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Wall Street History
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07/23/2004
The Crude Story, Part I
Over the years, I have commented extensively on the energy sector, particularly in my “Week in Review” columns where I not only give updates on actual data but my own opinion on the direction of prices and / or share values. I have also used this space for more extensive reports, particularly on past market- moving events concerning the oil & gas industry.
What follows below is a little different. It is information from a recent internal report generated at a large money management firm. I am not able to identify the author, but for those of you who are energy junkies it’s terrific research.
I edited the piece slightly, mostly to eliminate the more technical bits, and included a news item from this week that relates to the discussion.
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Most oil analysts base their supply-demand models on data generated by the International Energy Agency (IEA), the organization set up by the industrialized economies in the mid- 1970s to monitor global oil markets in the wake of the 1973 oil crisis. Since 2000, the IEA has forecasted that future non-OPEC supply would increase faster than global demand. However the IEA data has consistently underestimated global oil demand and overestimated non-OPEC oil supply. These errors in IEA supply and demand data led to the creation of a huge number of “missing barrels.” These enigmatic barrels have neither been produced, nor consumed, and can’t be found physically in global inventories. Although most energy analysts should have concluded just by looking at US oil and refined product inventory behavior (which was dropping when the IEA said it should be rising) that there was something wrong with the IEA data, they chose not to. The IEA’s incorrect forecast of a global inventory build resulted in almost every energy analyst having a bearish oil price forecast over the last four years .
The IEA’s biggest problem is consistent overestimation of non- OPEC, and particularly non-OPEC / non-FSU (Former Soviet Union) oil production. Over the last four years, the IEA’s downward revisions of non-OPEC / non-FSU production from its original estimates have been impressive.
The IEA’s original 2001 estimate was revised down by 500,000 barrels per day, and its 2002 estimate was revised downward by 400,000 b/d. Its 2003 estimate was revised downward by 900,000 b/d, and its 2004 estimate has already been revised downward by 700,000 b/d. On a four-year cumulative basis, the IEA has overestimated non-OPEC / non-FSU production by almost 3.7 billion barrels.
My analysis of the global oil markets, as outlined in (an earlier piece) shows that the reason for the IEA’s overestimation of non- OPEC oil production was centered on erroneous analysis of both US and North Sea oil production. In both cases, it appears that the IEA has failed to understand (various geological constraints) .In 2003, the IEA had originally estimated that US oil production would rise by 100,000 b/d and that North Sea oil production would be flat in 2004. As has been the case over the last four years, these figures continue to be wide off the mark. In fact, DOE (Department of Energy) statistics now indicate that US liquids production has probably declined by over 300,000 barrels per day in the first six months of 2004 vs. the first six months of 2003.
From UK data, it appears that UK North Sea oil production is down 400,000 barrels per day year over year in the first six months of 2004. The drop in production from these two sources alone accounts for almost all of the 700,000 b/d downward revision in the IEA’s original non-OPEC supply estimate.
The only area where the IEA has consistently underestimated production is the FSU. This is important because over the last three years the only area of growth in the non-OPEC world, outside of West Africa, has been production from the Former Soviet Union .However, I think the IEA trend of underestimating FSU production will come to an end in 2004. Because of pipeline constraints in Russia, essentially no exploration in the last 15 years, and the jailing last year of Khodorkovsky, the head of Yukos, (which has definitely given western oil companies something to think about regarding future Russian investments) it looks as if the huge increases in FSU oil production since the late ‘90s might be coming to a close.
It’s interesting to note that the IEA has not revised upward it’s 2004 FSU oil production from its 11 mm barrel per day original estimate made last year. This is the first time in five years that the IEA has not made a mid-year upward revision to its FSU production forecast. It’s also interesting that last week (ed. week of 7/5/04) saw the first significant downgrade of FSU production by a major forecasting body. The Energy Information Administration (EIA – the statistical arm of the DOE) cut its forecast for oil production growth for the FSU by 100,000 b/d in 2004, and 400,000 b/d in 2005.
It’s critical to understand how important these FSU figures are. Unanticipated FSU production has masked the underlying non- OPEC supply problems that we are experiencing today. If it had not been for extra FSU production, the spike in oil prices that we are seeing today most likely would have happened two years earlier .
