What's Behind the Oil Spike to $107 (and Counting…) by Kent Moors Ph.D. | published April 1st, 2011 Crude oil prices continue to rise, increasing significantly to close yesterday at $106.62 a barrel for West Texas Intermediate (WTI) futures in New York and $117.36 a barrel for Brent in London. Already this morning, WTI hit a new two-and-a-half-year high of $107.83.

The latest rise is not a result of new geopolitical developments – although they do continue to weigh on the market.

Nor is it a result of any short-term inventory problems in either the U.S. or western Europe. In fact, available supply of both crude oil and finished products continues to run considerably above five-year averages. American stockpiles are now at multi-year highs.

This spike is our introduction to a very quickly changing oil sector… one in which demand is coming from new quarters, and concerns are increasing over sufficient balance among regions.

It has been some time since the OECD (Organization for Economic Cooperation and Development) countries – essentially Europe, North America, Australia, Korea, and Japan – have actually controlled this market. Demand now comes from developing, not developed, economies.

And that is prompting a new oil dynamic.

What occurs on a day-to-day basis in the U.S. – still the largest end-user market in the world – has a declining impact on price. This affects both crude oil and finished products such as gasoline, diesel, high-end kerosene (jet fuel), and low-sulfur heating oil.

There is an important point to remember from all of this.

The Global Oil Market Is An Integrated One Regardless of how much surplus inventory may exist in an individual national economy, prices for gasoline (or diesel or heating oil or jet fuel) are still fundamentally driven by what occurs elsewhere.

Neither "Drill, baby, drill" nor "Fortress America" will have the impact their proponents anticipate. In fact, the idea that domestic crude can reduce gasoline prices is fundamentally incorrect.

Domestic crude is considerably more expensive to extract than oil exported from elsewhere. And since the cost of crude is the single largest component in the cost of refining, having the source closer to home does not translate into less expensive refined products.

Now, if this is a national security argument, pricing considerations take a secondary seat.

Security deals with having supply under control; it does not address price.

If Americans were to accept paying more at the pump (and we are talking way more here – well over $5 a gallon, as we will see in a moment) as a necessary cost of weaning ourselves from Middle East sourcing, then the solution would be simple.

Unfortunately, it is the pricing side that captures the attention.

And if we are concerned with the price of oil and gasoline, diesel, etc., with the net impact of rising oil prices on the U.S. economy and recovery, of jobs, tax base, and industrial infrastructure at risk, then importing from abroad becomes the cheaper option.

The security/pricing tradeoff is both the most all-encompassing and the most politically misused element in the entire energy debate.

Yet it does bring the real issue into focus.

Domestic Production Is Unrealistic Each one-dollar rise in the price of a barrel of crude oil translates, on average, into a 2.5-cent increase at the pump for a gallon of regular gasoline, and closer to a 3.2-cent increase for a gallon of diesel.

Let me put what this means for American domestic production into perspective.

During the second week of July 2008, when oil prices hit $147.27 a barrel, with gasoline nationwide on average over $4.20 and diesel over $4.60 per gallon, there were more than 360,000 capped wells in west Texas holding, in aggregate, millions of barrels of crude oil.

But even at with oil at $147.27, it was too expensive to open them up. These are "stripper wells," the source of over 60% of the crude pumped daily in the U.S. Each well provides less than 10 barrels of oil a day but upwards to 200 barrels of water.

And that disproportionately increases the cost of extraction.

At the time, I estimated it would take a price of $183 a barrel to make these wells profitable enough to allow an oil flow. That $35.73 price difference (between the actual $147.27 and the required $183) would have catapulted gasoline prices to an average of $5.09 and diesel to $5.74 per gallon. And that was almost three years ago.

It is little wonder, then, that we are experiencing a rise in imported gasoline and other oil products into the U.S. It is becoming cheaper to refine them abroad.

This is the real reason we will not see new refineries built in the American market.

The actual barriers to new refineries are not environmental regulations or NIMBY (not in my back yard) sentiment. Rather – even forgetting about the billions in expense involved – it would take about a decade to bring a new refinery on-line from scratch. Well before that period expires, the more cost-effective approach is simply to import what additional oil product is needed.

