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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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