Recent trends in oil markets
Concerns that US sanctions on Iran would lead to supply shortages drove a surge in oil prices. From mid-August to early October, the price of Brent went up 25%, from USD 68 to USD 86. Once the concerns subsided, the price dropped 17%, to USD 75, within a month – its steepest decline in more than a year. Developments on the global fuel markets were no less interesting. In early September, the ARA (Amsterdam, Rotterdam, Antwerp) market saw quite an unexpected turn: while diesel oil prices were climbing fast reflecting the surge in crude prices, gasoline prices began to fall so that, after a month, they were below those of diesel oil. This unusual relationship between gasoline and diesel oil prices may continue for some time, irrespective of how crude prices will be trending.
Let us first take a look at crude prices, though. On November 4th, the worldwide import ban on Iranian oil came into effect, and the next day the world learnt that several countries (PRC, India, Italy, Greece, Japan, South Korea, Taiwan, and Turkey) had been granted a six-month exemption. The market must have digested these developments earlier, as oil prices remained largely flat although they were at their lowest in more than a year. Or is this another lull before the storm?
In order to gain a better insight into why oil prices are no longer expected to rise, we must first dissect their macroeconomic environment. Next, we will try to foresee how it might change over the next few quarters.
Risk of a slowdown in global demand for crude oil and liquid fuels Demand for oil has so far held up strong. It will have increased by 1.6 mbd by the end of this year and is forecast to keep rising over the next two years by 1.5 mbd annually. These figures factor in the expected growth attributable to the new International Maritime Organization (IMO) regulations. Without this driver demand would be weaker, due mainly to the risk of an economic downturn outside the US. The ongoing US–China trade war, tensions in Turkey and Saudi Arabia, and increased risks in the European Union (as Italy is facing a budget crisis and no breakthrough has been achieved in the Brexit negotiations) are worsening the outlook for emerging economies and the euro area. The condition of emerging economies has a strong impact on demand for crude oil and liquid fuels, while risks in the eurozone translate into an appreciation of the US dollar, driving up crude and fuel prices in currencies other than USD. High oil prices are, in turn, a factor constraining demand. Many international organisations, including OPEC, have been revising downward their oil and fuel demand projections. The results of the US November mid-term elections are already known, but it remains to be seen how they will affect the US foreign policy under Trump’s administration. Will tensions between the US and China mount or ease off?
Global oil output has surpassed expectations The strongest growth was recorded in the US, with Saudi Arabia, the UAE, and Russia also seeing a notable rise. According to IHSM, in August the US produced over 11 mbd of crude oil, 1.5% more than expected. With a 1.3 mbd increase in oil output relative to December 2017, the US has already become the world’s largest oil producer and has significant potential for stepping up production over the coming years. Since most US oilfields are not connected to a pipeline network, the producers’ capacity to effectively transport shale oil from the heartland to seaports is severely reduced by resultant bottlenecks, which is why most US crude has to be processed domestically, with only surplus fuels, mainly gasoline, being exported. Relevant infrastructure is expected to improve in the second half of 2019. Saudi Arabia and the United Arab Emirates are the two OPEC members that have also ramped up production. However, if they keep increasing output without capacity enhancement, their spare capacities – a safety cushion for the global oil market – will become even tighter. Currently, they are estimated at less than 2 mbd, a level already considered dangerously low, and their further decline could breed concerns over the countries’ ability to maintain current supply levels, exerting upward pressure on oil prices. Production has also been increased in Russia, but keeping this trend up would require investment in new fields, just as in the case of Saudi Arabia. Another country which has raised output levels is Nigeria, from where PKN ORLEN has recently sourced some oil. However, it is rather uncertain whether Nigeria will be able to sustain production at the current levels.
Iranian oil exports are likely to have shrunk less than was expected, but experts point out that only Iran knows how much it has actually exported. At any rate, the zero-exports scenario does not seem plausible. More likely, Iran’s oil export revenue in USD will be reduced to zero, severely constraining its access to the US currency. The countries exempted from the import ban, e.g. India, could open an escrow account into which they would make payments for Iranian crude. The credit of such account could be used by Iran to purchase a limited range of goods and services in India, such as food, medicines and other humanitarian supplies.
Given a considerable degree of uncertainty as to how these factors could develop over the next few quarters, crude prices tend to respond sharply to any piece of news that emerges. October forecasts reflect a general consensus that the price of oil will rise by the end of this year, but diverge widely on how far up they will go. Also, it cannot be ruled out that OPEC will resort to production cuts if oil prices continue at the current low levels for a longer period of time. After all, Saudi Arabia has declared that oil prices in the region of USD 80 per barrel do not pose a risk to long-term demand.
