Engineering News

Politics of Oil Rises to a New Level with Oil Release
July 6, 2011

On June 23rd, the International Energy Agency (IEA) called an emergency press conference to announce that its 28 member countries, in a coordinated action, will release 60 million barrels of crude oil from their respective strategic reserves during the month of July. Under the arrangement, the U.S. will release 30 million barrels while the remaining 27 countries collectively will offer up an equal amount. The volume of crude to be put onto the market equates to 2 million barrels per day (b/d), or about 2% of global demand. The action is being done in response to the "emergency" situation that has developed as a result of the loss of the 1.4 million b/d of oil exports from Libya due to the civil war underway in the country and the 300-400,000 b/d lost from Yemen due to its recent civil disturbances.

The immediate reaction to the announcement was roughly a $4 per barrel drop in crude oil futures prices from the mid-$90s a barrel to the low-$90s. When the announcement was made that an emergency press conference was being called, analysts, investors and energy economists began scratching their heads trying to figure out what exactly was going on. The most popular explanation was that the IEA decision reflected a decision by governments to counter faltering global economies due to high oil prices and the inability of global monetary authorities to boost economic activity through other stimulus steps. This was an especially popular conclusion given that U.S. Federal Reserve Chairman Ben Bernanke had told reporters in a press conference the prior afternoon that the Federal Reserve had no idea why the economy was slowing and that the agency would sit tight and not implement another "quantitative easing" program. Instead, he said that stimulus actions needed to come from the fiscal authorities, e.g., governments.

The questionable emergency is becoming more questionable daily as analysts examine the past experience with coordinated oil releases and they look deeper into the current oil supply/demand balances. In the United States, current crude oil inventories, excluding the oil stored in the Strategic Petroleum Reserve (SPR), are at the highest level they have been since 1980. The high level of inventories is largely a function of increased U.S. oil production, the growth in oil imports from Canada, principally due to its expanded oil sands output, and infrastructure limitations that restrict the movement of this inventory from the midcontinent region to the refineries located along the Gulf Coast.

Exhibit 12. Oil Supplies Are Healthy

Source: EIA

In the IEA's May oil report, which was based on data through March, total oil stocks in the OECD countries had declined into the mid-point of the 2006-2010 range. The IEA's estimated outlook for 2011, based on the continuation of the output cut from Libya and rising demand consistent with a global economic recovery, projects a steady decline in oil stocks through the balance of the year. According to the chart, in June total stocks would fall below the bottom of the recent past range of inventories suggesting that global oil prices would rise to ration the oil supply. With the additional output cut from Yemen, the projected inventory decline could accelerate, however, as the global economic recovery is fading rapidly there would be an offsetting reduction in energy demand.

Exhibit 13. Global Oil Stocks Falling Absent Libya

Source: IEA

While the total OECD oil stock inventory appears to be reasonably comfortable as of March, the story within two of the three primary markets – the U.S. and Europe – is significantly different. As mentioned above, U.S. inventories are the highest they have been since 1980. In Europe, however, inventories are at five year lows. The lack of Libyan and Yemeni oil output, coupled with falling production in the North Sea, is putting increased upward pressure on petroleum product prices in Europe, which are already very high.

Exhibit 14. Europe Oil Inventories At Lows And Falling

Source: IEA

While the IEA's outlook may be behind its push for the release of oil stocks, another important consideration is that the lost Libyan oil supply is light in quality and therefore extremely important for the refineries in Europe. Those refineries are configured to refine the lighter oil and cannot use the heavier, sour crude oil Saudi Arabia has said it will add to the global supply to help offset the lost Libyan output. This is a reason why the IEA's coordinated oil release will be primarily light, sweet crudes that can be refined by European and U.S. refineries that should boost the supply of gasoline and diesel, which will help reduce those product prices.

Exhibit 15. U.S. Divided Into Oil Districts For Control

Source EIA

It is this particular crude oil supply release in the U.S. that is creating more questions about the impact it will have on oil and product prices beyond the very immediate term. The U.S. established a system of monitoring oil supplies during World War II. Due to the history of where oil was discovered in quantity and thus became the center of the domestic industry, refineries were located nearby. This has put the U.S. refining center in the Gulf Coast states that comprise PADD 3. This region is also where the U.S. SPR is located so any oil released will be targeted at buyers operating refineries there. According to Platts, more than 50% of the nation's refining capacity is located in PADD 3.

Exhibit 16. Half U.S. Refining Capacity In Gulf Coast

Source: Platts, EIA

When we examine the EIA's data on crude oil stocks in PADD 3, however, we find that inventories are nearly at a recent high suggesting the refineries are not desperate for additional oil supply. This may mean that when the EIA seeks bids for the released oil, there may not be many takers. The last time there was a release from the SPR following Hurricane Katrina when many of the Gulf Coast refineries were put out of service and then could not secure domestic oil supply due to the damage to offshore pipelines and producing facilities, only 37% of the estimated volume was taken. That could happen in this situation, also. Since the released oil has to be replaced by the buyers, we are essentially borrowing supply that will then boost demand in the future. The decision buyers will need to make is what price they have to pay for the oil, what profit margin they can make from refining and selling it, and what price they will be able to buy the replacement oil. As this is written, oil futures are just a couple of pennies under $92 a barrel. They have subsequently jumped back up to the mid $90s. If we assume that later this summer oil prices move above $95, will the incremental cost to replace the SPR oil be offset by profits from refining and marketing the output? We are now hearing that some SPR oil buyers may merely store the oil on tankers parked in U.S. ports for redelivery later when the futures trades the buyers have entered into are settled. All that has happened is that some oil traders are locking in profits and not helping the market.

Exhibit 17. Gulf Coast Oil Supply Very Healthy

Source: EIA

Another interesting issue about the PADD 3 situation is that the refineries there are largely geared for lighter crude oil supplies, which is what will be released from the SPR. But an interesting comment from a webinar held by Platts was that oil output from the Eagle Ford formation in South Texas was at about 100,000 b/d and growing. Projections are that Eagle Ford output will reach and possibly exceed 200,000 b/d by year-end. This oil is particularly light with an API rating of 42 to 60 degrees with an estimated distillate yield of 39%. According to Platts, some of this oil may be too light for Gulf Coast refineries, even though Valero (VLO-NYSE) is using about 40,000 b/d at one of its Gulf Coast refineries and Koch Energy is buying some oil for its Corpus Christi refinery. Speculation is, however, that Eagle Ford oil may be the first oil to be exported from the United States since the late 1990s.

At the end of the day, it seems that the IEA's coordinated oil release is addressing a growing problem in Europe due to the loss of Libyan oil output and the slow ramp up of additional oil supply from Saudi Arabia. Additionally, the oil to be released will immediately address the need for additional light, sweet crude oil for use in European refineries and to help boost gasoline and diesel supplies helping to hold down or actually reduce oil prices. The problem is that this oil release may only have a marginal impact on industry dynamics (much of that impact may have already occurred) in the near term and add further challenges on the supply and demand situation longer term. The biggest damage may be that governments (led by the U.S.) are becoming more involved in the oil market, much like they did in the 1970s. That adventure was not successful, but for politicians and government bureaucrats with little knowledge of history and how the oil industry works, their willingness to get involved in a free market will create unintended consequences. As the history of the 1970s governmental involvement in the oil business demonstrated, the unintended consequences led to greater involvement and regulation of prices and profits – not an attractive outlook, but a scenario we can envision happening again.

Source: Parks Paton Hoepft & Brown

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