Brace yourselves for the next oil price shock
Looking at the oil supply & demand fundamentals, next year looks like an accident waiting to happen. If economic growth in emerging economies remains on track, and that is a big If, the next oil price shock will occur in 2012.
Dave Rosenberg recently put the odds of America going into recession in 2012 at 99%, but I doubt he had oil in mind when he said that. On the current path, oil is set to hit $150/barrel next summer. Take an economy in recession, add in oil prices well in excess of $100/barrel, and what do you get?
Let's briefly review the fundamentals. Here's the Energy Information Administration's current outlook (STEO, June 7 edition).
EIA projects that total world oil consumption will grow by 1.7 million barrels per day (bbl/d) in 2011, which is about 0.3 million bbl/d higher than last month's Outlook, primarily because of higher forecasts of consumption for electricity generation in China, Japan, and the Middle East.
Projected world consumption increases by 1.6 million bbl/d in 2012, unchanged from last month's Outlook. Projected supply from non-OPEC countries increases by an average of about 0.6 million bbl/d in 2011 and 0.5 million bbl/d in 2012.
EIA expects that the market will rely on both a drawdown of inventories and increases in production from both OPEC and non-OPEC countries to meet projected demand growth.
These daunting numbers—1.7 million barrels-per-day in 2011, 1.6 million barrels-per-day in 2012—portend a demand shock just like the one the world experienced in 2006-2007. The key phrase is a drawdown of inventories. This is precisely what happened prior to the oil shock of 2008. If you are forecasting that new oil demand will be met by depleting global stocks, you are already acknowledging that supply can not meet that demand. The EIA can't just come out and say that, of course.
If the mother of all oil price shocks is coming, the situation in Libya will loom larger with each passing month. Despite rumors to the contrary, the world has yet to replace the shut-in oil in Libya.
Source: Gregor's The Dark Side Of The OECD Oil Inventory Release
The EIA says this about Libya—
While OPEC crude oil production declines 0.4 million bbl/d in 2011 because of the disruption forecast to Libyan production, OPEC non-crude liquids production grows by 0.6 million bbl/d. EIA expects the world crude oil market will continue to tighten in 2012, with forecast OPEC crude oil production increasing by 0.7 million bbl/d and OPEC non-crude production growing by 0.4 million bbl/d.
This is typical government sleight-of-hand. OPEC crude oil production (on average) will be down 0.4 million bbl/d in 2011, and if it increases 0.7 bbl/d in 2012, our net gain is 0.3 million bbl/d in 2012, assuming the Libyan oil remains shut-in. Right now it looks like the production disruption will be protracted, despite NATO bombing runs. Non-crude liquids production refers to natural gas liquids. If you're lucky, you can get some "natural" gasoline from refining these liquids, but you won't get any middle distillates—diesel—at all. Gas liquids are used primarily in the petrochemicals industry.
Speaking of precious diesel fuel, the EIA's This Week In Petroleum had some scary things to say about China's demand for it in Chinese Oil Demand 101: The Role of Electricity.
It helps to remember that coal, rather than oil, accounts for a larger share of China's energy mix, in contrast with the United States and other mature, industrialized nations, which tend to be, primarily, oil economies... Past experience shows that even temporary shifts in the Chinese power generation mix from coal to oil can result in surprisingly large increments in apparent oil consumption.
Thus, in 2003-2004, Chinese oil demand spiked when electricity shortages occurred as the country lacked sufficient capacity to generate needed power. Faced with chronic brownouts and blackouts, or merely concerned with the potential for electricity shortfalls, many end-users turned to back-up generators, and ramped up their purchases of diesel to fuel them, or simply to keep as a precaution in the event that those oil-fired generators came in use.
Similar issues were at play in 2007-2008, when a growing wedge between market-based coal prices and state-regulated electricity prices made it uneconomical for some utilities to produce electricity, again resulting in shortages. In response, the state implemented new rates and pricing mechanisms in late 2008, which alleviated economic pressures to some extent. The economic downturn also helped mitigate shortages at the time...
Already middle distillates (diesel) account for the lion's share of Chinese oil demand (unlike the United States, where gasoline plays that role). One of the consequences of the expected uptick in Chinese oil demand for electricity generation this summer will be to further increase diesel's share of the Chinese demand barrel.
On a positive note, steep increases in Chinese refining capacity this year will boost China's capacity to produce these needed middle distillates domestically. In recent years, China has moved very close to Japan as the world's largest importer of Middle East crude oil. At the same time, as China's refining capacity has grown both larger and more complex, its ability to extract middle distillates from those relatively low-quality grades has substantially increased.
Never underestimate the role middle distillates play in driving crude oil prices. If diesel is in great demand, and clearly it will be given the Chinese scenarios laid out above, the "best" oil which provides the highest quantities of this product via the refining process is also in great demand. If there isn't enough of it to go around, prices spike. Ethanol substitutes for gasoline. At large scales—just about anything bigger than the gas tank of Willie Nelson's bus—nothing substitutes for diesel.
At the level of abstraction presented here, that's all you need to know. China's thirst for diesel fuel is unrelenting, and will easily overwhelm their ability to refine it from domestically produced crude. There were global diesel shortages in 2007-2008, and we are well on the way to having them again next year. The lost Libyan light sweet crude is "good" oil in the sense that you get lots of gasoline and diesel when you refine it.
Although I could bring a lot more supporting evidence to bear, all things being equal, a major oil price shock is coming in 2012. Just as in 2007-2008, the skyrocketing price will be driven by a demand shock and a supply situation incapable of meeting it. Unlike this latest "mini-shock" driven by the Libyan situation and speculation in the oil markets, the price shock to come will be the real deal.
What do you think? Leave a comment below.
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