Two competing narratives have shaped the oil market so far in 2012, and are likely to continue to do so for the rest of the year, analysts say. On the one hand, macroeconomic gloom stemming from the European sovereign debt crisis and the sluggish US recovery have led many forecasters to predict slow growth in global demand, and perhaps even a slight drop in consumption in the world’s developed economies. On the other hand, fears of supply disruptions – most notably, the potential fallout from the standoff over Iran’s nuclear programme – have added a premium to the price of oil, which could surge enormously if such tensions provoke another war in the Middle East.
Taking the average forecast of 17 analysts surveyed by Energy Risk, the price of Brent crude is expected to average $111.63 per barrel (/bbl) over the course of 2012 – a slight uptick from last year’s average Brent spot price of $111.26/bbl. The price of West Texas Intermediate (WTI) crude oil is expected to come in at $104.62/bbl, with the spread between the two benchmarks narrowing towards the end of the year.
Given the risks on both the downside and upside, however, analysts offered a broad range of possible lower and upper bounds. Credit Suisse, for example, offers a ‘bear case’ that would put Brent at $80/bbl and a ‘bull case’ where it would leap to $126.25/bbl. The bullish scenario has in fact become more plausible since the start of the year, as concern over Europe has eased somewhat and as Iran has dominated the headlines, says Jan Stuart, the bank’s head of energy research. “We went into this year with the broad feeling that the downside risk roughly balanced the upside risk, so the tails on our forecasts were quite fat,” Stuart says. “We saw big risk from Europe, in terms of demand, and we saw big risk from the Middle East, in terms of supply. At this point in the year, it seems to us that the demand risk – the European system risk, if you will – is receding, while the supply risk is becoming bigger. What that means is that prices may well break out to the upside.”
In January, the European Union approved a plan to ban imports of Iranian oil by July 1, its strongest step to date in the international effort to isolate Tehran over its controversial nuclear programme. Iran responded by threatening to close the Strait of Hormuz. Some 35% of the world’s seaborne traded oil passed through the strait in 2011, according to the US Energy Information Adminstration (EIA), so such a move would likely trigger a massive spike in oil prices.
Most analysts believe Iran is unlikely to carry out its threat – not least because closing the strait would cripple its oil exports – and that, even if Tehran did take such a step, the US Navy would take countermeasures to restore shipping flows. Still, the tensions surrounding Iran have continued to simmer, keeping worries about supply disruptions front and centre in many analysts’ projections. US sanctions aimed at limiting financial transactions with Iran, threats by Israel to attack Iran’s nuclear facilities, and bomb plots in India, Thailand and Georgia that were attributed to Iranian agents have all added to a sense of looming crisis, with huge implications for the oil market.
That general mood of uncertainty has helped push up prices, even if many analysts doubt Iran will carry through on its threats. “It’s unlikely that the straits themselves would be shut for a long period,” says Leo Drollas, director and chief economist of the London-based Centre for Global Energy Studies. “The more worrying thing is that in a conflict, there could be damage to onshore installations, like refineries and gas-gathering centres in Saudi Arabia, or the Ras Tanura oil export terminal. Anything could happen.”
Saudi Arabia has pledged to make up for any shortfall caused by sanctions against Iran, but that does not provide an iron-clad assurance against possible price spikes, says Mike Wittner, global head of oil research for Société Générale Corporate & Investment Banking (SG CIB). “With the EU and US sanctions on Iran kicking in towards the middle of the year, we think the net impact of that is going to be bullish, because we believe Iranian exports will go down significantly,” Wittner says.
“In other words, they’re not going to be able to simply shift crude to Asia and have a lot of customers pick up the slack. And what it means is that the Saudis will make up the Iranian flows to Europe, but then Saudi spare capacity becomes very tight.”
William Brown, president of WHB Energy Research, believes the most probable outcome of the Iran standoff is a drawn-out situation in which prices remain elevated because of uncertainty over supply – not to mention financial players who bet on a bull market. “What I see of a higher probability is an oil market that is generally supported above fundamentals due to the Iranian factor,” Brown says.
“But it will tend to be relatively constant and of longer duration in nature than what you’d expect from a closing of the strait or a military strike… That would be my bottom line: a pricing environment that’s generally supported, on average, above fundamentals, with contributions to this end by the financial community, who are always searching to generate ‘excess returns’.”
Of course, Iran is not the only geopolitical factor propping up oil prices. Conflict between Sudan and newly independent South Sudan, as well as unrest in Syria and Yemen, have already led to modest supply disruptions in early 2012. Many analysts are hopeful that Libya, which produced 1.6 million barrels of oil per day (mbpd) until the violent rebellion against Muammar Gaddafi last year, will quickly return to top form now that the rebels have won. But an unsettled political situation could still result in fresh disruptions in the North African country.
Likewise, Iraq remains a wild card in the geopolitical scene. Oil majors such as ExxonMobil have sought to tap into the country’s rich petroleum resources, and many forecasts are counting on a resurgence of Iraqi exports to help boost global supplies this year. But as international troops have withdrawn, allowing tensions between Sunnis, Shiite and Kurds to burst into the open, some analysts have raised doubts about Iraqi production. “You can’t quite call it a low-grade civil war yet, but it appears to me that we are headed for that,” says Credit Suisse’s Stuart. “I think progress on the big multinational, multi-party joint venture projects is going to fall well behind schedule, and despite the fact we are improving export infrastructure in the south, I don’t think we can expect to see much growth in exports from Iraq anytime soon. Indeed, we need to be prepared for declines.”
