & Energy Investor that demand is increasing quicker than anticipated.
That means the market will completely absorb both the 500,000 barrels per day unilaterally added by the Saudis after the last OPEC meeting, and the 60 million added by the IEA/SPR move, before the end of this year.
It is important to point out that the primary demand increases worldwide are not coming from North America or western Europe – not, in other words, from the developed countries – but from regions where the IEA/SPR volume injection has limited initial short-term impact.
So if the intent was to arrest a price increase resulting from supply-demand considerations, this was not a particularly effective way to do it.
It over-saturates regions that don't need the volume and distorts the aggregate crude balance when considering those parts of the world where the demand is increasing. Several months are actually required to redress this cross-regional balance consideration.
Yet a significant dimension has emerged.
It surfaced almost immediately in target=”_blank” href=”http://oilandenergyinvestor.com/2011/06/the-greek-debt-crisis-and-the-price-of-oil/”>my Athens conversations directly after the announcement, became part of the market analysis I was doing in Mexico City for PEMEX, and was even introduced in what were essentially evaluations of shale gas potential during my stay in Morocco. And in my London meetings, the matter has taken a central position.
It comes down to this…
The IEA/SPR release was timed to address an issue before it occurs.
In response to a tirade of criticism, the IEA last Wednesday released a tersely worded defense of its action. It said it was not attempting to react to the current pricing environment, but to provide a response to market conditions.
The same justification is now moving through policy circles in Washington.
All of which translates into this…
A “Production Deficit Bubble”
I have been seeing indications of a constriction in oil supply forming as early as the end of this quarter (3Q/2011). It results from several factors colliding at the same time.
As demand increases quicker than expected, the market is still facing the results of a prolonged decline in forward drilling.
You see, for each month the price of crude oil declined from August 2008 through the first three quarters of 2009, followed by a sluggish level into 2010, we lost about two and a half months of forward drilling volume.
That translates into us being more than two years behind when the demand (and the pricing) began accelerating. That “production deficit bubble” moving through the system has now intensified the impact of that added demand.
Also, delays in major projects like the Kashagan Field off Kazakhstan (the largest find in the last 40 years) have reduced short-term supply projections.
We are hardly running out of oil…
But getting it to market for the remainder of the year may be a bit of an adventure.
The assumption that increasing volume from Iraqi fields could make up the difference is being reevaluated. The crude is certainly there, and the expected increases in production will be significant as a group of international majors ramp up extraction at already huge fields.
Unfortunately, the condition of infrastructure – processing and gathering facilities, pipelines, oil field services, water and associated gas injection systems, and the like – will limit the ability to bring significant new volume to market anytime soon.
The only way the combined IEA/SPR moves make any sense is as an attempt to deal with a market strain in advance of its onset. (The Washington decision also has a political element; but that it not a relevant matter in the case of the IEA.)
For us, this is a very useful “heads up.”
The investing environment for the next several months will be different from what we're used to.
Normally, the slowdown in car-driving at the end of the summer brings expectations of declining prices in North America. Not so this time around.
The market will be severely tested to provide sufficient supply, with spot shortages possible.
And that means additional opportunities to make some profits.