Post Edited (Forum Admin) : 5/29/2008 12:32:14 AM GMT

Dear Friend,

Yes the world today is different and it isn’t. The Asian Tiger, The Chinese Dragon awakening all occurred in the years immediately following the collapse in oil demand, the whole region became a new entrant. Their GDP boom didn’t stop the OECD from severely curtailing demand for petroleum and go on a massive infrastructure investment in alternative energy. We are saying the same is very likely to happen today. After all the Asia Pacific region is more mature and itself could do with alternatives.

Dear Jan - Isn't adaptation what human beings are best at, for better or for worst? Like you I remain optimistic that satisfactory solutions will be found.

Today “commercials” hold 827 million barrels of length (for sure almost the same in short positions but that’s not the point). In the early part of this decade they held between 300 and 400 million barrels only. World consumption hasn’t grown by 100% and “true” commercials that are classified as natural hedgers by the CFTC only hedge part of their production, never 100%, unless they are very small marginal producers whose finances are tied to hedging 100% of production (even that must have change in today’s environment). In fact big oil never hedges production at all. They only lock-in physical commitments with spreads which is their bread and butter since the time optionality associated with delivery has never been priced-in and is theirs for the taking.

So where are all these new 400 million barrels of “commercial” activity coming from? Well when an Investment bank option trader takes an order from one of its client like a “hedge fund”: “Buy me 40 million barrels Dec-09 OTM calls, will pay no more than 5%” the bank’s trader will make him a market (over time etc.) but then the bank’s delta hedging is now classified as a natural hedger and the option’s delta goes into the “commercial” classification. Now how do you disentangle between a physical hedging and a speculative hedging? The fact is that the bank’s hedging activity from its customer flow is not purely related to physical hedging. If it was then the open interest for commercials wouldn’t have changed so much.

Does that affect the price?

That’s an even more contentious issue. I am of the opinion that we’ve recently witnessed three types of hoarding of commodities:

1. Price hoarding from commodity index speculation. (Type 1)
2. Physical hoarding from some ETF contractual obligations. (Type 2)
3. Commodity exposure hoarding for lowering a portfolio’s correlation. (Type 3)

The first point above, Type 1, constantly adds volume on the buy side which forces higher price level regardless of the fundamentals of the underlying market. Yes for every buyer there is a seller but then why does price change? It changes because of tiny liquidity gaps where no seller can be found or not much volume is to be found on the sell side, forcing buyers to chase volume at higher price. Speculation is a natural phenomenon associated with open markets and it serves a valuable purpose. Today, however, the decision to enter the long side is mainly based on price momentum which feeds upon itself. That can and will disappear, however.

The second point, Type 2 is worrying because if you hoard physical commodities purely to satisfy contractual demand based on price then that commodity will not reach the markets in times of penury. After all there’s nothing like penury to send price higher so hoarding becomes even more attractive.

I'll explain the third point, Type 3. In 2006 I attended several workshops on ETFs. It became clear that portfolio managers only interest was on diversification through low to negative correlation. Price had no meaning. If a manager bought oil at $200 and its price fell to $100 the manager would keep on buying as long as it served its beta purpose.

Now if enough players enter a market to hoard for any of the three reasons above then we reach a stage where price gains momentum and sustains it purely on that buying decision. If we look at the price of oil, historically a price trend never lasted for more than 3 months. Now we've been in an uptrend for over 18 months and that trend keeps on accelerating. So hoarding type 2 and 3 kill the purpose of price acting as a signal. The only signal we get today is that price is getting higher which in turns motivate price hoarding (type 1).

The purpose of government inventories is to store in years of plenty and release stocks in meager years. A practice that dates back since Joseph interpreted the dream of the seven fat cows followed by seven lean ones.

In my view none of the points above achieve a smoothing out of commodity supplies and certainly not type 2 or 3. In that case price signal has ceased to exist (we don't rely on dream signals anymore). It is just incidental that today's oil markets could do with a price spike to shake-out consumption behaviour (some readers will beg to differ, I know).

While I do not doubt that demand behaviour is changing we are in no ways assured that a serious slowing in demand will in any way affect the price uptrend. So far it hasn't for oil.

That's why I believe that Michael Masters' analysis and recommendations are extremely relevant. What I think is being missed in reading his analysis is precisely that current hoarding will never achieve a smoothing out of supply. That is the point that was very clearly understood in the early years of 20th century America by market regulators. And to ensure that price will keep on acting as a signal to stabilize supply/demand balances, regulators then had to seriously limit non-commercial position size. That has completely disappeared today.

I’m not too sure that qualifies for a 101 in oil futures and would be happy to clarify further.

