A global oversupply of oil enabled by OPEC's quota violations could lead prices to fall. (image: tehrantimes.com, blog.redfin.com, and AP via cbsnews.com)

Monday, an article in the Financial Times questioned the strength of OPEC in light of its members’ extensive quota breaking, and stated some analysts believe that a current global oil glut could drag down prices by the end of the year.

OPEC quota compliance has become an especially important issue as quota “cheating” is happening with increasing frequency, and OPEC announced on Wednesday that it would maintain current quotas, despite some members exceeding them.

Back in December 2008, the cartel responsible for 1/3 of the world’s oil agreed to make the biggest production cut in its history; a slash in output of 2.2 million barrels per day. The cut was motivated by the financial crisis’ blow to global oil prices, which plummeted by nearly 70% in the months following July of that year. Since then, OPEC’s official quota has not budged, remaining at 24.845 million barrels a day despite the widely-recognized fact that the true output of its members has run hundreds of thousands of barrels per day above this level.

In 2008, analysts estimated OPEC overproduction ranged from 600,000-800,000 barrels daily. This past January, Reuters Africa reported that an OPEC document registered overproduction at 1.87 mbpd. The FT article stated that OPEC quota compliance—a percentage measure of how real output matches agreed-upon levels—has slipped to a low of around 50 percent (its highest in the past two years was 80 percent, in spring 2009).

Iraq’s lode of international oil contracts could soon boost OPEC production by several million barrels, the article pointed out. With the second-largest oil reserves in the world, Iraq’s new participation in OPEC (after years of sanctions and disruption brought by war) could, in a scenario where quotas remain unchanged, either force the body to curtail the above-quota production in other countries, or explode the fissure in compliance to a point where OPEC loses the unity it needs to keep order and retain control over prices.

When OPEC nations break their quotas, they profit from the higher prices permitted by the supply restraint of fellow members.

However, some countries pump excess crude in order to stave off consequences of their own economies’ severe fragility. This is the case with the worst quota breakers: poverty-stricken Angola, which has observed no cuts in its production, and Nigeria, which was overproducing by 300,000 barrels daily in December. It’s also an expected motivation for war-torn Iraq, which is currently the only OPEC member exempt from quotas but whose pending contracts will soon change this as its production soars.

Additionally, when many members break their quotas and overproduce, previously compliant nations are pushed to overproduce in order to make up for the loss in profit that resulted from the supply glut’s depreciation of their oil. Compliance brings higher prices through supply restraints, so quota violations bring lower prices through increased supply. In a somewhat ironic feedback loop, members increase output to compensate for lower prices; the further increase in world supply contributes to lower prices.

Exceeding quotas, in conjunction with low oil demand worldwide, could be the reason for the oversupply the FT article mentions:

Some analysts and traders note that despite recent upward revisions in demand – especially from China – markets remain oversupplied and Opec faces some risk that prices will fall this year.

A global oil glut has been present for years, ever since the recession dampened demand from developed economies, and worldwide oil demand has only increased nominally in the last year or so. The current supply-demand imbalance would indicate that prices should fall, yet the price of crude has climbed by 79% over the past 52 weeks.

Therefore, any price declines would have to be brought on by a confluence of several factors. According to the FT, some analysts see nearing-termination of government stimulus packages (both the US and China), and the new limits on energy trading in the US (which could lessen price-hyping speculation activities) as two such important factors.

A grim future looks to be in store for refineries like this one, owned by Valero. (image: roamsecure.net)

As the global recession made deep cuts in oil demand, the refining sector was hit especially hard. For major oil companies, refining has sucked away profits made in exploration and production. Refiners without such a diversified business have simply struggled, squeezed between low consumer demand for refined oil products and the rising price of the crude oil refiners have to buy.

What can refiners do to get back on their feet? The Financial Times’ Energy Source blog examines the argument from a pair of analysts at the investment bank Barclays Capital who say they have the answer: close more refineries.

