Andreoli on Oil and Fuel: Oil and fuel developments to watch in 2012

When it comes to the oil and fuel markets, it’s been quite a year. On the supply side, the biggest story was the Middle East and North Africa (MENA) region uprising epitomized by the Libyan revolt that led to the death of Muammar Gadaffi and the shuttering of 1.6 million barrels of daily oil production.

Looking forward, it’s possible that much of the lost production will be brought back online in 2012, but it will take time for the infrastructure to be rebuilt and for reservoir pressures to be re-established. Furthermore, there is a chance that some reservoirs were permanently damaged—so only time will tell whether or not Libyan production will reach pre-revolution levels before the end of the year. Doing so will certainly require political stability, and the re-emergence of conflict in Egypt highlights just how tenuous such stability can be.

Perhaps the second biggest supply side story came from the world’s third largest oil producing country, the U.S., where the deployment of new extraction technologies (hydraulic fracturing) has permitted the extraction of previously inaccessible shale oil in the Bakken and elsewhere and reversed decades of declining oil production. While shale oil production is not going to win the country energy independence, it’s positively impacting oil production rates and prices in the Midwest.

This brings us to the biggest price story of 2011—the divergence of the world’s two most prominent benchmark crude oil streams: West Texas Intermediate (WTI) and Brent Blend. Because these two crude streams are very similar in composition (both are relatively light and sweet), the market has historically priced the two streams within just a couple of dollars of one another.

Geographically speaking, however, these two streams are quite literally an ocean apart. The delivery point for WTI is Cushing, Okla., and the delivery point for Brent Blend is the Sullom Voe Terminal located in the Shetland Islands in the North Sea.

Whereas Libyan oil is primarily shipped to, refined, and consumed in Europe, Bakken oil is primarily refined in the Midwest U.S. As a consequence, when Libyan oil production fell to zero, the European market tightened, and the price for Brent Blend, the European benchmark crude, increased.

Meanwhile, oil from the Bakken (North Dakota) and Canadian oil sands flooded refineries in the Midwest U.S.—which were and are still operating at nearly full capacity. As a consequence, the price differential increased from just two dollars in October 2010 to more than $28 in October 2011, though it has since dropped to the $10 to $12 range.

Such large price differentials provide a strong incentive for physical arbitrage in which “surplus” crude which has been accumulating in Cushing is shipped to Europe. In order to do this efficiently, the pipelines that are currently configured to flow from the Gulf of Mexico to Cushing must be reversed, and this is exactly what pipeline owner, Enbridge, has announced that it plans to do some time in the first half of 2012.

When this happens, the WTI-Brent spread should narrow, with WTI rising and Brent falling. This, in turn, causes U.S. refiners’ average acquisition costs to increase, and these costs will inevitably be passed along to consumers.

The second big price story of 2011 was the divergence in the retail price of gasoline and diesel. Between 1992 and June 2006, the spread averaged 1.2 cents per gallon. The spread jumped, however, when ultra-low-sulfur diesel regulations were introduced in June 2006.

At this point, many refineries had yet to put in place capacity to remove sulfur, and since they were no longer allowed by law to sell medium and high sulfur distillates to U.S. retailers, diesel exports quickly rose to 20 percent of refinery output. Rising exports caused the U.S. diesel market to tighten significantly and the price for diesel began to diverge from the price of gasoline.

The U.S. is now exporting 22 percent of domestically produced diesel. Foreign consumers are increasingly outcompeting U.S. consumers.

Foreign competition and rising diesel exports explain why diesel prices remain stubbornly high, but do little to explain why gasoline prices have been falling. In large part the answer to this riddle is found in rising production of corn-based ethanol, which can be blended with gasoline, but not with diesel. Over the last ten years, ethanol production has grown at a compound annual rate of 26 percent. Currently, ethanol production amounts to 823,000 barrels per day or roughly 9 percent of refinery output of gasoline.

As a consequence of rising diesel exports and ethanol production, the diesel-gasoline spread reached an estimated $0.67 per gallon in December 2011. The monthly spread has only been higher twice before (the last two months of 2008), and there is little reason to believe that the forces underlying this gap will change significantly in 2012.

The year ahead
I’m fond of saying that while hindsight may be 20/20, foresight is rarely better than 50/50, and I urge you to take any and all oil/fuel forecasts with a grain of salt. But as Louie Pasteur said, “luck favors the prepared,” and being prepared requires the evaluation of likely scenarios.

The most important determinant of oil and fuel prices is spare oil production capacity. Historically, when spare production capacity is declining rapidly or when it dips below 1.5 percent of total world liquid fuels production, both prices and price volatility rise significantly. Consequently, forecasting spare production capacity is the single most important metric for evaluating future oil price scenarios.

Unless the world economy remains in the dumps or oil producers significantly outperform expectations, oil markets are likely to tighten and prices are likely to remain high and volatile. Here in the U.S., oil prices will likely be pushed upward as the physical arbitrage pulls the WTI price up towards the Brent Blend price, and diesel prices are likely to remain high one way or the other because U.S. and foreign demand are likely to remain strong.

Of course, Libyan production may climb to as much as a million or more barrels per day, but such gains are tenuous as are oil exports from elsewhere in the MENA region. Of particular interest and concern are the mounting tensions between Iran and the West, which have continued to escalate as a consequence of Iran’s nuclear weapons program. The West is seriously considering imposing oil sanctions as a punitive measure, and in turn, Iran has threatened to block the Strait of Hormuz—an act which would cut off much of the exports from Iraq, Kuwait, the UAE, and Saudi Arabia.

Needless to say, an extended closure of the Hormuz would result in skyrocketing prices, possible military intervention, and potentially a global recession.

But Iran’s problems are not purely external. Ahmadinejad’s gaze is anxiously fixed on their ally, Syria, to see how the rebellion against the Assad regime unfolds. The conflict in Syria is the Arab Spring knocking on Iran’s door. Should the protestors force out Assad, oppressed Iranians may find the courage to follow suit. Iran currently exports 2.6 million barrels of oil per day, and the loss of Iranian exports would cause spare capacity to fall to 1.5%. 

Between Iran and Syria lies Iraq, a country that could prove to be either a white or black swan in 2012. On the one hand, Iraq has incredible potential. With the adequate investment, production could feasibly increase by 350,000 to 500,000 barrels per day by the end of 2012, and climb to over 5 million barrels per day by the end of the decade. On the other hand, tensions between Kurds in Northern Iraq and Baghdad to the South are frothing, and oil lies at the center of the dispute.

To date, the Iraqi central government has not passed a hydrocarbons law to govern the distribution of oil revenues, but this has not stopped Iraqi Kurds in the North from signing roughly 40 oil contracts with foreign energy firms on a production-sharing basis. Personally, I find it more difficult to imagine a diplomatic solution to this disagreement than a situation in which internal conflict greatly reduces Iraq’s oil output potential, but only time will tell.

Like Iraq, Russia could prove to be a black swan in 2012. Russia is the world’s leading oil exporter, but the country has been somewhat destabilized by popular revolt against a political system which has been accused of corruption, and an electoral process which has been accused of being rigged. If instability causes exports to decline, spare capacity would quickly evaporate to dramatic effect.

In short, 2012 looks to be as interesting if not more interesting than 2011. Supply chain managers will likely be challenged by high and volatile fuel prices, and competitive advantage will be bestowed on those that minimize their exposure to fuel price volatility.