(image: chrisjordan.com)

Right now the price of crude is $83 on NYMEX. Global daily demand for oil, assuming no change from the 2009 average, is 84.9 million barrels a day (mb/d) according to the IEA’s December Oil Market Report.

The global economy is in flux and it’s anyone’s guess which factors will exert the most influence over demand for crude oil in 2010. The question for many has been whether growth in China and other non-OECD countries like India and Brazil will be enough to offset declining demand from North America and the United Kingdom. An added factor that has received little attention is the historic levels of global crude and distillate supplies currently in storage—a massive overhang of 159 million barrels—the likes of which have not been seen for 26 years.

U.S. distillate supplies, long view. Based on data up to September 2009, when distillate inventories were at 171 million barrels, the highest level in 26 years. According to EIA data, the decline in distillate inventories over the next few months, including the reported “surprise drop” in the last few weeks, have had negligible effect on the historic situation, shifting the 26 year record by less than one year. (image: tonto.eia.doe.gov)

The U.S. oil glut, close-up. DOE Fuel Oil Total Inventory, past five years. (image: doe.gov)

Demand Rebound

The majority of analysts covered on this site, including Goldman Sachs, the IEA, and the EIA, declared it likely that oil demand will improve in 2010. Despite the economic slowdown felt most acutely by mature economies, these analysts find the surprising growth of developing nations, particularly China, in the same period as reason to expect a broader market recovery this year.

The most optimistic within this pack is the world’s largest energy trader, Goldman Sachs, who has predicted global demand to accelerate to 86.4 million barrels a day (mb/d) from 2009’s 84.9 mb/d due to growing consumption in China, India, and Brazil. Citing dwindling production levels in the world’s largest oilfields, Goldman Sachs projects that supply will fail to meet needed levels of demand in 2010, which will bring about a price hike to $90/barrel this year and $110 in 2011.

That demand will outpace supply is a perspective found in the results of a November Reuters poll of “ten prominent oil-tracking organizations,” and in Saudi Arabia’s oil minister Ali al-Naimi, who said in September that a demand rebound would quickly make the massive stockpiles of the commodity irrelevant. Despite vacillating positions on this issue in every report since October, the International Energy Administration has also most recently come out in favor of a short-term demand spike, predicting that 2010 demand will rise to 86.3 mb/d, and crude prices upwards of $100.

Table of 2010 oil demand predictions.

A Long Bottom

Other agencies, though agreeing that global oil usage is poised to rise, place this event farther off in the future. Relatively weaker demand estimates from OPEC, JP Morgan and the EIA reflect greater weight attributed to the economic recession and floating oil stockpiles.

OPEC said demand would rise only later in the year, and in the first part of 2010 would drop further. In its December report, it predicted a daily global consumption of 85.13 million barrels in 2010, a mere 0.82 mb/d increase over 2009 levels. As explanation, OPEC noted the extremity of the global oil glut. JP Morgan also cited the record supply glut in its demand forecast, which predicted a 1.1 mb/d increase.

In early December, the U.S.-based EIA lowered its national 2010 demand predictions at the same time that OPEC and the IEA were upping predictions for worldwide demand. While those other organizations were responding to new data from China and other non-OECD countries, the EIA was responding to a weaker-than-expected US economy, though the source of this newer wariness was not shared its Report Summary. Even without this minor adjustment, the EIA prediction would still be on the low end of the spectrum, at 85.22 mb/d, a 1.1 mb/d increase. The agency attributed “almost all” of expected 2010 oil demand growth to developing countries, underscoring the major shift in oil demand from wealthier to poorer nations.

In contrast to a Reuters poll mentioned earlier, a BDO Seidman survey of 100 American small and medium oil and natural gas companies predicted that 2010 oil demand will not rise at all. 

Demand Downturn as Market Correction

Only a handful of voices covered on HeatingOil.com believed oil demand could fall in 2010. These were motivated not by a belief that another economic downturn is imminent, but by skepticism for the “realness” of current oil market figures. A December Economic Times article and European oil trader Trafigura have posited that a price bubble is in the works, similar to the one that grew in the housing market a few years ago and caused the mortgage crisis of 2007 and subsequent credit crunch when it finally burst. Both pointed to the world’s massive oversupply of oil as reason for concern over the market’s high prices.

