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Crude Oil Prices Moving To Red Alert

Commodities / Crude Oil Jan 08, 2012 - 08:53 AM GMT

By: Andrew_McKillop

Commodities Best Financial Markets Analysis ArticlePeak oil is moving back fast as permitted dinner time talk - and office time action with futures and options. And the reasons are multiple, well known, but heavily discounted until now. Through late 2011, many times, the IEA's chief economist Fatih Birol has outlined how radically the IEA sees the oil price outlook, particularly the coming and fast intensifying trend of reserve depletion hitting onshore, mature, conventional oil production. Lost in the climate crisis talk however, the oil price message was often sidelined.


Birol's agency in November said this: "If fossil fuel (energy) infrastructure is not rapidly changed, the world will lose for ever the chance to avoid dangerous climate change", but the oil price punch line came later: even in semi recession, oil prices grew through 2011. Birol has many times sounded the IEA warning: oil prices increased through 2011, despite the European crisis, near-recession in the US, recession in Japan, and falling economic growth in China and India.

Oil price rises in 2010-2011 levered up the OECD's net annual oil import costs (after re-exports and refined product exports) by 30% to about $790 billion from around $625 billion in 2010. For year 2011, Brent grade oil import prices to the 3 largest world importer countries and regions - USA, Europe, China - averaged $111 a barrel.

Until late 2011, both the US EIA, IEA and most analysts were forecasting only low level price growth in 2012, but the bets are now off.

DEMAND DRIVEN PINCH ON SUPPLY SURPLUSES

Oil imports to the United States are expected to stagnate or decline over coming years because of new fuel efficiency standards for cars and trucks, and an increase in domestic oil and natural gas production, but oil import demand in Europe, and especially China and India will continue growing in a global supply-constrained environment. For this reason, joined by rising nearterm geopolitical threats to supply in the Middle East, both the EIA and IEA continue forecasting high oil prices - even very high oil prices.

Certainly for the last 2 years, since 2009, the IEA deliberately confuses the subject of limiting global average temperature rises to 2 degrees celsius by 2025 through cutting OECD fossil energy consumption enough to prevent CO2 levels rising above 450 ppm (0.045%) in the Earth's atmosphere - with the real issue of how to prevent oil prices hitting $150 a barrel by as soon as this year, 2012. We can expect it will rectify this in the near term, but the most extreme CO2-cutting goals would imply a cut in world oil demand by as much as 33%-50% by 2025, which could be taken as a proxy for the needed cut in demand to prevent oil prices spiraling upward due to weakening supply surpluses.

The IEA, more outspoken than the US EIA presents what it calls unfavourable scenarios able to bring $200 a barrel oil by as early as 2015-2017 - without any special geopolitical tensions or pressure. The IEA basically signals little respite for energy consumers in a context where oil supply constraint grows every year due to supply-demand constraints.

The OPEC link is clear: in November, the IEA repeated warnings of the "clear need" for more OPEC oil this year, and every year forward in its 5-year scenario to 2017. While the US EIA's end year forecasts for oil prices in 2012 range through a more than generous $49 to $192 a barrel, underlining the critical level of uncertainty that exists in oil price forecasting, both the IEA and EIA assume that year-average oil import prices will steadily rise. Goldman Sachs, since Sept 2011, forecasts a highly precise 2012 oil price target of $130 for Brent and $126.50 for WTI.

Current IEA price forecasts range from an unrealistically low $114 a barrel in 2015, to $212 in 2035, in current dollars. This implies 2015 prices well above $125, and 2035 prices in dollars of the day which could exceed $275 a barrel.

CAN WE KEEP PRICES DOWN ?

On the supply side, this switches the focus to global spending on energy infrastructures, and oil and gas E&P (exploration-production) in particular. For the IEA, a vast upsurge in oil E&P spending is presented as critical to heading off Climate Change Crisis, but the the real nearterm threat to the economy is oil prices spiraling up to $150 a barrel and staying there - even during low level or "contained" economic recession of the type operating in the US, Europe and Japan at this time.

Optimistic forecasts say global energy companies are expected to raise oil and gas E&P spending nearly 10% this year, according to Dahlman Rose & Co., which estimates that despite sluggish economic growth and concerns about European and US sovereign debt, spending will hit $595 billion in 2012.