So the current spike in oil prices is not an aberration. It is not because of events in Libya, or Syria or Bahrain or Egypt. It results from the built-in pricing problems of the market itself.

This will guarantee higher oil product prices, supported by a number of the other elements we have been discussing here over the past 15 months.

As another presidential election cycle begins, you need to keep this in mind. Political rhetoric aside, the gasoline pricing issue and the cost of crude are not a result of Democrats, Republicans, Independents, Vegetarians, Reformed Druids, or any other political party or movement. They come from the oil market itself.

We will continue to bounce from crisis to crisis until we recognize this fact… and begin the genuine, difficult, exasperating, long, and incredibly expensive process of moving from a crude-based economy to a more balanced energy model.

Sincerely,

Kent


Can the Saudis Deliver the Oil the World Needs? by Kent Moors Ph.D. | published February 25th, 2011
As decades-long autocratic rule unravels in the Middle East, volatility in the global oil markets continues to point toward one overriding concern… oil.

Almost two-thirds of the world's known conventional oil supplies are located in the region. How can we maintain an oil flow balance in the face of the rising uncertainty?

Most analysts reduce it to a supply equation. If a certain amount of normal deliveries is suddenly withdrawn from the market – say, for example, the 1.6 million barrels a day produced by Libya – what is the remedy?

We look for other readily available sources to pick up the slack.

That's why, while Brent prices are still increasing in London – once again approaching $113 a barrel – the rate of that increase is beginning to level off. Meanwhile, West Texas Intermediate crude (the benchmark for settlement on the NYMEX) could be down as much as $1 when the New York market opens this morning.

The Saudis have agreed to replace the volume from Libya lost to the market – actually, lost to Europe, since 80% of Libyan exports move there. Saudi Aramco, the state-owned national oil company, has pledged to move 700,000 barrels into the export flow immediately.

And, with the Saudis, "immediately" does mean just about what the word says.

With roughly 2.5 million barrels per day excess capacity of physically available supply, that can be done in a matter of hours from Saudi fields… translating into a few days or so, when you factor in the transit time required.

Of course, that's only a momentary respite. We still face the question of sustainability in a longer-term crisis…

And that may be just what we are looking at here.

With Libya Oil Clogged, We Need A Reliable Surplus As of this morning, about 80% of the Libyan supply is off-line. Forces opposed to strongman Colonel Muammar Gaddafi are now in control of some pivotal export terminals and port facilities.

Libya is descending into a civil war. That is the next stage in this unraveling – a new dimension guaranteed to prolong the crisis period and provide numerous opportunities for the effect to ignite other countries. Already, we are looking with concern on developments in neighboring Algeria.

Saudi oil cannot quell the disturbances in the streets. But at least it can calm down global oil trade.

…Or can it?

Saudi Oil Minister Ali al-Naimi has said repeatedly over the past two years that Saudi Arabia has an upward capacity of 12+ million barrels a day it can move into the market… and it could do so for the next 88 years.

His comment this week – that OPEC would also meet shortages as they appear – is reassuring but not particularly significant. Other OPEC members are regularly selling volumes in excess of their monthly quotas. The apparent surplus available there is on paper only.

When it comes to any reliable surplus of crude, Saudi Arabia is it.

Russia and Canada Aren't Up to the Task There are possible non-OPEC sources, too. But they are problematic.

Russia, for example, is now the usual world leader in monthly exports, having displaced the Saudis last year. And the Canadian oil sands provide prospects for additional volume in the longer term.

Yet Russia is facing a rapid maturing of its traditional fields, and significant capex would be required to keep current volume from declining. There may be some marginal help from the Russians… but not to the extent we may need if an entire region becomes unsettled.

As for Canada, the time element gravitates against a solution. The logistics simply are not there to crank up production rapidly; nor, for that matter, is there a transport network to move the oil where it needs to go. The crisis is erupting much faster than an oil sands solution can be put in place.

So it seems we are back to relying on Saudi Arabia.

Is Saudi Oil Enough? Now, I am overlooking the Armageddon scenario in all of this.

