RIYADH, Saudi Arabia (ResourceInvestor.com) -- The growing disconnect between oil as priced on futures markets and fundamental supply-demand conditions in the crude market has been a prominent and pervasive theme at the in Riyadh this week.
Oil, gold and the commodities markets are now undergoing changes akin to those that have changed the structure of markets across a range of financial products. A relatively long period of economic growth and stability, globalization, easy monetary policies, the ongoing evolution and growth of derivative products and the huge strides made in computing and telecommunications technology and infrastructure in the past decade or two all factor into the rapidly changing situation OPEC member states and all oil industry participants find themselves facing.
Financial markets and flows - now essentially a digital information industry - are evolving much faster than industries and markets do with the production and trade in real goods and physical products such as oil, as well as outpacing regulatory regimes and capabilities. Political, economic and oil industry conditions, or at least the perception of them, has lead to a situation where the tail is now wagging, and in nominal monetary terms is larger than the dog. RI was fortunate to be able to tap into the knowledge and experience of one senior OPEC Summit delegate to gain some insight into this and related issues.
An Insider's View
Growing speculative and investment flows into oil and other commodity markets by non-commercial industry outsiders is by now a well-established trend, and it has affected price and volatility levels, according to one senior OPEC delegate.
"We have seen record long positions in the market the past year or so - the futures market is now four to five times the size of the physical market - and this magnifies the effects in these markets of events such as extreme weather, geopolitical tensions, fluctuations in reserve levels and what have you. ...Ten to 15 years ago the possibility of a hurricane or geopolitical tensions affecting oil supplies did not cause the volatility - $3 to $4 intraday price movements - that we see today."
The markets for oil futures contracts, which serve as base references for all oil trading, are out of producers' or industry control, according to OPEC. "Five or six investment banks and hedge funds are primarily responsible for magnifying the negative effects of developments and causing a disconnect between oil prices and fundamental supply and demand conditions," the delegate maintained.
Oil stocks, for instance, are above their medium and long-term averages as is forward days' cover and are not as low as the market seems to perceive. "OPEC's spare capacity is running at 4.5 million barrels per day and member countries are investing some $120 billion to increase production capacity 15%, from 34.5 or 35 to 40 million barrels per day by 2012. ...The outlook for supply is positive."
Moreover, the recent sharp run-up in prices and increasing volatility is short-sighted and not in OPEC's best interests, according to this delegate. "We don't stand to benefit from this," he asserted.
He pointed out that oil demand is inelastic only to a certain degree, at which point continuing price increases lead to lower demand and accelerated investments in alternative energy sources.
"We're not against alternatives, but we are calling for caution and considered studies of sustainability. ...The rush to invest may lead to developing alternatives that prove to be unsustainable...
"We have to learn from history. High prices of the late '70s and early '80s lead to demand destruction and the oil crash of 1986. ...With cheap oil, demand went up dramatically at that lead to a 3 million barrel per day (bpd) capacity increase in one year."
OPEC accounts for some 36% of global oil production at the moment. The organization now faces the difficult and daunting challenge of deciphering all the market signals and considering them in light of member countries' and the oil industries' overall exploration and production capacities and forecasts of increasing energy demand to determine what it considers an equilibrium price - and then a yet more daunting challenge of finding some means of influencing price levels along in that direction.
"High prices are not good; low prices are not good. We need to establish a moderate price level. What is the correct price today? I don't know; I have no idea, but industry needs to be able to invest in new capacity to meet future energy needs," the delegate stated.
As surprising as it may sound, particularly to U.S. ears, OPEC has a limited toolkit and ability to influence price levels, particularly given recent market and industry changes. OPEC doesn't participate in any of the oil futures or options markets, even to hedge future production, for instance. "We believe they add a lot of volatility to the market and we are not in favour of that. We need a stable market with predictable outcomes in which we can invest."
Fast rising production and refinery construction costs, as well as shortages of equipment and skilled personnel, are also troubling OPEC and oil producers generally. Hedge funds and other large non-commercial investment funds taking large speculative positions are contributing to the industry's rapidly rising exploration and production cost bases, as well as the build-up of inflationary pressures, the delegate commented.
"Commodity prices have gone up across the board, as has the price of building refineries. Five years ago, it cost around $4.5 billion to build a 500,000 bpd refinery; today it costs around $16 billion. ...And whereas it $8 billion to $10 billion to bring 1 million barrels per day on to the market, it now costs around $15 billion," he noted.
Financial flows into commodities markets across the board, and into oil futures in particular, in the wake of the U.S. subprime mortgage market crisis marked the turning point and start of a divergence between 2007 and 2006 price trends, according to this OPEC delegate. "The price of oil from the beginning of the year up until September matched 2006's price trend when 2007 prices diverged to where we see it today."
Rising uncertainty is acting as a drag on real direct investment that is needed to meet forecast increases in global energy demand. "Increased uncertainty creates disincentives to investment, as illustrated by international oil companies cancelling plans to build refineries in the U.S. in the wake of new biofuel investment incentives," the delegate pointed out.
"Our outlook is for 49 million barrel per day production into 2030; if you add significantly to uncertainty - growing use of alternative energy, inflows from the financial markets - it is adding uncertainty something on the order of 5 to 10 million barrels - in monetary terms from $400 to $700 billion, or $300 billion of uncertainty. ...This is especially important considering our countries have huge development needs dependent on an industry with very long lead times and return on investment terms."
Environmental and climate change concern and awareness is also rising in the Gulf and OPEC member states, and this is also likely to have a growing influence on oil industry investment decisions. "There is approximately 18 million bpd of oil traffic passing through the Gulf and it is exerting pressure on the ecosystem. ...The decision to increase capacity investments might not be popular with the population and government"
Another source of concern for OPEC is the ongoing depreciation of the U.S. dollar. "The thing that is worrisome about the lower dollar is that not only does it lower the value of our current revenues but lowers the value of earnings amassed from previous years...and this is a growing cause of concern given the fast-growing populations and huge development and economic diversification needs of OPEC member states."
Also causing OPEC members consternation is a political situation in the U.S. in which OPEC serves as an always-convenient scapegoat, illustrated according to the delegate by actions such as Congress effectively blocking efforts to open up ecologically sensitive federal lands that hold promising oil prospects while supporting a NOPEC bill that gives U.S. citizens the right to sue OPEC for conspiring to raise oil prices, "a bill that actually runs against the UN charter according to which we operate."
So what is OPEC focusing on in light of a fundamentally changing operating and financial environment? "We continue to do our work to manage the market, and we are trying to understand the effect of hedge funds and how they work. ...We will continue to try to achieve the goals we have set for ourselves: a consistent supply of oil for consumers at prices conducive to economic growth with reasonable returns for people investing in our industry," he concluded.