$25/Barrel Oil? Coming Up!

The days of $25/barrel oil are not far off, and the status of US refinery capacity may be greasing the wheels.

Four years ago, the US had inadequate refinery capacity to meet growing gasoline demand. A new refinery had not been built in the US since 1976 due to high upfront capital costs, not-in-my-backyard (NIMBY) objections, and environmental regulations.

The focus on fuel has shifted from the production of gasoline to ethanol and diesel. Global demand for diesel is growing faster than that for gasoline, much of which emanates from Europe (where 40% of new cars sold have diesel engines, and diesel fuel carries fewer taxes than gasoline) and the developing world. Domestically, as the mandated ethanol content of gasoline increases, the amount of gasoline produced from refineries decreases. Refineries’ highly-technical construction is calibrated to suit particular types of crude, with varying degrees of flexibility and range. US refineries are mainly calibrated for gasoline production, and reconfiguration of a gasoline-calibrated refinery to produce diesel is an expensive infrastructure investment. In this financially-constrained environment, it is unlikely that many such retrofits will take place in the near future.

This leaves us, however, with much idle and unprofitable refinery capacity, and an impending gasoline glut. There is too much gasoline and not enough diesel in the world.

Refining geopolitics

Venezuela is a telling example of the potential geopolitical consequences of refineries shifting towards the use of heavier, sour crude.

President Chávez cannot sustain his energy revolution without a major alternative energy partner to the US. Venezuela is a hard supplier to ignore because of its massive reserves, topping 80 billion barrels in 2007 – and the fact that it is the sixth-largest net exporter in the world. Estimated reserves in the Orinoco Belt region range between 100 – 270 billion barrels. Venezuela also continues to lay claim to 60% of Guyana – all the land west of the Essequibo river, which is rich in mineral resources and viewed as an extension of the Tar Belt, in which Venezuela is aggressively pursuing development of oil resources with China among the investors.

The major technological and market barriers that would severely hinder Venezuela’s disengagement from the US market might be softened by a global refinery shift towards processing diesel. However, the mutually beneficial relationship involves over 14,000 Venezuelan-owned CITGO gas stations and 6 refineries that process heavy, sour crude. Caracas is attempting to build up its tanker fleet in order to be able to ship more crude to China – its perceived geopolitical counterweight to the US – but the cost of shipping heavy crude in terms of weight-to-value ratio is unfavourable[1], making the geographic proximity and refining capacity of the US important and providing some stability in the US-Venezuela energy relationship, despite political tensions.

Demand destruction

The fundamentals underlying oil and gas demand outweigh the short-term impact of rampant speculation and are fueling the global demand slowdown. Speculators and hedge funds that took long positions are having to dump crude oil and refined products on the market, placing further downward pressure on oil prices.

The economic downturn is further exacerbating the supply/demand imbalance. Less demand and low prices have led to increased stockpiles in strategic reserves. Accumulation of inventories in oil further promotes and escalates contango. The expectation of higher oil prices in the future (and in this case, long-run future) combined with decreased demand makes storage an attractive option; so much so, that tankers are being converted to floating storage facilities.

The latest OPEC production cuts, agreed on 17 December, will take several months to impact prices and will not be enough to rebalance global supply and demand since it is highly likely that several OPEC countries will cheat on their new quotas. Incentives to cheat are strong, given that the leaders of many of the producer states derive their power in large part from oil revenues.

Countries like Venezuela and Iran that have budgeted for high oil prices ($95 – $120/bbl) and have massive public spending regimes and completely undiversified economies will feel the greatest political and economic pinch.

In the case of the UAE, the pending financial implosion of Dubai and the need for Abu Dhabi to bail out its government – but not its foreign investors – especially in the housing and financial markets looms on the horizon and will send stock markets reeling.

Lower revenues will make it more difficult for the well-oiled corruption machine in Nigeria to function to placate MEND, and this could actually lead to a rise in bunkering – diversions of large amounts of crude into illegal spot markets – kidnapping of foreign oil workers, and trading for arms. The rebels can outgun most military units, even in open waters, as evidenced in the summer 2008 Bonga attack 75 miles offshore.

While Russia has managed to build up significant reserves from oil and gas export revenues, its economy is in a tailspin as oil, gas and other primary mineral commodity prices have collapsed on world markets. Russia’s renewed blustering against Ukraine for non-payment of $2 billion in energy debts and its leadership in forming a gas cartel should be seen as a last gasp of the bear before his winter hibernation, licking his wounds from his own market shenanigans against Shell, BP and rival oligarchs. Meanwhile Gazprom, the darling of hedge fund managers and ‘smart’ mutual fund gurus, has fallen from grace – slipping from the 4^th largest company in the world to 35^th. With billions of dollars required to restore its sinking reserve/production ratio, and to make long-delayed investments in maintaining its capital stock, Gazprom is now in the unenviable position of having to spend billions of dollars on near-term investments from which it may not make any financial return for the foreseeable future. Finally, Medvedev’s signals that Russia will cut production in line with OPEC’s cuts are less indicative of a willingness to cooperate with the cartel than of declining production due to a lack of investment in upstream production which previous high oil prices allowed him to defer. When prices rise in the future, Russia is likely to abandon its ‘cooperative spirit.’

What does the new price environment mean?

A low-oil price environment portends the collapse of the US oil and gas service industry. With delayed investments in new oil production worldwide already totaling 4-5 million barrels per day, short-run changes in price will impact long-run investments in exploration and production (E&P). More delays or cancellations such as Kuwait’s decision to back out of a nearly $14 billion petrochemical project with Dow Chemical has sent stocks in these companies plummeting. It is clear that demand for these products are slackening around the world, and this is placing additional downward pressure on oil prices. Ironically, by the time longer-term economic stabilization begins to set in and investment conditions are more favorable, postponed E&P and other energy-related infrastructure projects that were planned under high oil prices to bring more oil and gas online to alleviate the tight supply market of the past year will not have taken place. As a result, once economic growth resumes, the tightness of the market will persist until higher energy prices make deepwater drilling and unconventional oil and gas profitable again. By that time, we will be right back where we started.

Renewable projects cannot currently compete with low oil, gas and coal prices absent massive tax credits, the enactment of a gasoline tax, and the introduction of a tough cap and trade system or a carbon tax. Falling raw material costs will make nuclear more cost-competitive, but not nearly as much as the ‘nuclear renaissance’ proponents predict.

Economic conditions may be keeping consumers from rushing out to buy gas-guzzlers again, but in December, more SUVs and light trucks were sold than fuel-efficient cars — a harbinger of what lies ahead. As oil prices test $25/bbl, the reduction in vehicle miles traveled (VMT) and other gas-saving improvements in behavior may be lost, as memories of the past summer’s high prices fade.