Actually holders of futures contracts can always go for EFP (exchange for physical) which would move them onto the spot market. The rules are that 3 days prior to expiry you cannot hold any large quantity of futures contracts. This is to avoid having anyone cornering the market at expiry. So any player, whether long or short, will have to roll his position to the second nearby or exit some time before expiry.

Whatever they do will not involve anyone on the spot market which is a very different market, although it prices off as a differential to the prompt futures.

Dear Greg,

as a quick answer since we will publish soon about these questions.

1. I think Peak Demand has become mainstream now and that should accelerate as price subsidies keep on being removed or lowered. If energy prices keep on falling the incentive to remove them altogether will become greater. Then will see what is the true demand from EM. Afterall current demand keeps on getting weaker, future demand is seen even lower than at present and world growth is seen as slowing. Meanwhile imports are slowing, refinery runs are slowing, stocks are building and pure refining companies are seeing distrastrous falls in their YoY profits. Supply demand balances are improving as a result and should get much more comfortable next year.

2. I believe that oil prices have stayed high to very high long enough to radically change not just consumer behaviour (the prime example being the collapse of light trucks purchase in the US) but also at governmental level. Again the US is the most vociferous example or most visible one. Besides drilling for new oil there is ample talks and action taking place on the renewable space, especially for the production of electricity from wind and solar to displace natgas away into a transportation fuel.

The French President has even proposed that the North African desert should be used to build solar power plants and its output sent to Europe. Theoritically it is feasible.

Many proposals won't see the light of day but what matters is that they are openly aired at the highest level. So we are exactly where we were after the first oil shocks with a search for alternatives which means getting more power and less driving.

I believe the change will be permanent and also that countries like China have every incentive to move away from oil towards alternative solutions on a large scale and pull a similar type of policy (and growth) as Japan did in the 80s.

Dear Rob,

You are making quite a few hypotheses on agriculture.

In a recent paper: Comparative Advantages: Oil vs. Land (http://gavekal.com/redirectdoc.cfm?r=1&id=3933&rn={ts%20'2008-08-08%2019:18:31'}&CFID=368689&CFTOKEN=40290937) we talked about how Africa's farming is likely to become much more efficient thanks to large FDI from land poor but cash rich countries such as the UEA.

Will the same happen across Asia? We do not have any particular view that this will happen, although if it did then in theory this would increase efficiency.

so working with a theoritical yes we'd now have a new labour force entering cities. By and large cities are more energy efficient per capita than the country side so there is no clear evidence that that new labout force would add to energy demand. the net effect from more efficient farming methods and new city dwellers could be a net saving on energy.

on that note it is interesting to find that the latest "Energy Use Per Unit of GDP" figures out of China are showing a 2.88% fall year to date,  thus as very large numbers enter the cities.

But regardless i think hard to draw hard conclusion on the hypothetical questions you've raised other than China's precedent shows efficiencies.

Thanks for your comments Rob.  From my experience, living in rural USA, farmers will change in accordance with the times, if they need to—even if this occurs between generations as you suggest, rather than in the midst of one person’s working life.   But like everyone else, farmers will have a tendency to resist the change in favor of the status quo. These tendencies are eventually overpowered by the market’s constant insistence on reallocating resources for more efficient use, but only if the market’s signals are allowed to reach the farmers. And for some reason, the farming sector has been particularly successful at getting the US taxpayer and US consumer to fund the manipulation of market signals and the preservation of the status quo (whether through subsidies, tariffs, etc…).

A few years ago, I attended a farm bill meeting with a senator from Idaho, and found myself to be the only non-farmer.  I remember one farmer saying to the Senator: “I keep getting offered more and more money to sell my land (this was during the housing boom), and with the price of my crops going down and my costs going up, I may just sell one of these days.”  This was meant as a threat to the US Senator (i.e., “Do something Senator, or I’ll sell the farm, move and vote for someone else.”).  Someone else later said: “I want to keep farming, but prices are just too low. We need the government to figure out some way to reduce supply and prop up prices.”

Finally, I stood up and suggested the economist’s solution to these problems (in stark contrast to the politician’s solution):  “Why don’t you, Sir, sell your land for the pretty penny you have been offered (by someone who clearly thinks they have a more productive use for the land).  You can then fund your retirement and/or pay for your kid to go through college (so that he or she can enter a more profitable industry).  This, in turn, may also help the guy who still wants to farm, but is complaining about low prices. After all, you will have allowed the market to naturally drive down excess supply.  And the advantage of allowing the market to drive down supply naturally, rather than the Senator’s proposal to “pay farmers not to farm” and tax emerging market farmers out of competitiveness, is that the efficiency gains that result will also help the average US consumer (such as the same kid you are sending to school), the US taxpayer (again, your child will soon be an example) and the EM farmers.