Should the unrest imperil (or even close) transit through the Straits of Hormuz – the primary oil chokepoint in the world – the globe would descend into a mega economic contraction in short order. (On any given day, about 25% of the world's oil supply passes through the Straits. That includes all of the Saudi supply that cannot be moved by pipeline across the country to Jeddah on the Red Sea.)

But let's say that does not happen and the increased supply is available from Saudi. Is it enough?

Pumping upwards of 12 million barrels a day from Saudi fields is likely to do some serious damage to the reservoirs. And quickly.

Avoiding for the moment the question raised by the late Matt Simmons and others (including myself) as to whether the Aramco resource and field reserve figures are even accurate, the oil market needs assurance that flows are sustainable to avoid rapidly increasing prices.

Personally, what has disturbed me, on each of my visits to Aramco and its fields, is the use of secondary recovery techniques at the very start of field activity.

Put simply, Aramco is injecting water into wells almost as soon as they are open. That always means at least two things:

1. Field engineers have immediate pressure problems, and
2. The water flooding will damage the integrity of the deposit and lower overall production.

Putting maximum stress on the production network will only intensify this problem.

But there are two other even more pressing concerns right now…

Higher Refinery Costs, Soaring Demand First, the Libyan exports are light sweet (low sulfur) crude. The Saudi (or OPEC, or Russian) is sour crude (with high sulfur content). It is more expensive to refine and process into products like gasoline, diesel, heating oil, and jet fuel.

So even if the volume concerns are met, the Saudi solution will still mean rising prices for the end user.

But the major problem remains the most basic. Assumptions about increasing Aramco flow to meet production declines elsewhere rally means that we have only about three million extra barrels a day available.

Libya, in full-blow conflict, takes up more than half that amount.

And that excess capacity figure was calculated last year, based on global demand rates. Those rates are now increasing faster than expected.

OPEC itself quietly raised its worldwide demand estimate three times in 2010 – the first time that has ever happened.

By 2012, soaring international requirements for oil may effectively reduce the Saudi surplus to about two million barrels a day. That reduces the effective Saudi surplus after Libyan replacement to about 400,000 barrels a day.

Period.

Oil traders make pricing determinations based on forward-looking perceptions, rather than current availability. If demand continues to rise (and it almost certainly will) and Libyan supply remains interrupted, we would need a single new hotspot to emerge in an already troubled Middle East to exhaust the Saudi solution.

Saudi Arabia just may not have enough oil to go around.

Sincerely,
Kent


The Crisis Unfolding in the Middle East (and What I Won't Be Telling FOX Tomorrow…) by Kent Moors Ph.D.
published February 22nd, 2011 I'll be on the air again tomorrow afternoon, shortly after 2 p.m. Eastern, talking to Brian Sullivan of FOX Business Network. Brian wants my views on events in the Mideast and the continuing surge in oil prices.

But I thought I would fill you in first on what I plan to tell him… and what I won't tell him about how investors should play triple-digit oil.

The Risk Factor Is Taking Center Stage We are now looking at the prospect of significant and sustained instability in the region of the world that's home to two-thirds of the known crude oil reserves.

It has already sent shivers through the international energy sector, and the problems are likely to be getting worse.

Brent crude prices in London are closing in on $110; there is no reason to suspect they will retreat anytime soon. Meanwhile, in the U.S., the March futures contract for West Texas Intermediate (WTI) – the benchmark for New York traded futures – closes today, and the April contract is already $97 at market open this morning (it breached $98 overnight). Both Brent and WTI opened today at two-and-a-half year highs.

The futures contract curve reveals that traders do not regard this as a short-term problem.

We have an escalating and contango market – one in which each month further out has a higher price than earlier months. In addition to the uncertainty spiking prices, traders will have to unwind shorts immediately. The market holiday yesterday will make that an even more essential move today. They were betting on the crude oil price declining, and they were absolutely wrong.

If ever there were doubts that exogenous (outside of the market) forces could dictate trade, the current events will push them aside. The volatility will now kick in big-time… and that will further unnerve the trading environment.

