Oil on the boil, again Sunday, July 05, 2009 By David Horg The main driver of fuel retail prices is the price of crude oil.
This was traditionally driven by the physical balance of supply and demand. But nowadays, there are 16 financial trades for every barrel burnt. So the crude price is now determined by financial players. Some are legitimate hedgers, like Aer Lingus, but most are speculators affected by geopolitical factors. With the collapse of confidence in the dollar, oil is seen as a ‘hard dollar’ - a store of value and inflation hedge.
The euro price of crude oil is driven by the dollar exchange rate. This troughed at $1.20 to the euro in winter 2005, peaked at $1.60 last summer and is now $1.40.Other costs include transport, refiners’ margin, the retailer’s cut and taxes. Tanker rates are at six-year lows: transport costs fell from $4 last summer to $1 per barrel today. Refiners were actually losing $1.30 at the beginning of 2009, but now earn €14.30 per barrel.
Fuel retailers’ margins are thin. Garages are limited to one-storey, so many sites were sold for alternative development during the boom. Most survive by the sale of high-margin snacks.
Irish excise duty is 52 cent on petrol and 48 cent on diesel. But the 22 per cent Vat is levied on the total, so is a tax on a tax. The Green Party wants to increase carbon taxes, so the tax take of excise and Vat increased by 10 cent per litre of petrol last September, followed by 5 cent per litre of diesel in the mini-budget. Fear of border arbitrage limits the scope for further increases until the British government imposes higher taxes.
Does the stronger oil price reflect fundamentals?
No. A tight market in 2003/4 sparked an upward trend, which attracted speculators. This commodities bubble tipped the world into recession.
The bubble burst in 2008, and the oil price collapsed.
Opec failed to halt the panic at $60 per barrel but succeeded by drastic cuts at $40.Thisworked because nonOpec supply is flat. The Saudis took 75 per cent of the cuts and will soon have 4.5 million barrels idle. The Saudis also hardened payment terms, effectively increasing their price by $3.
Many thought such cuts were impossible without hitting associated gas for power generation - but the Saudis had reduced their power -generating dependence on such gas.
The Saudi objective was stability in the $40s, leading to a long-run average of $75,which seemed compatible with world growth. Instead, the demonstration of a price floor at $40 drew speculative money back.
Past efforts to maintain the Opec cartel resulted in cheating. But bullish exporters like Venezuela and Iran suffer production decline because of harsh fiscal terms and political uncertainty.
What should the oil price be?
On fundamentals, the price should be around $50.Demand has fallen for three quarters - a decline of 3.5 per cent globally, the worst correction since the 1980s.The fall is higher in industrialised countries, but balanced by growth in China, India and the Middle East. Tanker rates show demand for the marginal barrel, and they are at six-year lows.
Opec’s disciplined 3.7 million barrels supply cut is impressive, but means there is an overhang of six million barrels of surplus capacity.
This should remove much of the risk Premium over troubled exporters like Nigeria and Iraq.
The longer-run price should average over $80.World economic recovery will restore trend demand growth of about 2 per cent yearly. Renewables like biofuels are subsidised but pose little economic threat as long as oil stays below $80. Unconventional oil and gas need similar prices to pay their way. Onshore heavy oil began as a loss-leader but there are now 11 million barrels of profitable heavy oil production.
What to do about speculation?
The US regulator (CFTC) asserts efficient market theory, being ideologically opposed to interfering with markets.
A 2005 Nymex study argued that speculators reduce price volatility and exert no net effect on average price. But this ignores the role of hype in how markets really work: long only investors only buy - they don’t liquidate positions like hedge funds studied by Nymex.
This debate was settled decades ago over the stock market, food and drugs - so why not futures?
Financial crises have shown the need to monitor and regulate futures markets. Initially there was German political criticism of hedge fund activity, then more thoughtful market analysis, and finally the US Congress.
The core problem is that speculators (who are acceptable counterparties) could bet with as little as 2 per cent cash. They should report positions fully and put up 20 per cent in cash.
Isn’t oil running out?
We know that hydrocarbons are finite and that oil can only be burnt once. But the oil supply curve is more elastic than peak oil theorists maintain.
The world as a whole does not peak and decline like individual fields: we face a long undulating plateau in supply as technology and oil price squeeze more oil out of reservoirs.
There are ample geological reserves but extracting hydrocarbons is complicated by resource nationalism.
The stalemate over developing Iraq shows the problem: 80 per cent of conventional reserves are held by national oil companies that are not agile or efficient.
Resource nationalism limits access: Arabia, Mexico and Iraq (so far) are closed - except for services. Economic returns are low and title problematic from Russia to Libya - this jeopardises potential oil recovery, as poor practices often result.
Unconventional developments are capital-intensive and long-term: investors need stability and incentives to justify development. Without title and sufficient return, it’s hard to justify research and development.
What should producers do?
Exporters like Iraq should logically seek to maximise their own returns. They should not care if contractors earn exceptional profits, as long as the return to Iraq is maximised. They are better paying Shell exorbitant fees to extract 50 per cent of a reservoir’s oil than recover only 30 per cent themselves.
Markets work best when interests are aligned. But resentment over past abuses heightens suspicion, which becomes part of culture. Nationalists focus on minimising the size of the slice, rather than maximising the size of the cake.
The challenge is persuading the oil exporters, from Iran to Venezuela, to achieve their maximum potential by embracing the best skills and technology available. Oil combines money, science, politics - and sometimes blood.
David Horgan is chief executive of Petrel Resources.
|
Text-Only