Decoding oil price a complex puzzle

By Deborah Yedlin, Calgary HeraldFebruary 14, 2009


Despite evidence that the Organization of Petroleum Exporting Countries has been complying with the stated production cuts, the benchmark West Texas price for oil continues to languish under $40 US per barrel. Of course, it doesn't help that U.S. crude oil inventory numbers released last week showed a build of 7.2 million barrels, when analysts had expected something around 2.9 million barrels, or that there are more signs of slowing global economic growth--and therefore slowing oil consumption.

All this, however, doesn't surprise Philip Verleger, the David Mitchell/EnCana professor of management at the Haskayne School of Business who is suggesting demand is set to fall further.

Verleger sees global oil demand dropping to about 80 mil-lion barrels a day, which would put the world back to 2003 in terms of consumption, before the dramatic increase in Chinese demand.

What's even more interesting is that Goldman Sachs recently came out with a research piece that said non-OPEC producers will have to join the production-cutting party in order for oil prices to strengthen.
- But with not enough money being spent in 2009 to stem the decline rates, let alone find new reserves to offset declines or production, non-OPEC production is going to decline in 2009--no matter what.
- Adding to Goldman's perspective is Bank of America Securities-Merrill Lynch, which predicts that without investment, the non-OPEC production could decline from 50 million barrels a day to about 47 million barrels in the next five years.

The puzzle here is that the OPEC cuts, coupled with falling demand, is creating a situation of excess capacity, which could result in oil prices staying in the $40 range until the impact of the lack of investment is felt. The question is how long will it take.

Oil prices are continuing to sit in a situation economists call "contango."What this means is that today's price is lower than what the future's curve is showing. The consequence of oil prices sitting in contango is that companies will hang on to their barrels as long as possible to take advantage of higher prices, assuming there is sufficient storage. Not only does this put a premium on storage, it says there is money to be made playing the spread. In current terms, the spread is about $9 per barrel, implying a healthy 20 per cent return for anyone wanting to play that game.

"Contango tells you the market is loose; there is not enough demand and too much supply," said Martin King of FirstEnergy Capital Corp.

While there is evidence--especially in overseas markets--that the floating storage is disappearing, Verleger is convinced a number of factors will conspire to keep demand lower than it has been in the last five years, which means prices are going to stay in the $35 to $40 range. He points to the current recession as being one of the reasons demand will stay soft.

"Two years of negative growth in global GDP will decrease energy demand," he said. He also believes the regulatory changes from both the economic and environmental standpoints will also depress demand.


But not everyone agrees with the analysis. Xavier Denis, economist and strategist with the French bank, Societe Generale in Paris, believes there is a supply/demand imbalance. Aside from the current state of affairs, Denis points out that fields are effectively declining at a faster rate than demand, which means when demand does start to recover there won't be enough supply. And this points to higher prices.

Certainly, when statistics such as the numbers showing China's car sales in January exceeding those in the U. S. on an annualized basis, it's clear that the growth in energy consumption is not going to come from North America.

The one possible bright spot in terms of where a price recovery might begin lies with light, sweet, crude.

That's because of proposed environmental regulations limiting the sulphur content in the fuel used for ships.

Verleger's analysis suggests implementing these rules could effectively block the processing of roughly 25 per cent of oil supply. It doesn't take much to realize that if one quarter of supply is shuttered because of environmental regulations, oil prices will rise, with the light stuff leading the recovery.

As to the oilsands? Despite the Alberta government touting the province's oilsands as the key to U.S. energy supply, Verleger, as do others, subscribes to the view that unless oil prices stage a sustainable recovery --or there are big subsidies thrown at the industry to encourage more production-- it's unlikely the number of barrels coming from that resource will rise in any meaningful measure. His view was supported by a recent report from the Canadian Energy Institute warning investment in the oilsands could reach its lowest levels in a decade--matching what was spent when oil was below$20 US per barrel.

Having said that, there was a time not that long ago when energy companies did make money with oil prices in the $20 range, not to mention making big bets on investment in the sector. But that was also a time when credit markets were healthy.

There are a couple of ways to look at the current oil price. Either $40 per barrel is the new$20 of five years ago, or it is a signal of the excess capacity being built in the market as a result of production cuts and drops in demand around the world that will take a long time to work through and stymie new investment in the process.

People in the business who have been through this cycle before say this slump is different because it is the result of a confluence of so many variables at once, not the result of bad management practices. It's about the only thing that makes sense these days.