Three Factors Create Oil’s “New Normal”
As you read this, I am delivering a keynote address to the annual Shell Oil Global Technical Conference in San Antonio, Texas. The audience is comprised of field specialists from around the world.
Shell has asked me to update this esteemed audience on the current state of the market.
One thing I have learned from almost four decades of doing this is that oil and gas specialists know a great deal about what they do personally for a living. However, few specialists really understand enough about what the person to their right or left of them does.
The business breeds tunnel vision. And these days it has become a serious problem. That’s because what is already hitting the market will require more expansive and integrative understandings of what is taking place.
The Markets are Evolving
We are entering a period in the energy markets that I have begun calling the “New Normal.”
You see, a volatile, dynamically changing combination of factors now undermines the traditional way of viewing oil and gas markets.
And it is about to get a whole lot more unnerving for the average analyst still insistent on pushing square pegs into round holes.
Markets require that we be able to project where things will likely move at some point in the near future. After all, the inability to make such predications pretty well describes any investment strategy – be it for an international oil major or an individual retail investor.
Unfortunately, for the old school aficionado, we are rapidly moving into new territory. Here, market machinations are occurring that defy the “traditional” explanations.
You know what I mean by “traditional.” The talking heads on television try to explain the latest spurt or dive in oil prices by relying on the same trite and tired lineage of explanations. In just the last month, we’ve seen movements in energy prices justified solely on the following factors:
- A supply glut in Cushing, Okla.;
- Fluctuations in the euro-dollar exchange rate;
- The European credit crunch;
- The latest unemployment figures;
- Manufacturing, housing, or production figures.
But it really doesn’t work this way anymore. While such factors are not completely irrelevant, they are also not calling the shots.
There are several factors contributing to this New Normal, but I will be restricting my comments in the speech this morning to three.
Now, I want to share the same three factors with you.
- The balance between conventional and unconventional production;
- Increased market volatility; and
- Global geopolitical matters.
So let’s get started.
Unconventional Production on the Rise
The rise of shale and tight gas and oil, coal bed methane, heavy oil, bitumen, and synthetic (upgraded) volume from oil sands has fundamentally changed the production landscape.
But it has also fundamentally altered the dynamics upon which pricing is determined.
Initially, most of us assumed that these unconventional sources would serve to restrain price, as more supply came online to meet rising global demand.
The reality, however, appears to be that this new largess is becoming more expensive to produce, transport, and process, while the distribution of the shale, sandstone, or in situ hydrocarbons are rendering basin projections less reliable.
There is more available, but the cost of production and the price commanded on the market are creating short-term aberrations with attendant risks and opportunities.
One thing it has done is temper the Peak Oil approach. It is certainly appropriate that I am going to make that observation before a Shell audience assembled in San Antonio. Over 50 years ago in an address here in this city of the Alamo, Shell scientist M.K. Hubbert kicked off the movement with one of the most famous presentations in the history of petroleum analysis.
Today, it is not availability, but where it is available and at what price that is making all the difference. The balance between conventional and unconventional, therefore, is making an impact but hardly all in the same direction.
Volatility with a Capital “V”
The second factor – volatility – is no stranger to regular readers of OEI.
This is not simply quick rises or falls in price, although these are the clearest impressions left. The Oil VIX is supposed to register volatility, and a “traditionally normal” market would expect that the OIL VIX would rise (as risk rises) in parallel with a fall in oil prices.
That often no longer happens.
The volatility now experienced is occurring within the average range of VIX figures. Stated simply, our new volatility is providing cycles occurring more rapidly than the session averages provided by the VIX. The traditional way of expressing what volatility means in the oil and gas markets no longer helps us in compensating for changes in investment patterns.
Such volatility also translates into how futures contracts on oil and gas determine current market prices. It used to be that, as we moved closer to the expiration of a futures contract – as the convergence between the paper barrel (the futures contract) and the wet barrel (the actual consignment of crude or natural gas) approaches, the two would merge into the same underlying price.
Often, that would make it necessary to buy on one side or the other to produce the desired equivalence. But such arbitrage was easily done, and the market was better off because of it.
As I indicated in my last book (The Vega Factor: Oil Volatility and the Next Global Crisis), this is not usually a result of speculators or manipulations by companies, distributors, or mega investment funds.
Rather, the inability to connect the future contract with the actual price of the oil or gas results from problems within the trading system itself. This volatility has produced the rise of a whole new generation of derivatives, itself a clear sign that the market is not coping with rapid change.
Global Tensions Heat Up Oil Prices
Third is the geopolitical factor.
Now international events have always had an impact on oil prices. The current climate, on the other hand, has given the factor new urgency.
It is the reason I have been spending much time lately dealing with the Iranian crisis and the prospects of Iraqi production. Flash points in the region upon which the global market still depends for the brunt of its conventional oil are weighing heavily on our ability to estimate supply and price.
Most observers still regard these considerations as exceptions to some general textbook rule of market practice.
Sorry, this is not the case.
As I indicated last week when writing from my briefings in London, the closer one gets to the crisis centers, the more analysts recognize the longer-term implications of the geopolitical.
None of these new factors is going anywhere anytime soon. They are central parts of the New Normal.
Investors should become used to dealing with them.