Are Oil and Products Supply Dynamics Set to Change?

I spoke at Commodities Week in London in early November. There were many great presentations and topics shared there but of all the presentations the one that interested me the most was by Ed Morse.

Ed is Chief Energy Economist with Lehman Brothers and his presentation covered Oil supply and demand. His main thesis was that new refining capacity set to come onstream over the next few years will significantly change the supply side picture by the turn or just after the turn of the decade. In effect, by 2009, refining capacity additions should outpace demand growth by a factor of 2:1 he argued.

In making this assessment, Lehman has been conservative in looking at new refining capacity excluding projected refinery capacity upgrades in politically sensitive areas like Venezuela for example. Additionally, they see some strong political agendas to support the capacity build out that include;

• Saudi Arabia has a strong need to alleviate downstream bottlenecks which has in effect, reduced that country’s control over the oil market;
• Chinese self sufficiency
• India’s plans to re-position as an export refining hub and its ability to bring the Reliance refinery onstream ahead of schedule; and,
• The need to process heavy oil in situ so as to get it to market more effectively in a number of producing countries.

The upshot of all of Lehman’s calculations and analysis is that by 2012 some 13m b/d of refining capacity could be built resulting in some 4-5m b/d of excess capacity. However, Lehman’s analysis continues to see issues in the U.S. reining sector with skills shortages and zoning/licensing issues.
Since 2004, refining margins have been high and refiners have delayed maintenance in order to run their plants. Refining utilization rates were at a high in the U.S. during August at around 92% but there are still potential shortages of heating oil this winter and gasoline inventories have been slowly eroding despite slightly reduced North American demand. Under Lehman’s scenario, this will not continue. Lehman state that “refinery investments likely to go ahead, but (there will be) no appreciable spare capacity until (the) next decade”.

On the demand side, Lehman sees nothing much changing and their thesis is that “Asian and Middle East-led demand growth continues to outpace non-OPEC supply growth, eroding OPEC spare capacity.” It sees changes only on the supply side where additional refining capacity and non-conventional supplies will dampen oil prices in the longer-term. Morse stated that while non-conventional supply is growing only slowly it is enough to have an impact on global supply and refinery margins and that biofuels could meet 1/3rd of incremental transportation fuel growth by 2010 albeit with many caveats. It sees much of the non-conventional supply coming from condensate as condensate splitter capacity also grows over the remainder of the decade.

So what does all this analysis mean? Well, Lehman’s analysis suggests that by 2009 there may well be a ‘turning point’ in the price of oil and products and that by early in the next decade, refining margins will be lower with spare capacity and prices will also be lower. As Morse stated, “the balance of risks appear bullish to 2008, neutral in 2009 and bearish thereafter.”

For the last several years, we have been arguing that an extended period of lack of investment in infrastructure and a demand side surprise is behind the rise in oil prices. But energy is cyclical and as oil prices rise it fuels increased investment and usually reduced demand as prices feed through to the consumer. Two things appear to me to be different this time. The first is one that we have often commented on and it’s the environmental factors at play that include increased costs, time and complexity in developing new projects as well as the increased interest in alternative fuels. The second is the weakness of the U.S. Dollar which has the effect of amplifying the rise in price as expressed in U.S. Dollars and has been a large factor in recent oil (and other commodity) price rises.

What is interesting purely from an objective point of view is that much of the development of new infrastructure – especially on the refining side – now appears set to occur outside of North America. China and India are tackling their growing energy needs in a very direct manner and building new plant to reduce reliance on imports is a key component in their aggressive stance. Furthermore, OPEC countries are making the investment too, in part, to enable them to maintain political power over the price of oil but also to ensure that heavier crudes can get to market. North America remains a place where no one wants a refinery in their back yard!

Surely, other than an impact on prices due to changed supply/demand dynamics, all of this will have some additional impacts too. North America or the U.S. will need to increasingly rely on product imports as well as oil imports. Influence over product prices will shift from consumer markets to producer markets too. For the investor, even though the fundamentals may change it surely means continued opportunities across the board to profit including freight rates, arbitrage and overseas investment.

This article also appears in Energy Hedge issue 56 - Energy Hedge is the e-newsletter of the Energy Hedge Fund Center - www.energyhedgefunds.com