SERIOUS MONEY:CRUDE OIL is back in the spotlight as political upheaval in the Middle East and North Africa region continues to intensify. The recent turbulence began with the outbreak of social unrest in Tunisia last December, though the oil price was already climbing higher and had registered sharp gains in the year to date on the back of substantially improved fundamentals.
Market uncertainty increased once political turmoil erupted in Egypt, which precipitated legitimate concern that shipment of oil through the Suez Canal and Sumed pipeline between the Red Sea and the Mediterranean would be disrupted. The Egyptian government under Hosni Mubarak was toppled relatively peacefully in mid-February, but calm in the region proved short-lived, as the crisis quickly spread to Libya and the first real threat to physical supplies arrived.
Libya accounts for close to 2 per cent of global oil output and it is believed that the North African country’s production is currently running at just one-quarter of its pre-crisis level. It comes as little surprise that oil prices have since jumped to their highest level since the middle of 2008 and raised fears that the pace of global economic growth will be severely dented.
It is important to appreciate, however, that the production shortfall arising from the shutdown of Libyan oil production is relatively small as compared with previous supply shocks. Indeed, the maximum reduction in oil supplies as a percentage of global output is only half the size of the production shortfall arising from the loss of Iraqi production in 2002 and barely one-quarter of the output loss incurred during the Gulf War in 1990.
Furthermore, Saudi Arabia and other members of Opec have repeatedly stated they will increase output to compensate for any production shortfall. The International Energy Agency (IEA) estimates Opec’s current spare capacity, which it defines as capacity levels that can be achieved in 30 days and sustained for 90 days, at more than 4.9 million barrels a day excluding Libya, or roughly three times the troubled North African country’s output in January. It is also worthy of note that the oil market remained reasonably well-supplied before the crisis struck, with OECD commercial inventories in December at 57½ days of estimated forward demand versus a normal target of 52-54 days.
Investors, however, have legitimate concern that Saudi Arabia, which accounts for more than 70 per cent of Opec’s spare capacity, excluding Libya, will be unable to make good on its promise. Oil observers question the reliability of Saudi estimates and it is widely believed that spare capacity could be as much 30-35 per cent below the official numbers.
The suspicion is corroborated by the fact that the kingdom failed to respond to higher prices in 2008 until they surpassed $120, and the resulting increase in output was far less than anticipated at just half a million barrels a day. In any case, even if the estimates of the kingdom’s spare capacity are correct, it is still unclear whether Saudi can fill the production shortfall given that its oil is not of the same high quality as that from Libya.
Investors also question whether OECD commercial inventories are sufficient to absorb both an output shock and currently robust demand. The level of forward demand cover may well be above normal targets of 52-54 days, but they are at the lowest level in two years, while inventories in Europe, which depends on Libya for roughly 10 per cent of its oil imports, are below their five-year average.
The Libyan crisis has occurred at an inopportune time given that global oil demand is running at the fastest pace since 2004, which means the seemingly adequate inventories could well be depleted rather quickly.
The greatest concern, of course, is that the crisis spreads to a major oil producer such as Iran or Saudi Arabia, in which case no amount of spare capacity or inventories would be able to plug the gap. Prices would almost certainly soar to record levels above $150 a barrel. Though still a low-probability outcome at the present time, it is clear that the kingdom’s King Abdullah is not dismissive of such a possibility given the recent $36 billion in welfare grants for the Saudi people.
The bottom line is that a geopolitical risk premium is likely to remain in the oil market for some time as the ongoing saga in the Middle East and North Africa continues to unfold, while continued robust demand alongside dwindling inventories should underpin crude’s upward price trajectory. The shock is not sufficient as yet to derail the global economic expansion, but high oil prices are here to stay.
charliefell.com