A Protracted – and Violent – Struggle Is Underway Tunisia and Egypt were disconcerting. But the events in Cairo may end up being the exception to the rule.

The unrest in Bahrain and Libya is far more dangerous. The unraveling of autocratic rule in the Middle East and North Africa (MENA) will not be a peaceful event.

With Libya, we have a major source – and one of the last sources – of light, sweet (low-sulfur) crude. This is most prized by refiners because it requires the least processing expense. There is one other source. Unfortunately, that happens to be Nigeria – a place not particularly known for its stability either.

Libya is descending into civil war; the foreign oil companies have stopped activities and have begun pulling out most of their personnel. As of 9 a.m. this morning, 6% of production in the country is offline… and that number is growing.

Europe is directly in the path of this interruption, since it is the end user for about 80% of all Libyan exports.

The bodies in the streets of Tripoli and Benghazi are a harbinger of what is to come. Unlike the army in Egypt, which served as a restraining influence, the army in both Tripoli and Bahrain is a weapon against the crowds and a virtual guarantee of further bloodshed. Neither Gaddafi nor the ruling family in Bahrain will be leaving voluntarily.

And that means a protracted struggle is underway.

In Bahrain, however, something perhaps far worse is on the horizon…

The Perfect Storm That Everybody Wanted to Avoid In Bahrain, there is oil, but there is also the incendiary religious division – a Sunni minority ruling class against a majority of Shiites. Combine that with the acute economic problems experienced by average people throughout the region, and frustration is leading to rage.

Bahrain is also located, strategically speaking, in the worst place for such an uprising.

Yes, the U.S. bases its Fifth Fleet there, and that has been a primary ingredient in American Persian Gulf policy. If the fleet needs to leave, that will provide another ingredient in rising regional instability.

However, the real problem is this.

Bahrain is a 665-square-kilometer archipelago directly across the water from Iran and connected to Saudi Arabia by a causeway. Tehran has almost certainly started to provide support to a Shiite uprising; but the Saudis will do everything they can to prevent one.

This is because Bahrain connects directly to the eastern province in Saudi Arabia that contains its principal oil production. That province also has a Shiite majority. When Ayatollah Khomeini led the Shiite revolution in Iran back in 1979, the Saudis had to use the military to put down a revolution in its own province. This time around, Riyadh will not wait for that to happen.

The concern over contagion – the spread of unrest throughout the region – is certainly genuine.

That means the volatility prompted in futures oil prices will be figured into the unfolding dynamic for some time.

Now for what I will not be telling the anchor on FOX Business tomorrow afternoon…

How to Play Triple-Digit Oil There are three overarching considerations here, and we are seeing these moves already this morning.

First, the primary hit will be taken by those oil majors with exposure to the region and the impact the region's events are having on the broader oil market.

The big boys will survive, but they will have to counterbalance developments in places like Libya with production from other areas. That will take some time.

Watch the well-focused medium and smaller-sized companies, especially North American operations. They will be the primary beneficiaries.

Second, this will generate at least a short-term impetus for the transition from crude oil to natural gas. Expect primary natural gas producers to experience a pop. The

longer the crisis remains, the more the transition between these fuels will gather steam.

This should also be the case with high-grade coal holdings and alternative energy. However, there are other factors at work in both sectors. In the first instance, there's

the unwinding of the global coal picture, with Australian volume slowly coming back online after severe flooding; and in the second, there's the length of time needed to

move significant renewable and alternative energy capacity into those sectors where rising crude oil prices would dictate a switch.

Yes, this is another reminder that ultimately means a move away from crude as the energy source of choice. But crises demand more immediate solutions; they rarely

allow for a period of R&D.

Finally, at these prices, all sources of unconventional and synthetic oil become attractive, especially if they are not in the region coming unglued.

For North America, that means Canadian oil sands and American or Canadian oil shale are back on the front burner. As the MENA sourcing for conventional crude

becomes a rising issue, these alternatives already producing closer to home are a ready substitute.

It used to be a problem of price. But at triple-digit levels for crude on both sides of the Atlantic, that is no longer an issue.

Sincerely,

Kent