The hopes of widely anticipated production increases by OPEC, in its meeting last week, have crashed as the cartel was split half-half on that proposal and the markets have rightly surged on that disappointment. The Saudis were the chief proponent of increases in supply to keep the world economies growing and, in fact, much before this meeting, they had been pumping more than 200,000 barrels a day over the agreed limit and would have increased it by a similar quantity if OPEC had decided on the increases.
But the perils in prognosticating crude oil prices are not that simple: it is not just a demand and supply factor. If that were so, there is no need for the prices to be so high, threatening each day to take it to new heights. The world is amply supplied with oil, inventories are good, with enough spare capacity and no crippling movement bottlenecks. These comfortable factors do not justify the prices of $100/bbl and above. The prime reason, as was suspected and now widely confirmed, is the speculation and hedging in the futures market as the futures are determining the price for the physical barrel.
It is precisely this element of speculation that renders it difficult to make any prognosis of oil price trends. Not that it was easier when speculation was not factored in. In addition to the usual factors that determine the price of any commodity in a market, oil is now being affected by several structural shifts in the energy market as a whole, like new demand/production centres, technological breakthroughs in shale gas and oil sands production, alternating fortunes of nuclear power, unreliable non-renewables and so on. Massive discoveries of shale gas have revolutionised gas and LNG markets and, of course, geopolitics. The US is estimated to have reserves to last for 100 years at its current levels of consumption, and China even more. So are oil sands, Canada alone having reserves of over 170 billion barrels?as against 265 billion barrels of Saudi Arabia?s oil reserves?large enough to change balance of world oil market.
It, therefore, becomes necessary for OPEC to maintain its relevance in the oil market. In spite of apparent unity outwardly shown by OPEC, it is not a secret that unilaterally individual members are producing more to bring comfort to consumers in the US, Europe and China to replace the shortfall of Libyan and other crudes. But there is also the need to meet rising domestic demands, as Middle East as a whole has been increasing its own consumption. While such increases are possible by members with spare production capacity, price hawks like Iran and Venezuela appeal to those who can add revenues only by higher price and not by volumes. The Saudis are batting for a price band of $70-80 for crude oil, to keep it affordable to consuming economies as well as to stymie the viability of competing alternatives. Of course, all members of OPEC are overproducing in some manner or the other and it has not been possible to realistically estimate such volumes. And these would distort prices normally determinable by official production numbers.
Another major change uniquely influencing oil prices is the way natural gas is priced and transported. Gas trading is taking place separately in three major markets, Henry Hub in the US, National Balancing Point in the UK (where gas is priced on its own), and most of Europe and Asia, where gas is sold at a percentage of oil prices under long-term contracts. The recent rise in oil prices has hurt those locked in to oil-linked prices. But the US?s decision to export LNG, with their own gas prices remaining the lowest, actually amounts to exporting its low prices. This influx of LNG and depressed demand have pushed down spot prices in Europe giving them a leverage to renegotiate the long-term oil-linked deals. Add to this the furious development of shale gas in the US, most of Europe and China that would replace liquid fuels and thus further depress demand for and price of oil.
Another technical revolution in the making is Gas-to-Liquids (GTL) technology. The world?s largest plant with the largest investment is coming on-stream in Qatar, turning low value gas into high value diesel, now becoming viable due to high oil prices. Qatar has 900,000 bcf of proven reserves, almost 15% of the global total, and it finds in GTL a diversification from LNG, of which it is the biggest exporter. GTL thus provides a natural hedge to the gas market. If this gets more universally adopted, issues of relative merits of diesel from oil and gas will dominate market and thus oil prices. This development needs to be closely watched in making any long-term projection of oil prices.
But all these predictables are overwhelmed by speculation in oil futures and financial hoarding of oil by hedge funds. Studies chiefly sponsored by banks have claimed that financial speculation has no effect on price but this specious argument diverts attention from the main issue of shooting oil prices beyond what market fundamentals warrant. Financial investors are placing enormous paper bets with investment banks who hedge these bets in oil futures markets by continuously buying without regard to prices, and this financial activity is inflating prices. Nomura analysts warn that this could push prices to $240/bbl before long, only to crash as happened when the price hovered around $150/bbl. The obvious solution to neutralise this is for all oil producers to enter the futures market but offer the physical barrel and not a financial settlement. This would bring in price equilibrium and result in the right price discovery. But producers are loathe to do this as they are beneficiaries of the high prices of the futures.
Alternatively, government intervention to curb speculation and outright ban on this type of financial hoarding can prevent the market from becoming dangerously dysfunctional, a prospect that does not seem far away. So, any attempt to make a prognosis of oil prices will be no different from crystal gazing.
The author is chairman of the Energy Think Tank and former secretary, ministry of petroleum & natural gas