Sanford Bernstein (attempted) to analyze when Russian oil production will peak. Since Russian oil production increases also represent 85% of the FSU oil production increases over the last five years, then picking the peak in Russian oil production is incredibly important – the peak in FSU production will be the peak in Russian production.
Sanford Bernstein’s conclusion is that Russian oil production should peak in 2007 at approximately 10.2 mm b/d, up from today’s production of 9.2 mm b/d. Given that the remainder of FSU production should grow by 150,000 b/d over the next several years, then we should see the peak in FSU production in 2007 at approximately 12.5 mm b/d – up from today’s production of 11 mm b/d .If the Sanford Bernstein analysis is correct then we should see significant slowing of FSU production in the next several years. [Ed. There is a large find in the Caspian Sea that does not come on line until 2008 at the earliest.]
With the biggest acceleration of increases in FSU production potentially behind us, the likelihood of further disappointments in total non-OPEC production becomes greater and greater . There is a very large chance that non-OPEC / non-FSU production will actually decline in the next two years. With FSU production de-accelerating, the last large source of non-OPEC supply growth is literally drying up .
According to my (work), non-OPEC / non-FSU production has not rolled over, in fact it has continued to grow, although at a very slow 1% / year compounded over the last six years, which is down from a 2% growth rate since 1980. I think that when we do hit the peak in non-OPEC oil production, (my proprietary index) will roll over and resemble what has happened to US natural gas production, which has fallen precipitously over the last 4 years. Once this non-OPEC / non-FSU index rolls over, I think that we will have entered into what will turn out to be an unrestrained bull market in oil. At this point, the only source of new oil supply, with its concurrent pricing power, would be OPEC / FSU.
In addition to the problems with its supply forecasts, as I mentioned above, the IEA has consistently underestimated demand over the last 4 years, and has already severely underestimated demand in 2004 .The IEA, by its own revisions, underestimated global oil demand by 500,000 b/d in 2001, 600,000 b/d in 2002, and 800,000 b/d in 2003; this year, it has already admitted to a 1,500,000 b/d revision upward from its original 2004 estimate made in November of 2003!
Putting all the supply and demand revisions together produces some pretty impressive numbers. On a net basis, the IEA’s underestimation of demand and overestimation of non-OPEC supply are this: 600,000 b/d in 2001, 800,000 b/d in 2002, 1,300,000 b/d in 2003, and 2,200,000 b/d in 2004. If you were using IEA data to make your oil price forecasts during those years, you were incredibly off-the-mark compared to what actually happened. Using the revised IEA figures, the 2004 global oil market has now slipped from an earlier projected 1.5 mm barrel per day surplus to being balanced. This has occurred with OPEC pumping close to 1.4 mm barrels a day more (and near full capacity) in 2004 than in 2003. These are still theoretical numbers, but US inventory data imply that they are close to accurate.
I am a firm believer that it’s almost impossible for US inventories to be anything else but a reflection of what is happening in global crude and product markets. Because of the tremendous growth in oil and oil product trading in the last decade, it is impossible for oil to draw down in one area and not draw down in another, except for short periods of time.
Traders, using pricing differentials and arbitrage, are able to make the global inventory picture even out in very short time periods. Oil analysts over the last five years have made the repeated mistake in thinking that even though US oil inventories were declining, they were building up somewhere else. It was an attempt to “find” the “missing” IEA barrels, which ultimately never existed.
Since the beginning of 2004, total US inventories (i.e. crude plus refined product) have grown only slightly and are still only 2% above last year’s historic lows. Although we have had a healthy build in crude oil since the beginning of the year, we have not seen corresponding builds in either gasoline or distillate because of strong end-use demand.
Given that we have entered the seasonal strong period of crude oil demand, there is a good possibility that this crude oil “cushion” is going to evaporate in the next six months. If this cushion disappears this summer or fall, then we will once again be back at historically low levels in crude oil inventories, with the potential of spiking prices to over $50 per barrel before year- end.
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It’s not just the IEA that has underestimated supply and demand. A story in the Wall Street Journal, July 22, notes:
“China’s crude-oil imports hit a record 2.8 million barrels a day in June, suggesting the country is increasing its dependence on imports to fuel its economy as domestic production falls.
“Chinese traders said full-year crude-oil imports are expected to surpass a government forecast of 2.2 millions barrels a day, to reach a record 2.4 million barrels a day.”
Wall Street History returns July 30 with part II The Oil Market in 2004 and Beyond.
Brian Trumbore
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