This however includes all sectoral financing operations like M&As and debt restructuring, and the narrowly defined number for real physical spending in 2011 and 2012 will come in closer to $400 bn - which is only equal to oil and gas E&P spending in the most recent record year, of 2007.

IEA studies and reports, since July 2011, claim that for every $1 of energy sector investment in recent years, from high cost and hard-to-integrate renewables to oil, gas and coal, electric power and the now flagging low-profile nuclear industry, this must be raised to $4.30 by 2017. This is a 330 % increase, with an implied or hoped-for target in global oil and gas E&P spending of at least $1.6 trillion-a-year, but the chances of this massive boost in energy sector spending happening are nearly zero.

The downturn in oil and gas spending since 2007 was partly due to recession, but was also driven by a large rise in green energy "vanity tech" investment and spending, reaching its most recent peak of about $300 - $350 bn in year 2010, according to Bloomberg New Energy Finance. To be sure this is tapering down quite fast now, but the potential for oil and gas sector spending levering up to $1.6 trillion-a-year by or before 2017 is so low we don't even have to think about it.

The implication for oil prices is easy. World conventional, onshore, mature oilfield reserves and production capacity is falling, at dangerously high rates, probably around 3.3 - 4 Mbd lost each year: without deep and sharp, global scale economic recession we can only have Oil Shock defined as prices rising to previously unknown high levels. When we have sustained Oil Shock of that type we will likely also have global economic recession - or inflation: the closed loop is so simple that average political deciders can understand what is threatened, and we can expect action !

ADD THE GEOPOLITICAL PREMIUM

Probable action may simply focus increased "quantitative easing", printing fiat money to compensate rising oil prices - making oil prices grow even faster. However, the geopolitical risk premium, already as high as $10 on each barrel today, in the opinion of many analysts, is capable of mightily rising. Far more than any other basic commodity, with few and small scale exceptions oil remains "The Prize" of oil crisis book writers, like Daniel Yergin and others.

For the potential, and threatened oil shocks of the near term future, we can be certain that Arab Spring revolts, the Iran nuclear crisis, threats to Putin's power, and ever rising Chinese and Indian oil demand can or will play a major role in advancing the arrival of an economic event horizon. This can be set with a simple question that has complex answers: The economy has to absorb higher oil prices - but how will this happen ? Not having too many answers question shifts us back to heroic-type supply side responses and actions.

With the possible but unsure exception of Libya's regime change in 2011, military action to ensure oil supply security and push down prices has been a long story of failure, but this does not prevent the military option happening again. The major problem in the present context is time: net surplus oil production capacity has continually fallen for as long as 7 - 10 years, according to the IEA and other sources, and is now set to significantly accelerate. This makes it high risk to operate regime change military adventure in major oil exporter countries, if only due to loss of export capacity during the hostilities, certainly further raising world oil prices in that interval.

This then re-shifts the focus to non-oil energy production, and oil-saving initiatives and programs in the major oil consuming, oil intensive economies, which is likely the "hidden agenda" of the IEA's climate crisis and green energy quest or crusade in recent years. Here we find a direct relation with oil prices - green energy development without heavy and permanent government subsidies needs much higher oil prices to give these high cost alternatives economic elbow room. Green energy delivers high priced energy, so if we want green energy, we must accept higher price energy - which hurts the economy.

For many reasons however, including economic and geopolitical relations with oil exporters, political deciders in consumer countries will not openly engage and commit to raising oil prices, due to this being a green flag for oil exporters to seek higher prices. Likewise, oil saving programs operated either through raising oil prices, or only on a voluntary basis, have usually failed and caused economic damage in a global economy context where fear of limiting economic growth still remains stronger than the fear of high oil prices.

The bottom line at this time is that oil prices can easily rise to new "exotic" levels this year. This will cause initial stretching of the Brent/WTI premium, due to Middle East conflict and the Iran oil embargo hurting Europe a lot more than the US, followed by a later and large shrink of the premium, even to almost nothing. The potential "target price" for both grades may be as high as $150 per barrel, with the time needed to reach these price levels being able to be short, under worst case scenarios.

By Andrew McKillop

Contact: xtran9@gmail.com

Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

© 2012 Copyright Andrew McKillop - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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