What’s curious is that establishment agencies such as the IEA have also repeatedly voiced strong concerns about the high price of oil, but have done so while neglecting to mention the supply overhang. In November, Goldman Sachs confessed in a report that it had “underestimated” the impact of the distillate oil glut, but made no adjustments to its 2010 demand predictions.

Price hedging activities by the Mexican finance ministry and oil traders as observed by analyst Phillip Verleger support the idea that the possibility of a coming bubble burst is more widely accepted than the highest-ranking analysts would have one believe. However, other competing theories such as peak oil complicate the picture and make it difficult to reject optimistic demand predictions.

In Short

The near-unanimous consensus is that oil consumption will rise this year as long as world economic conditions improve. Key in this “if” is the economic growth of non-OECD countries (developing countries), which has taken place at nearly the same rate in the last few years as the economic slowdown of OECD countries (developed countries). Optimistic analysts believe that non-OECD demand growth will continue even as demand from developed countries remains flat. Very optimistic analysts believe that non-OECD demand will rise sharply, and/or that OECD demand will improve moderately.

Global daily oil demand by year, broken into contributions by OECD and non-OECD countries. Based on the IEA Oil Market Report data of each year’s quarterly average, available here: http://omrpublic.iea.org/balances.asp.

However, the degree to which any nominal demand growth actually registers as real growth will depend on the speed at which countries absorb the distillate supply overhang, and to a lesser extent the crude overhang. If this does not happen quickly, then it forms another factor encouraging flat demand.

Widely anticipated as a year of transition by optimists, it will take time to see how each factor affects the others.

Note: This summary excluded discussion of oil prices, which are heavily affected by factors outside of real demand such as inflation, the strength of the U.S. dollar, and speculation in the oil futures market.

The floor of the House. (image: njp4wf.org)

Last Friday, the House of Representatives passed a bill that could radically strengthen financial regulation. As the New York Times reported, legislation containing the biggest changes in financial regulation since the Great Depression passed by a 223 – 202 party-line vote (all Republicans and 27 Democrats voted against the bill).

The bill still needs to be reconciled with Senate legislation before it can take effect. Not only will that take some time—the Senate moves slower than the House—but given different personalities and priorities in the Senate, the eventual law may include significant departures from the version passed last week. However, the provisions of the House bill, which in some way or another should be reflected in any final financial regulation law(s) signed by the President, include:

• Creation of a new Consumer Financial Protection Agency, with authority over consumer borrowing such as credit cards and mortgages

• Enhanced scrutiny over the Federal Reserve by Congressional watchdogs

• Restrictions on leverage (borrowing) and liquidity to make financial firms more stable

• Creation of a Financial Oversight Council with enhanced power to regulate financial firms that are too big or in distress

• The FDIC could take over and liquidate failing non-bank financial firms, for an orderly dissolution, the same way it can seize and liquidate failing banks

• Hedge funds and private equity funds would have to register with the SEC

• The SEC generally gets a larger budget and more authority, including over credit rating agencies

The provisions most important to heating oil users deal with what’s known as OTC—or “over-the-counter”—derivatives. A small part of derivatives trading is speculation in oil. Excessive speculation was blamed for spiking oil prices in 2008 as well as increasing market volatility—how much (and how quickly) the price of oil can swing.

The requirements relating to derivatives—including oil futures contracts and other instruments for investing in oil—include:

• Whenever possible, trades must go through regulated exchanges or central clearing

• Even when certain derivatives can’t be cleared centrally, they must be reported

• Regulators can set position limits, or caps on how large a bet any one investor can place on a given commodity (like oil)

• Financial firms will be limited to owning no more than 20 percent of a OTC derivative clearinghouse

If regulations like those in the House bill end up being enacted, they should reduce the influence of speculators on oil prices, which could reduce the cost of heating oil and gasoline—many blame speculation for holding oil prices well above the level indicated by supply and demand fundamentals.

Is this last word in regulation? That depends on how cynical you are. If cynical, you may think that yes, this is it—at least for next 70 to 80 years. After all, Wall Street is huge source of campaign contributions and lobbying: well over $5 billion over a 10-year period, for example. Once Congress and the government can say that they’ve “reformed” financial regulation and therefore quieted public outcry, they can go back to a cozy relationship with their contributors.