According to the Barclays Capital analysts, only closing refineries—not selling them or waiting for oil demand to recover—can eliminate the refining industry’s overcapacity that is dragging down profit margins. Not that refineries haven’t been shut down; Sunoco closed a refinery in New Jersey, Valero did the same in Delaware, and the French oil company Total set off a strike that led to fuel shortages in France when it closed the doors to its refinery in Flanders. Yet Barclays’ analysts think refiners would need to make more drastic cuts to revive profit margins, and to make those cuts they will have to overcome the political opposition to refinery shutdowns that comes from consumer groups, workers, and communities. In their logic, the French oil company Total erred when it promised to close only one refinery, after workers at all of its other refineries went on strike to protect their jobs.

Political opposition in the US comes from consumer groups that have accused refiners of keeping prices artificially high by reducing operating capacity, as an editorial in Monday’s Los Angeles Times noted. Yet refiners are in a difficult position. Higher crude oil prices don’t necessarily mean that refiners profit. At all times their operating costs are dependent upon the price of crude; they make money on the difference between crude prices and the price of refined petroleum products. In 2008 they were criticized for not increasing capacity as oil prices hit record highs in response to spiking demand; now that demand has fallen, they are under fire for closing capacity. Like any business, refiners made cuts when faced with reduced demand for its products.

Even if refiners cut capacity further, closed more refineries, and alienated consumers in the process, their troubles could still continue. As the Barclays analysts note, capacity cuts in North American or European refineries will have little affect on prices of refined oil products (and therefore on refiners’ profits) if capacity is added in China.

It’s hard to see many bright spots in the refining industry’s future. Depending on your point of view, oil demand in the developed nations that make up the OECD will either stay flat or has peaked and is set to decline, but neither prospect is encouraging for refiners. Crude oil production is likely to move to unconventional sources, raising the price of crude for refiners.

For consumers of refined products like heating oil and gasoline, it might be beneficial to have Chinese refiners step in and add oil products to the market, which helps keep prices down. But it seems unrealistic to expect refiners to continue to produce when it only cuts into their profits; no business that did so would survive for very long. Refiners may begin to see the same things the analysts at Barclays see, and slash capacity to swell profits, at the expense of consumers buying heating oil and gasoline.

As heating oil demand falls and gasoline demand rises, what will happen to the price of crude? (image: blog.nj.com and cnn.com)

As the heating season prepares to give way to the driving season, oil traders shift their focus from the market for distillates (including heating oil) to the market for gasoline. More people drive than heat their homes with oil, so crude oil futures tend to rally when gasoline demand picks up, as it usually does in the summer. According to The Globe and Mail of Toronto, traders are making big bets that gasoline prices are going to rise and rise soon. But according to the Wall Street Journal, gasoline inventories are near a 16-year high and refiners aren’t in a hurry to buy up crude before the summer—a sign that they are not worried about rising prices.

Big oil traders, such as the trading firms Vitol and Trafigura or investment banks like Morgan Stanley and J.P. Morgan, aren’t concerned about existing inventories, reports The Globe and Mail. As they see it, low refinery utilization will let increased demand quickly cut into gasoline inventories, shrinking supplies and raising prices.

While financial institutions see crude oil prices moving upward, the Wall Street Journal notes that refiners and fuel consumers haven’t taken steps to protect themselves from price increases. Perhaps Vitol and Morgan Stanley see this as further evidence supporting their case—refiners aren’t buying crude, therefore they won’t be producing much gasoline, reducing gasoline supplies and raising prices—but other traders disagree. Though rising gasoline prices higher profits for refiners, and they have an interest in making sure supply doesn’t overwhelm demand, rising crude oil prices increase the cost of business for refiners—if refiners thought gasoline prices would rise, they would have every incentive to buy crude oil now, before it becomes more expensive. Even if refiners have misjudged the direction of gasoline prices, the struggling sector may step up its activity if prices do begin to rise, profiting from price increases while simultaneously adding to supply and keeping prices from rising further.