The economic picture
The analysts contacted by Energy Risk diverged in their views of global economic growth in 2012, and thus their outlook for oil demand ranged across the spectrum. In general, though, the consensus was that oil consumption would be roughly stagnant among the advanced economies of the Organisation for Economic Co-operation and Development (OECD), while oil demand from emerging markets would rise, though a bit more slowly than previously. The most recent forecast from the International Energy Agency (IEA), for instance, has OECD demand dropping by 0.3 mbpd in 2012, even as demand from non-OECD countries jumps by 1.4 mbpd.
Much of that growing demand, of course, will be from China. In recent years, China’s breakneck economic growth has propped up the global oil market, but the rate at which Chinese oil consumption increases has been slowing down lately. The US EIA projects that Chinese oil demand will grow 5.4% in 2012 relative to last year, which is healthy, but nonetheless slower than the 7% increase in 2011 or the more than 10% increase in 2010.
Not surprisingly, then, analysts see major downside risks to the oil price if China’s economy undergoes a hard, rather than a soft landing, in 2012. “Many factors at the moment seem to be supportive of the price, but definitely the largest risk for the price is currently on weak economic development and the possibility of a slowdown in China,” says Eugen Weinberg, head of commodities research at Commerzbank. “In terms of fundamental demand, Europe is definitely not as important as it used to be,” he adds.
Amrita Sen, an analyst with Barclays Capital, agrees that Asia is likely to have a bigger impact on demand than Europe, but believes the risk is to the upside. She argues that many observers are overly fixated on stagnant demand in the West rather than healthy demand in the East. “One of the things we would argue the market is underestimating at the moment is Asian demand,” Sen says. “Asian demand is very strong. Former Soviet Union demand is very strong. We see them pulling a lot of barrels from West Africa, from the Middle East, and I think that is something we will have to keep a close eye on, simply because it is very easy for us to look at the weekly US data, which is quite weak, and get the impression that all global oil demand is quite weak. It’s quite the contrary.”
Of course, the prospect of financial disaster in Europe – even if it has receded since the start of the year – continues to weigh on the oil market. “If Greece defaults, it will be a shock to the whole financial system, and the oil market will not be immune to that,” says James Zhang, energy research strategist at Standard Bank.
Finally, another hotly debated topic in the analyst community is the prospect of loose monetary policy and how it might affect the oil market. Last year, the US Federal Reserve’s second round of quantitative easing (QE2) was often blamed for helping to fuel a surge in commodities prices. Critics of QE2 say it weakened the dollar, which led to rising prices for dollar-denominated commodities such as crude oil. Could that happen again in 2012? Harry Tchilinguirian, head of commodity markets strategy at BNP Paribas, believes QE3 is on the cards this year, along with further loosening of monetary policy by the European Central Bank and the People’s Bank of China. And all of that will boost oil prices, he says. “We are clearly looking towards further monetary easing globally,” Tchilinguirian says. “All that further monetary easing is going to be a big theme for us in terms of providing price support, or at least a price floor, to the market.”
WTI and Brent: together again?
North America has once again become a hotbed of oil production thanks to technical innovations that have allowed the development of unconventional resources such as the Bakken shale in North Dakota or the Canadian oil sands in Alberta. That unexpected oil boom is one reason why many analysts expect decent growth in non-Organisation of Petroleum Exporting Countries production in 2012.
But the resurgence of North American oil production has had a limited effect on global markets, so far, because of a lack of pipeline infrastructure needed to deliver that oil to global markets. That has led to a dislocation between the price of WTI, the preferred benchmark oil price in the US, and global oil prices. WTI traded at a steep discount to Brent last year, largely due to the glut of crude from Canada and North Dakota accumulating in storage tanks in Cushing, Oklahoma, an oil transport hub that happens to be the price settlement point for the WTI contract traded on the Nymex.
Analysts expect the WTI-Brent spread to narrow in 2012, particularly after Canada’s Enbridge and US-based Enterprise Product Partners implement their plan to reverse the Seaway pipeline, allowing oil to flow from Cushing to the Gulf of Mexico. The proposed Keystone XL pipeline, a 1,700 mile-long pipeline that would run from Canada to Texas, could have narrowed the WTI-Brent spread further, bringing more North American oil to global markets – but the administration of US President Barack Obama rejected the Keystone XL pipeline in January, citing environmental concerns.
Without more pipelines such as Keystone XL, the WTI-Brent disconnect will persist throughout 2012, argues Barclays Capital’s Sen. “The Seaway reversal is not enough to provide takeaway capacity if all that oil did go into Cushing,” she says.
“You still need rail to move crude around, and that is why Cushing is not getting full, because you’re moving crude by rail straight from the Bakken to St James [an oil hub in Louisiana]. And as long as you need rail to move that around, you will have the WTI-Brent spread at $8–10, at least.”
How should corporate hedgers process all this information? In an oil market without a clear directional tendency, analysts offer a variety of recommendations for hedging, depending on how they weigh the upside and downside risks. Perhaps the only thing that can be certain is volatility itself.
With that in mind, perhaps 2012 could be a good year for opportunistic hedging. “There are going to be up legs and down legs,” says SG CIB’s Wittner. “So we are just telling corporate hedgers, whether they are producers or consumers, that they need to be nimble, they should know what they want to do, and they should be ready to pull the trigger when the opportunity presents itself.”
The week on Risk.net, March 10-16 2018Receive this by email