If you’re less cynical about government, you might think there will be further regulation. Why? While a good start and better than the status quo, the House bill doesn’t go far enough. Even without imputing bad motives to Wall Street, it’s simply become too big and too rich, its power and influence too great—Wall Street sneezes and the United States catches a cold, as many others have said before. It’s the proverbial tail wagging the dog, and it has to be regulated tightly in the same way that space shuttle engines and fuel tanks need to be built to exacting tolerances—because the consequences of failure are catastrophic. We saw that last year, when what began as nothing more than banks bearing the costs of their own bad mortgage loan underwriting turned into a global financial meltdown.

The extent to which the financial industry is too large for society’s health can be clearly seen in the following statistics:

• Size of the OTC derivative market (just derivatives; not counting stocks and bonds): $450 trillion

• World gross domestic product: around $70 trillion

• Total annual value of oil produced: around $2.3 trillion

• Total world stock market capitalization: around $50 trillion

In other words, the value of derivatives—those “side bets” on the value of other assets or commodities—annually is 6.5 times the value of all world economic activity. It’s 200 times the value of all oil produced yearly, or 7 times the value of all publically traded companies in the world. A 20 percent drop in the value of derivatives would wipe out as much wealth as if every public company in the world went belly up at the same time.

That’s far too much money to leave as (still) comparatively poorly regulated as it is, since as we saw last year, the consequences of financial missteps escape the pages of the ledgers they’re recorded on and devastate the lives of real people. That’s why there may be more regulation in the future, if the current wave of financial reform proves inadequate.

Agustin Carstens, Mexico’s Finance Minister, has hedged his country’s oil exports for the second year. (image: wikipedia.org)

Mexican officials were wise to distrust last year’s high crude prices. Believing prices would eventually fall, Mexico hedged all of its 2009 oil exports at $70 a barrel, which cost the oil exporter $1.5 billion dollars. According to the Financial Times this move paid off handsomely, resulting in over $5 billion in profit when the price of oil collapsed. On Tuesday, the Houston Chronicle reported that Mexico will be making the same move for the second year in a row in order to protect itself from price fluctuations. This time, Mexico “bought put options to sell crude for $57 a barrel.”

In a nutshell, a put option gives a seller the right to sell a product at an agreed-upon price. This gives the seller insurance in the case of a sharp drop in prices, and in exchange for this insurance the seller pays a fee. In this case, Mexico has bought options to sell its oil at $57 a barrel. Ultimately what Mexico has done is insure itself against the possibility that crude prices could drop substantially next year. Mexican Finance Minister Agustin Carstens asserts that this year’s hedging is not motivated by hopes of another massive payoff but is merely an insurance policy, noting “if we don’t collect any resources from this transaction, it’s OK with us.”

Mexico’s concern with protecting itself against price drops stems from the fact that oil is Mexico’s largest source of foreign revenue. According to the Houston Chronicle, “revenue from state oil monopoly Petroleos Mexicanos accounts for nearly 40 percent of the federal budget.” Because of its heavy reliance on petro dollars, dramatic falls in crude prices could prove devastating for the Mexican economy. However, it should be noted that a miscalculation in hedging could also prove devastating. The Financial Times noted that Ecuador lost nearly $20 million when it hedged its commodities exports in 1993. Either way, because of its reliance on oil revenue, Mexico treads a fine line when much of its financial well-being rests on something as tenuous and unpredictable as the price of oil.

Mexico’s decision to again hedge its oil exports is merely the latest chapter in a larger story focused on what next year’s oil markets will look like. HeatingOil.com has noted that predictions for future oil prices are all over the map, with some (like OPEC) arguing that prices will increase, others believing that prices will remain stable, and many energy experts asserting that oil prices are artificially high and bound to drop. By hedging its exports, Mexico lends credence to those who forecast a decline in oil prices in 2010.

(image: ntis04.hgac.cog.tx.us)

The Gulf of Mexico isn’t dead yet. Far from it.

So says the Houston Chronicle, which reported on Monday that oil companies have made 12 discoveries in the Gulf of Mexico over the past year, which equates to 1.5 billion barrels worth of oil. This marks the largest amount of oil finds in the region since 2002, which shows that, despite years of being drilled, the Gulf of Mexico will remain a prominent source of oil for years to come.

This has occurred thanks to new technologies that allow companies to explore deep-water fields that, in earlier eras, could not be reached. Major discoveries in the Gulf of Mexico are also of incredible importance due to their proximity to the American mainland, which gives major oil companies a chance to reap profits in a stable political environment.