I was expecting to get chased out of the room, and while the politician was quick to discredit such ideas as “too simplistic”, the farmers were surprisingly receptive of such suggestions.  In fact, after the meeting concluded, I found more of them came to talk to me about my proposals than turned to the Senator.  Clearly, US politicians continue to buy farmers’ votes with the earnings of the US taxpayer/consumer, but this experience gave me hope that farmers will adjust in accordance with what the economic realities of the time require, but first we have to pry their attention away from the politicians who aim to stand in the way of progress in favor of keeping their established voter pools dependent on the government (and the forced charity of the general population) for survival.

Post Edited (Greg Atkinson) : 8/13/2008 11:57:25 PM GMT

Dear Greg,

The best way to stimulate oil demand is for price to fall down significantly below $100 and remain there. That’s the catch-22. The Saudis, I believe, have understood the current risk of substitution that high oil prices bring and are extracting and supplying at their highest rate since the second oil shock, to bring down prices.

There is some environment friendly oil, mainly natgas. Shell’s the leader in the technology and is building a very large refinery in Qatar to make LPG out of natgas. Costs overruns are very large and it’s still a new technology. It would take at the very least a decade to have a meaningful substitution if everyone started now.

Biofuels from crop is just an intermediary step to biomass. By 2012 we should see more biomass refined into syncrude and by 2015 biomass should massively overtake crop. In any case crop based Biofuels volumes are capped by law I believe.

I think the world will keep on needing both conventional and synthetic crudes and that’s the expectation of the industry as well. Total fleet turnover in the US is still 17 years. Ultimately it’s all a combined effect, car makers won’t produce too many electric cars if there’s no infrastructure in place to reload them, same with lpg and natgas.

So oil will remain the predominant hydrocarbon for liquid fuels at least for the next 15 years.

Dear Greg,

short answer as i'm writting a piece onthat precise issue:

1. Demand has been damaged irreversibly like after the second oil shock. we are now in a period of seeking alternatives forms of transportation and production. there's a slight demand increase from cash rich countries to rebuild storage but that 's just a blip.

2. we will remain below $100 for a considerable time as we progress into a deflationary period.

3. it needs not cause pain to rich oil countries if the dollar keep appreciating. while their revenues will be somewhat less, in real terms they should be perfectly acceptable especially to those country that peg to the $. (see last week GaveKal Weekly Energy).

more answer to come in an AdHoc early next week

The IEA is a bit behind the curve to put it mildly. I personally assess world demand in September close to 85.8 not 86.5. the IEA overestimates US demand and is trying to catch-up. In any case yes there’s been supply disruption in the US Gulf of Mexico from two hurricanes and a greater part of the deficit in Sept is due to oil being held at sea. There has been supply disruption in the Caucasus as well in the Baku pipeline that blew up in Turkey. As a result stocks were drawn down in Europe.

Demand in the US is appalling as it is in the rest of the OECD. Still some question marks over EMs demand. I believe China is taking advantage to store a bit of oil in its SPR too. End year 2008 will show zero growth in demand or close enough to zero and ditto for next year if not negative demand. As a result OPEC spare capacity is climbing and should reach an extra 1Mbd for a total of over 3Mbd. That excludes the 900kb of new Saudi fields. So the total should be close enough to 4Mbd. Remember that tight supply demand balances were one of the main arguments for the bull-run. That is easing now.

The cost of production of unconventional oil is bound to be falling as all cost factors are falling the world over. I do not believe it ever reached $90 but even if it did due to demand falling the marginal barrel is now found at a lower marginal cost anyway.

Right now we are seeing a huge amount of deleveraging across all markets. In my view oil has removed all the excess speculation of the first half of this year and is now trying to find fair value in a fast changing environment. The bull-run and all the news that fed it is gone. You’ll need to re-assess much closer to fundamentals. For now demand is done, inventories are rising. The next step is for buying to ease and inventories to ease and OPEC to cut and spare capacity to rise. That should translate into a bearish price environment especially more so for next year. We won’t see $100 anytime soon, all things equal. The big inflation play with oil is dead and over.

I hope that helps. Do not hesitate to ask questions on the Energy Weekly publication too as I try to get closer to the trading environment.

OPEC’s production is reported by various specialised data vendors, among them Reuters, Platts, Argus etc. OPEC 10 supply in September was 30.4Mbd + 2.37Mbd; out of Iraq makes 32.77Mbd. Total OPEC capacity is 35.17Mbd. Its spare capacity in Sept was 2.4Mbd therefore. If OPEC cuts by 1Mbd to year end its spare capacity will be 3.4Mbd. if you add 900kbd of new fields in Saudia that’s 4.3Mbd. if you remove a very generous 500kbd of decline in older Saudi fields the Net is 3.8Mbd spare capacity for next year on the OPEC side alone.

