Oil: Where is the spare capacity?
This morning’s note from UBS’ Andy Lees addresses something about which I am sceptical regarding the escalating Libyan conflict: global spare oil capacity.
I am in the same camp with Jeremy Grantham. Call it peak resources, peak oil, the end of cheap oil, whatever – the fact is there is a finite amount of natural resources on the planet and we are consuming an inordinate amount of it. At some point, the demand for these resources will outstrip the affordable supply. This naturally induces a parabolic move in price due to inelastic demand – and that’s when the Easter island question presents itself:
With a dwindling supply of natural resources available,
- Do we have the foresight to plan ahead and reduce reliance on these dwindling resources?
- Do we see a ‘nationalistic’ response and resource grab that increases political tension and brings in the spectre of military confrontation?
- Or do we see a class struggle of the energy have-nots against the energy haves?
At least over the short-to-medium term, my view is that
[t]he rise in food and energy prices should be taken into consideration by government officials conducting pro-inflationary policies. What should be of concern regarding commodity price inflation is how it represents a regressive tax on lower income workers and consumers in emerging markets and developing countries. Lower income consumers spend a much greater percentage of income on food and energy. So when commodity prices increase, it has a disproportionate effect on them. One reason we saw food riots in emerging markets in 2008 has much to do with this.
–On Food Price Inflation, Nov 2010
Right now, oil supplies are tight at current prices and that is creating the parabolic move higher, aided significantly by speculation. I would argue that the conflicts in the Middle East right now should not be seen merely as democratic convulsions of people striving for greater liberty, but rather a natural consequence of increased population and energy consumption. It is a manifestation of the Easter Island question: when the resources of your world dwindle to a point at which not everyone can continue to enjoy the same lifestyle, how does society react?
In 2009, I argued:
we don’t need a conspiracy theory to see that the end of cheap oil is upon us. To find high quality oil deposits (I am not talking about Oil Sands in Alberta here) is becoming more and more expensive. And one oil field after another is hitting peak. We have seen it in Mexico, Russia, the North Sea, the Alaskan North Slope and elsewhere. The only thing keeping us from realizing the peak is Saudi Arabia, the swing producer in OPEC.
–Evidence that governments are underplaying peak oil, 10 Nov 2009
Here’s what Andy says about the Saudis:
Saudi oil production (chart 1) grew aggressively over the last 5 months. By February it was similar to the 2008 peak and just 250,000bpd off its 2004 peak – (Bloomberg data goes back to 1990). This was before the Libyan production was turned off and so has raised questions about whether the production Saudi has said it would bring on stream in response to Libya was already encompassed in these figures.
During February Libya’s production fell from 1.585m bpd to 1.385m bpd. As far as I am aware the rest, or at least the majority of the rest has since been lost. If Saudi Arabia was able to cover this by itself that would take Saudi production to 1.135m bpd or 12% more than its 2004 peak, ie totally unchartered territory. Saudi’s own domestic demand has been rising over the years limiting any growth in its exports and now with the King writing cheques to his population equivalent of over USD10bbl or about 10% of its proceeds, presumably domestic consumption of oil will rise by a similar amount meaning that production would have to rise still further over the previous peak to have a positive impact on exports.
The Saudis have a huge population explosion and that requires a lot of natural resources. The same is true all across the Middle East. Moreover, with civil unrest a real concern, the Saudis are spending tens of billions to mollify their citizens. So I do think we should ask whether the Saudis can rise to the occasion. Do they have the spare capacity? The WikiLeaks cables suggest there is reason for doubt.
If the Saudis don’t, who else does? Remember, Libyan and overall African production peaked in 2007. Andy sees problems there:
You will have seen today that Iraq is to add 5GW of diesel generator capacity, almost doubling its power output and giving it sufficient power to meet 16 hours of daily demand getting it back to a more normal level – (generators being supplied by MAN diesel and Caterpillar). In the long term that may help boost domestic oil production but in the short term it is likely to increase domestic oil demand by around 200,000 bpd if I have done my calculations correctly.
Russian oil production (chart 2) which accounted for about 60% of the growth in global oil production over the last 10 years as it recovered from the collapse in the early 1990’s when the Soviet Union fell apart, has been fairly flat since 2006 despite the surging oil prices and is actually down since October (I have ignored February as a seasonal fall). Production is still 700,000 bpd lower than the high in 1990 when Bloomberg records start. It seems unlikely that Russia has much ability to bring more production to the market in the short term particularly given it was unable to do so in 2008 when prices were a lot higher. Since June last year China has managed to grow its production by 225,000 bpd but that is only 5.8% so not enough to meet it own demand growth.
It seems highly unlikely to me that Libya’s shortfall can be made up and even if it can, it seems like the Middle East themselves are going to be consuming an ever greater proportion of their own output. In 2007/08 OECD inventories bottomed at 50.7 days cover in December 2007 compared with this January’s 58.2 days cover so that does offer some protection but it seems that this is another supply chain that really cannot afford any further disruption. Remember the US Joint Forces Command has warned "By 2012 surplus oil production capacity could entirely disappear and as early as 2015, the shortfall in output could reach nearly 10mbpd" and the US DOE has warned of the possibility of the world suffering a decline in world liquids production between 2011 and 2015.
As the 3rd chart shows oil did over-do-it on the upside in 2008 and then the correction, but the trend is very much still in place and it is just in the middle of a rough trend. With greater excess liquidity levels than 3 years ago (household savings, corporate cash and most importantly bank capital ratios) and the Fed unlikely to raise rates until unemployment has a proper fall, it seems it is still too early to abandon oil.
Unless we see demand destruction and recession, I don’t see why oil would drop significantly from here. When the Fed stops flooding the market with liquidity, things will change.