The projections already account for the effects of the regulations adopted by IMO to reduce maritime transport-related sulfur emissions from the current 3.5% to 0.5% as of March 2020. In practice, they will generate an increase in demand for middle distillates, i.e. diesel oil, from maritime carriers, which will have to compete for its supplies with road transport operators. There is little doubt that a spike in diesel oil prices is in the offing. According to experts though, demand for diesel oil cannot be met solely by increasing refineries’ distillate yields. Throughput will also need to be raised, boosting demand for crude oil, particularly its heavier grades, yielding more middle distillates. As a result, prices of heavy crudes will go up, relative to those of lighter grades, such as the American shale oil.
Although overall oil supply volumes match demand levels, there is a structural undersupply of heavy grades. This can be explained by prevalent geopolitical risks, as a result of which upstream projects are now being undertaken almost exclusively in North America, a region which primarily produces light and ultra-light oil. Elsewhere, upstream projects are more capital-intensive, with oil plays located in politically unstable geographies and time to first oil reaching 3–5 years. What is more, financial institutions are becoming less and less interested in conventional exploration and production projects, as they have investment options which are more appealing in the long term. And if no new upstream investments are made, output from producing fields keeps steadily declining. The current rate of this decline is close to 3 mbd, which is how much new oil needs to be discovered to maintain global production rates. Meanwhile, to meet the growing demand for crude oil and liquid fuels, production must be stepped up. On the other hand, in the US – where unconventional shale oil exploration and production technologies are commonplace – upstream projects are run according to an entirely different set of rules. Oil is explored for and produced by more than ten thousand small, independent businesses, as a consequence of which the costs of a single project are much below those of conventional production. Time to first oil is also very short, from 3 to 6 months, with 80% of recoverable reserves extracted within the first two years of production, which means that forward contracts can be used to hedge future profits. Also important is the absence of geopolitical risk, the same as in Canada. No wonder then that most global upstream investments are concentrated in North America, with the US accounting for the largest growth in oil supply. Its production is estimated to rise by a total of 1.5 mbd in 2018, i.e. at a rate matching this year’s growth in global demand. Canada ranks second, with oil output growth of approximately 300,000 bd. A similar rate of growth has been recorded by Saudi Arabia, although it cannot be attributed to investment projects, but rather to the Kingdom’s policy in spare capacity management.
Insufficient levels of CAPEX on upstream projects outside North America pose a serious risk to incremental supply in 3–5 years, corresponding to the average time to first production from conventional fields. This may have an adverse impact on the prices of gasoline, the excess supply of which is set to keep growing.
American shale oil already poses a problem, being a very light, sweet grade that yields almost twice as much light distillates, such as gasoline and jet fuel (approximately 60%), as Brent crude (approximately 33%). Meanwhile, global demand for crude is driven by demand for diesel oil, as the latter fuels economic growth, while gasoline is in excess supply globally. American refineries, dating back to an era when nobody came even close to envisaging a shale oil revolution, were designed to process heavier grades from South America. They only agree to buy light shale oil at a huge discount. The risk of excess light oil supply convinced the US government to lift its oil export ban. Initially, after the export policy was liberalised, there were some logistical challenges in delivering oil from mainland fields to seaports, as US pipelines were dedicated to fuel exports. At present, with an astonishingly rapid inflow of shale oil investment and production growth, oil exports from the Permian Basin have also been hindered by logistical barriers. Oil that could not be delivered to sea tankers had to be sold to local refineries, which only agreed to purchase it at a discount of approximately USD 20 per barrel in relation to the WTI price, that is USD 30 per barrel in relation to the Brent price. Until the end of August, a part of excess gasoline on the market was consumed domestically in the US, but once the driving season was over, large volumes were exported across the Atlantic, exerting downward pressure on gasoline prices in the ARA market.
So what lies ahead? Oil prices should be highly volatile in the coming quarters. On the one hand, demand for oil may be bolstered by the new IMO regulations, but on the other hand it may slow down in the wake of a global economic downswing and high crude prices. In the long term, oil prices will be affected by insufficient upstream investments outside the US. For these reasons, regardless of crude price fluctuations, gasoline is set to remain cheaper than diesel oil for as long as the logistical challenges which are hindering shale oil exports from North America are not overcome.