Global Oil Markets:
Crude Thoughts

from stratfor.com

Summary

Crude oil prices dropped sharply May 18. Oil's impressive run during the past 30 months could finally be coming to an end.

Analysis

NYMEX crude oil prices fell sharply May 18 to $47.90, marking an overall decline of some 20 percent since early April. Considering that the factors that have been bolstering prices for the past two years are running out of steam, such a development is not particularly surprising.

Oil prices are currently high for three main reasons.

First, no meaningful supply cushion exists, since all global producers are producing to their maximum capacity. While Saudi Arabia insists it still possesses some spare capacity, it is pumping more than it ever has before. Should it actually have more to pump, any excess capacity would be limited in both amount and reliability.

Second, in 2004, the global economy experienced its fastest growth in 20 years, and there is no indication that this growth is slowing appreciably. Faster growth and higher energy demand go hand in hand. China in particular massively increased the amount of crude it used last year by nearly 1 million barrels per day (bpd).

Third, terror and/or Iraq premiums are built into current prices. These premiums reflect the fear that something might go horribly wrong, such as the destruction of a supertanker or a major loading platform. These concerns inflate prices anywhere from $5 per barrel to $15 barrel depending on whom you ask.

But these factors are beginning to erode, and others look decidedly bearish.

For one, global commercial reserves of crude oil are at five-year highs. In the United States, commercial reserves are 8 percent above the five-year average -- their highest level in six years. And the bigger the stockpile, the lower the price tends to go. (A May 18 report that U.S. crude stocks increased by 4.3 million barrels the week of May 8 apparently triggered the May 18 sell-off. Such stock builds occur regularly each spring.)

In addition to increased commercial reserves, the U.S. Strategic Petroleum Reserve is also nearly full. At the current fill rate, it should reach its 700 million barrel capacity sometime in early August. While its fill rate of only about 110,000 bpd means that it will not add a meaningful amount of crude to the market, the idea that the United States has a fully stocked emergency reserve should cause anyone betting on short-term price increases to pause.

Lackluster European economic growth -- and therefore energy demand -- also suggests that oil prices could fall. Germany recently emerged from recession, only for Italy to drop into recession. Add in efforts to comply with Kyoto Protocol guidelines on carbon emissions, and the short- and long-term picture for Europe is for less oil demand.

While demand can be expected to drop in Europe, many also expect decreased demand out of China. Actually, this constitutes a misunderstanding among traders. Demand is not dropping in China -- the rate of increase is slowing. China will consume more crude in 2005 than it did in 2004 -- probably about 6.8 million bpd compared to 6.4 million bpd -- but the pace at which its energy demand is increasing is slowing, which has apparently dampened expectations.

Al Qaeda's diminished global activity is another factor bolstering the case for a drop in demand. More than a year after the Madrid attacks, al Qaeda has failed to launch a strategic attack anywhere in the world, and its influence within Saudi Arabia continues to wane. Aside from attacks in Iraq, which largely target domestic supplies (as opposed to exports), not one notable attack against any energy infrastructure anywhere in the Middle East or the West or Asia has occurred. Thus, major players could be starting to dial back their fear of terrorism.

In contrast to al Qaeda's inactivity, the Saudis have been very busy recently. To this end, they have begun serious efforts to increase crude oil production, and plan to add 2.0 million bpd of new capacity by 2010. (The desert kingdom has not increased its overall capacity -- as opposed to output -- since the 1970s.) Thus, more production is on the way, even if it is only in the long term.

Finally, the dollar has been gradually strengthening versus both the yen and the euro all year. Since oil contracts are all carried out in dollars, oil producers previously would use their dollar-based income to invest in non-dollar assets to protect their cash against a falling dollar. This created a reinforcing cycle that drove the dollar's value lower and the price of crude oil higher. This cycle may now be breaking, which would establish an opposite cycle -- one that would push the dollar higher and oil prices lower.

None of the foregoing actually means that crude oil will go down. The recent decline undoubtedly results in part from seasonal factors: crude demand tends to dip in the spring and autumn when electricity demands are lower and no one is driving to Yellowstone for the family vacation. It also is probably dropping because much of the speculative hype that has supercharged the markets of late is dying down. Stratfor simply notes that there are plenty of reasons not to expect crude prices to remain so strong.

While gyrations in the crude markets represent the norm, Stratfor does not anticipate any lasting changes in crude prices until there is a major shift in demand or supply patterns. For example, a collapse in Chinese demand would send prices lower, while the near-complete tapping of all easily reached crude reserves outside the Organization of the Petroleum Exporting Countries states would send them higher. Stratfor expects to see the former occur well before the latter.

Whenever the world's most traded commodity goes through prices shifts, it has an effect on political processes. This should not come as much of a surprise, given that with crude around $50 a barrel every day, more than $4 billion moves around the world explicitly for the purchase of oil. Tinker with the amount and direction of that flow, and various players begin to see their world very differently.

Such tinkering will affect different countries at different rates. The simplest means of figuring who will need to scramble, and when, is to compare a particular country's currency reserves and oil export revenues to the size of its total economy.

Reserves (in green in the graph) indicate what sort of cushion oil exporters have should prices weaken, while exports (in blue) indicate how much countries depend on revenues for their overall economic well-being. In general, it is much better to have a lot of green and just a little blue. Unsurprisingly, Malaysia -- Asia's largest exporter of crude -- is in the best shape, since its economy is heavily diversified away from crude. Meanwhile, Saudi Arabia -- a chunk of desert with little going for it besides crude -- has reasons to lose sleep.

This, of course, is only a rule of thumb that must be viewed through the lens of specific national characteristics. Mexico, for example, may not be dependent upon crude in national terms, but oil revenues form the backbone of the state budget, making any fluctuations in price disproportionately affect state stability.

Thus, were Stratfor planning on driving to Yellowstone this summer, we would expect an easier time at the gas pumps. But even the best-laid road trips often go astray, particularly when practicing an art as inscrutable as oil forecasting.