Since the price of crude oil is the most important factor in determining the price of heating oil, heating oil consumers have a stake in whether or not gasoline demand drives up crude oil prices. For heating oil users who sign price-lock or pre-buy contracts, the price of crude oil in the summer months can be very important for the rest of the heating season. Heating oil users may even be affected by gasoline prices during this heating season; if gasoline prices start pushing up crude oil prices in March and April, even before many people in the US have started taking any summer road trips, that could affect the price of some consumers’ final heating oil delivery of the season.

Today, heating oil prices jumped. In the last minute they rose four more cents. (image: s.wsj.net)

Gains on the stock market have generated economic optimism and boosted crude oil and heating oil futures on NYMEX. As the economy grows, oil demand will rise, and the price of crude has steadily increased today and brought the price of heating oil along with it. With inventory reports due out this afternoon and tomorrow, some traders could be pushing oil prices higher in expectation of drawdowns in supplies of crude or refined products.

As of 1:00 pm, the average retail heating oil price in the Northeast is 4 cents higher than this morning’s average price.

As the Ocean Guardian (left) makes its way from Scotland to the Falklands, rising tensions bring to mind a previous conflict between Britain and Argentina, the Falklands War of 1982 (right). (image: timesonline.co.uk and chandrakantha.com)

British efforts to drill for oil off the shores of the Falkland Islands, an overseas territory in the South Atlantic only three hundred miles from Argentina, have reignited tensions between the two countries. While developments seem unlikely to end in a replay of the Falklands War, the brief and bloody conflict in 1982 between Britain and Argentina over the Falklands’ soverignty (the Argentines call the islands the Malvinas), a war of words has escalated.

Royal Dutch Shell first drilled wells offshore of the Falklands in 1998, but halted further exploration out of concerns that the price of crude at the time, only $10 a barrel, made that activity unprofitable. Now, with oil prices between $70 and $85 a barrel, London-based Desire Petroleum is leading efforts to transport a drilling rig called the Ocean Guardian to the North Falkland Basin, reports the BBC. The Times of London says some analysts think there could be as much as 60 billion barrels of oil in the islands’ offshore territory.

The Buenos Aires government has threatened to detain ships passing through Argentine waters on their way to the Falklands, and could be trying to shore up its fading popularity by appealing to nationalist interests. London’s Telegraph has quoted Argentina’s foreign minister Jorge Taiana calling British actions illegitimate: “[What they’re doing] is a violation of our sovereignty. We will do everything necessary to defend and preserve our rights.”

For their part, the Falklands’ government rejects Argentina’s claim to sovereignty over the islands, and both the Falklands and the British government have underscored their military strength. Prime Minister Gordon Brown said that British forces are conducting “routine patrols” and that Britain had “made all the preparations that are necessary to make sure the Falkland Islanders are properly protected.”

Iran’s president may have to tone down his belligerent rhetoric if oil prices stay below $100 much longer. (image: vimooz.com)

Iran’s influence on oil prices appears to be a two-way street. Just as saber rattling by President Ahmadinejad or any other hints of possible armed conflict between Iran and its neighbors can push up oil prices, oil prices can force the Iranian government into negotiating with the international community. According to a report published by CNN Money on Thursday, the current price of crude oil (around $75 per barrel) is wreaking havoc on Iran’s economy and could force Ahmadinejad to the negotiating table over his country’s controversial nuclear program.

According to CNN Money, the economy of Iran, the world’s fourth-largest exporter of crude, requires an oil price of $100 per barrel for sustained economic stability. With current prices at just three-quarters of that target, many believe that the Islamic republic is already feeling the economic pain. The poor state of the economy in Iran is playing a role in the growing unrest among its people. As Fariborc Ghadar, a senior adviser at the Center for Strategic and International Studies and a professor of global business strategy at Penn State, explained, “[The regime] has to shoot their own kids. Women in the cities are angry. The economy is in terrible shape. The place is a mess.”

