Wednesday, February 2, 2011

Contango, Oil Stocks, and OPEC Economic Thought

I just checked the Nymex oil futures page, and as of this writing, the above shows key points on the futures curve (the price of light sweet crude oil for delivery at various points in the future).  As you can see, the front end of the curve is in very sharp contango - prices for oil a couple of years out are almost $10/barrel higher than prices for oil delivered next month.

This generally reflects a situation in which markets think there is adequate oil to maintain current prices at the moment, but are concerned that demand will increase, or supply fall, in the medium term.  This creates a powerful incentive to store oil.  In fact, if you could store oil for free, you could make a guaranteed profit of about $9/barrel by buying oil now, also selling contracts to deliver that oil early next year, and storing the oil in order to fulfill your future promises.  In reality you'd have to pay something to store the oil, but still you could almost certainly make money doing this at present.

So, unsurprisingly, US oil stocks have been increasing in the last few weeks.  If we take US weekly oil consumption numbers, and divide them into commercial stocks, we get the following graph of days of supply in oil stocks:

You can see the sharp increase in the last few data points (after an even larger fall at the end of last year).

I would tend to interpret this pattern of events as increasing nervousness over supplies - with Middle East social unrest on the march, US economic growth picking up, and China continuing to grow by leaps and bounds, the market is nervous as to whether there will be enough oil supplied, or whether there might be unexpected disruptions in the supply, and so, in addition to bidding up the price of oil, it also wants to store oil to make sure there's enough on hand to meet any contingencies.

However, OPEC has other ideas.  This important Reuters story says:
Oil prices have spiked due to tension in Egypt. Brent crude hit $100 per barrel for the first time since 2008 on fears instability could spread through the Middle East, which together with North Africa pumps over a third of the world's oil.

OPEC Secretary-General Abdullah al-Badri told reporters in London the Organization of the Petroleum Exporting Countries did not think it was necessary to call a meeting before its next planned gathering in June, But he added that the mood was changing due to the situation in Egypt.

"Before the Tunisian and the Egyptian crisis, we don't see it (an extraordinary meeting). But now, I don't know if this crisis will escalate. I hope not," Badri said when asked about chances for an OPEC meeting before June.
Saudi Oil Minister Ali al-Naimi told a conference in Geneva he thought the market was balanced in the short term.

"We cannot put oil in markets that don't need it," he said.
The head of the International Energy Agency Nobuo Tanaka, told Reuters on Saturday the West's energy watchdog wanted OPEC to be more flexible in the face of unrest in the Arab world and act quickly if needed.

But Badri said oil inventories would need to be drawn down to warrant an increase in OPEC supplies.

He told Reuters Insider OPEC would raise output if oil stocks in the industrialized economies fell to the equivalent of 53 days of future demand. The latest estimates put these stocks at the equivalent of around 58 days of demand.

"If after 2-3 months stocks come down to 53 days, we will increase production ... we cannot increase production because of speculation," he said in an interview.
This reminds me of the events of 2007-2008, where oil prices were going through the roof - first $80, then $100, then $140, and all the while OPEC, particularly Saudi oil minister al-Naimi, was claiming there was plenty of oil, the market was well supplied, there was no need for them to increase production.

Obviously, if the market is in contango over geopolitical risk and wants to store oil, but OPEC refuses to increase production because the resulting stocks are too high for their taste, the only possible outcome is higher prices.  This will depress demand, which will make stocks even higher, which will apparently cause OPEC to become even more determined not to increase production.  So supply and demand will not meet at the normal market equilibrium, but instead at a lower value determined by OPEC's insistence that stocks are too high, and western market's insistence that stocks are too low for the current perceived geopolitical risk.

I wonder how much of the recent history of oil prices is explained by the fact that senior decision-makers in OPEC appear to lack a basic understanding of economics.


Fixed Carbon said...

Stuart: Thoroughly fascinating post. But I don't understand your closing comments. In what way do not the Saudis understand basic economics? It seems to me that they either cannot supply more oil or that they find it in their interest to drive up the price of oil by creating an imbalance between supply and demand. You are the expert here, I'm trying to learn something.

Stuart Staniford said...

Fixed Carbon: well, you might be right. In the past I've assumed it was all about inability to increase production (and certainly rig counts suggested production constraints in the 2005-2008 episode). But I have a lot of trouble believing they are completely production constrained now, yet they are starting to make similar noises about not increasing production because "the market has plenty of oil".

It's true they could be just price maximizers - but then it would seem like they'd be targetting some particular price range that was the highest the market could bear without triggering marked sudden slowdowns in demand. But they don't seem to be doing that - prices have varied all over the map.

So I am wondering if part of what's going on is that they genuinely are operating from a place of incompetence, where they actually believe that they aren't setting prices (instead believing that speculators are doing that) and that they, OPEC, should just make sure inventories are about at some historically acceptable level (while failing to understand that market demand for storage is not fixed but varies depending on market and geopolitical conditions).

If so, it's a hassle. If there's going to be a cartel fixing prices for a critical economic commodity, you'd hope they'd at least be competent price fixers.

Stuki said...

I fail to see the supposed Saudi disconnect here. If the market is sufficiently in contango to make storing for a year a virtually risk free proposition, holding back supplies until that anomaly is rectified would seem like exactly the appropriate response. From a flow perspective, Saudi ‘storing’ oil in the ground is no different than some other market participant buying it above ground and storing it in tankers. Pull enough oil of the market, and immediate prices will entice those who have been storing for profit, to bring their oil back on line.

Whatever additional demand for stored oil is a genuine reflection of increased geopolitical risk, will still be present absent profitable contango. The difference then, being that those who perceive the risk, must pay for insuring against it, instead of the Saudis underwriting their fear alleviation, while letting them profit from it, to boot.

Stuart Staniford said...

jdl75: I have deleted today's comment. While I agree with your view that US gas taxes should be raised, as I imagine many of my readers do also, we are probably not in a position to bring that about, and you increasingly seem to be descending into free-floating anti-americanism. In particular, today's comment in advocating violence way crosses the line of my tolerance. If you'd like to continue to comment here, please do so in a polite and respectful manner.

jdl75 said...

Stuart, no problem, truly I'm not anti-American, but at the same time the picture provided by America is really something like "having given up", and not being in line at all in terms of urgency.
For sure you could say France or Europe are not much better, but at one point a message will have to get through towards Americans and others.