Searching for oil in deep-sea environments is incredibly risky. Drilling just one well usually costs upwards of $100 million. A series of misses can cause great harm to the balance sheet of any company. However, one major find can result in almost unimaginable profits. But the oil companies searching for oil in the Gulf of Mexico do believe that there is more to find. The recession has hurt industries that support oil exploration, making it hard for oil companies to find needed parts and find financing. The oil industry has been in constant turmoil these past couple years, as prices for one barrel of crude have swung from a low of $33 in February from a high of $150 in June of 2008, before recently settling in around the $70 to $80 range in recent months.

The finds in the Gulf of Mexico could add a significant amount of oil to the world’s supply. One industry consulting firm estimates that anywhere between 1.3 and 2.0 million barrels of oil per day could be harvested from the Gulf’s deep water sites from 2008 to 2016.

It’s not just in the Gulf of Mexico where firms are digging for oil. High oil prices give oil companies profits that they can use to invest in exploration projects. Shell, for instance, paid $2.1 billion to win leases awarding it the right to drill for oil in Alaska.
However, while oil exploration firms have benefited from high oil prices, others in the industry have not. Oil refiners are hurting, as the economy has yet to show signs of a significant rebound, resulting in a severe glut in supply. This has caused some firms to shut down facilities.

James Bullard, of the US Federal Reserve in St. Louis. (image: stls.frb.org)

On Wednesday, James Bullard, president of the Federal Reserve Bank of St. Louis, opined that a recent spike in oil and gold prices was not depressing the dollar’s value, according to the Wall Street Journal’s Market Watch.

While it is true that the price of oil is up steeply from its tumble last winter, there has been no return to the highs seen in Fall 2008. In addition, the Bullard’s opinion runs contrary to a recent analysis by Goldman Sachs, which claimed that it is higher oil prices which are in fact inflationary.

Oil bubble. (image: Jedi Tutor via flickr.com)

The oil market’s tepid response to a rather dramatic week could serve as an indication that the oil bubble is about to pop, or at least deflate. On Wednesday the Wall Street Journal reported that despite dramatic events in the oil world, oil prices are slowly ebbing away from the $80 a barrel mark. It all began on Monday when the Iranian navy detained five British nationals who strayed into Iranian waters when yachting from Bahrain to Dubai. Although the event spurred a rise in oil prices to $77.45 a barrel, the Wall Street Journal’s Brian Baskin asserts that the event was only good for a one dollar and one day boost. That same day, the market also yawned at the news of the hijacking of a U.S.-bound oil tanker by Somali pirates. Finally, on Wednesday it was reported that Iranian oil minister Masoud Mirkazemi threatened that Iran would cease exporting oil if economic sanctions continue.

The market’s ho-hum reaction to a series of dramatic events is a clear indication that very different forces drive today’s oil markets than they were as recently as two years ago. Back then, one could arguably rely on supply and demand being the two biggest influences on market prices. If such events occurred in 2007, oil prices would likely have increased dramatically. However, rising oil prices over the last six weeks despite high supply combined with the market’s indifference to such events suggests that today, a weak dollar, investor speculation, and a dreary economy are determining the price of oil. Because of the sluggish economy, the value of the U.S. dollar is down. The value of oil is expressed in dollars. Therefore, when the value of the dollar is down, “it takes more of them to buy a barrel of oil, increasing oil’s nominal price”.

Investors are also playing a role in determining the value of oil. Numerous economists and energy experts have recently asserted that the price of oil is greatly overvalued. According to financial analyst Jason Schenker, oil is currently valued so high because investors are trading as if the economy were fully rebounding and demand for oil was on the rise.

The ultimate indicator that oil prices are no longer driven by supply and demand is the fact that the United States currently possesses vast stockpiles of oil and yet prices seem largely unaffected by the excess supply. As of November 23, “heating oil stockpiles are at their highest point since Christmas in 1998,” yet this has not resulted in a drop in prices. Energy expert Daniel Yergin also asserts that today’s oil prices are not reflective of supply and demand, yet he is optimistic that over time supply and demand will once again take over as the primary influence of crude prices.

While it is too early to tell if supply and demand are slowly reclaiming their control on the value of oil, recent drops in crude prices and the market’s disinterest in traditional upward influences could be an indication that this is the case. After weeks of rising on even the least significant bullish indicators, this week’s reversal of that trend may very well mean that the steadily-rising tide of crude oil prices is beginning to recede.