As a result of this “mess,” Ahmadinejad and Iran’s ruling theocrats have seen their political power diminish both domestically and on the international stage. As Thursday’s reported antigovernment protests and resulting crackdown on dissidents in Tehran shows, the ruling party’s grip on power in Iran is already less than firm. A feeble economy and crumbling political power are enough to make any government swallow its pride in efforts to improve the situation. In Iran’s case, swallowing its pride may very well mean entering into negotiations with the US and other Western powers to halt or restrict its nuclear program, which many world powers see as a quest to attain a nuclear weapon. Agreeing to such negotiations would lead to an end of, or at least reduction in, trade sanctions that have exacerbated Iran’s economic woes. The lower the price of crude falls, the more pressure builds on Iran’s leadership to negotiate with the West.

If oil prices stay at or below current levels for the next few months, we may see a major shift in Iran’s tack in international relations sooner rather than later. When and if that shift occurs, Iran will likely be perceived as less of a threat to relative peace and stability in the oil-rich Middle East, which could, somewhat ironically, bring about lower and steadier oil prices.

And so it seems that the price of Iran’s power to control global oil prices is its vulnerability to being controlled by them.

(image: BenjaminJoel via flickr.com and life.com)

Oil prices fell on Friday despite the Commerce Department’s report that GDP had grown by 5.7 percent in the fourth quarter. Many analysts believed that GDP growth had been inflated by businesses restocking inventories that had been allowed to fall during the recession, and discounted Commerce’s figures. Demand for oil remained weak, shown by collapsing profits in the refining sector—Chevron’s refineries and filling stations lost an average of $278,000 an hour in the fourth quarter. A stronger dollar added further pressure on the price of crude and heating oil, since a strong dollar reduces the appeal of commodities as hedges against inflation.

Today’s average retail heating oil price in the Northeast is 1 cent lower than Friday’s average price.

Crude oil prices on NYMEX over the course of today, January 27. (image: ft.com)

Increases of distillate inventories, which include heating oil and diesel, and of gasoline inventories showed that demand for refined oil products remained weak, and oil prices tumbled as a result. The EIA did find a drop-off in crude oil supplies, but the builds in stockpiles of refined products overwhelmed the figures for crude; some analysts suspected that the decline in crude inventories was caused by a temporary delay in imports, and did not indicate any constriction of supply.

Today’s closing prices on NYMEX

Crude oil (March 2010 contract): Down 1.4 percent, $73.67 per barrel.
Heating oil (February 2010 contract): Down 1.7 percent.

(image: Getty Images, China Photos via abc.net and Nicholas Whitaker via heatingoil.com)

Concerns over China’s new policy to limit credit growth continued to affect the oil markets and pushed down the price of crude and heating oil on Tuesday. Oil demand remains weak despite colder weather in the eastern half of the US, and China’s more restrictive lending policy will cut into the growing demand for oil in the Chinese economy. A stronger dollar also weighed on oil prices, since it reduces the appeal of commodities as a hedge against inflation.

Today’s average retail heating oil price in the Northeast is 2 cents lower than Tuesday’s average price.

NYMEX price of a barrel of crude oil over the course of today, January 25. (image: ft.com)

A weak dollar and stock market gains pushed heating oil prices higher on Monday. Weakness in the dollar encourages investment in commodities priced in dollars, like heating oil, since they become cheaper for investors who hold other currencies. Predictions that Fed chairman Ben Bernanke would be reconfirmed boosted equities markets, which in turn lent support to oil prices. An oil spill in Texas closed down waterways to some refineries and bad weather closed a refinery in Mexico, but oil markets were only mildly affected by the threat to supplies.

Today’s closing prices on NYMEX

Crude oil (March 2010 contract): Up 1.1 percent, $75.26 per barrel.
Heating oil (February 2010 contract) Up 1.3 percent.