These are the numbers I’ve come up with and that seems to be close enough to consensus.

However much Dreyfus, Campbell and Simmons argue it is a matter of fact that demand is collapsing. So I guess they’ll have to revise their peak oil theory further in the future, which is a good thing if you think about it.

That’s because the IEA is still overestimating demand by 500kbd. Once it revises it down spare capacity will de-facto increase. The IEA publishes its data once a month only but the situation is moving fast. Also data gets revised.

Watching the oil price fall I was wondering at what point places like Russia + middle east start to get into trouble in terms of cash flow/budget deficits etc?   I seem to recall a figure of $50-60/barrel for Saudi Arabia.  Must have implications for a price floor + political/social unrest + cash flows into SWFs (remember those?!)

We should remember to use the yearly average price, which still stands at $110 for the Benchmark. Even if we subtract a good $10 for lesser quality crudes, most producing nations and IOCs are still within the $100 average so far.

Where it will get interesting is next year. My guess is that austerity budgets will become the buzz word for those that can; for those that can’t it will be painful. Yet the relationship is not as straight forward, for example inflation is clearly falling and fast. That was the biggest problem in most oil producing nations. Ditto the US$ is now rising so in real terms the fall in oil prices is not as bad as it seems.

In fact if oil stabilizes within the $60-$65 average next year, providing that the $ keeps on climbing, my guess is that most producing nations will do nearly as well in real terms revenues and certainly much better on the inflation side. While the net effect will be somewhat negative it will not be the end of the world. Obviously there are always nations who have a knack for blowing it-up whether oil is at $150 or at $10 a barrel ---but that can’t be helped.

Dear Gavekal,

Would it be possible to ask Ahmad if he can send me the study, or the article in which it is established that the cost of upgrading bitumen to higher-quality liquid is 5$ in Venezuela (as he writes in the last week's Energy Weekly)?

You should be able to get reports on estimated costs from the IEA, McKenzy, the Oil Journal and any other specialized publications. 80% of all oil production cost are below $20/bbl. If you look at the $/bbl paid for M&A in 2007 you will find that all deals went for less than $17/bbl valuation. If oil companies accept to sell themselves for less than $17/bbl that should tell you that $90/bbl is simply not the cost of the marginal barrel. But if a company wants to explore and produce from the most hostile and complex regions then there’s no end to how much it may cost. The question is whether that oil is required and in truth it isn’t thus the projects costing $90/bbl simply won’t see the light of day.

1. All fields deplete yet technology is constantly improving and is yielding greater extraction rates. These Enhanced Oil Recovery technologies can have substantial impact on production (see attached chart for example). The average yield worldwide is about 30% recovery. I have no doubt that the average will keep on improving. in 1960 total oil reserves were estimated at 300bn bbl yet over the following 40 years 760bn bbl have been produced!
2. Again technology allows us to get oil from new frontiers that we couldn't possibly explore a mere 10 years ago. Example deep offshore subsalt discoveries in Brazil (up to 100bn bbl?) or Palaeocene rock discoveries in the North Sea.
3. Some areas of the world have still not been surveyed. 2/3 of Libya has not been surveyed, a greater part of the empty quarter hasn't, very deep offshore etc.
4. The impacts of geopolitics have been appalling for oil production. In fact we currently live in an upside-down world where oil companies are chasing after the most complex and tech intensive fields whereas the majority of the oil to be available lies in easy onshore regions. Iraq comes to mind which could triple production rates or Iran who could produce a third more as it did before the revolution, etc. 

The bottom line is not a problem with the amount of oil stock which is huge (over 1 trillion barrels in Venezuela alone) but with flows, i.e. production rates. Technology, Investment and Politics are the main hurdles or enablers.

So I'd like to think of the cup being half full rather than half empty as our Peakoil friends think.

To make sure it is well understood the Peak Demand paper refers to demand for petroleum having peaked in 2007 and keeping lower for a considerable time. Not for total energy demand having peaked. Total energy demand should keep on increasing and the more so as more renewables finds their way to market. 

Dear Greg,

Japan has been putting a lid on its oil consumption since 1980 and like Europe has never consumed more than it did in 1979, apart from one year or two in 2000. Japan's demographics as well as strong technology improvement in transport efficiencies should see Japan's oil demand keep to a structural decline. And with Japan being a leader on hybrid technology my guess is that the dowtrend in Japan's oil consumption should accelerate.