Sleep walking into the next energy price spike
OPEC’s decision to leave its production target at 30 million barrels a day for the next six months, with the proviso that it is prepared to take steps to ensure that the markets remain stable should the need arise, was widely anticipated by the energy market. According to OPEC, supply and demand is in balance with Brent, the international benchmark, averaging just below $110 a barrel so far this year.
The production problems seen in Libya, Iran, Nigeria and more recently Iraq, which have taken over 2 million barrels a day off the market, have been offset by the rapidly growing US shale oil output.
The obvious question now is what will happen in the future? There are two potential scenarios.
First, the security situation in Libya, Nigeria and Iraq improves and sanctions are eased against Iran. The second is that the situation in Iraq deteriorates and the country descends into civil war.
In the first scenario with an improvement in the security situation in Libya, Nigeria and Iraq, either collectively or in any combination, over to 2 million barrels a day in extra production could hit the markets. This amount of extra crude in the market, without a corresponding increase in demand, will cause the price to fall to close to $80 a barrel. Under the second scenario, with the security situation in Iraq deteriorating and the country descending into a civil war that affects the oil producing regions of the south, a further 1 million barrels a day could be removed from the market forcing the price up to $125 a barrel.
Under both scenarios the question is what would OPEC do? Given OPEC’s past performance, it is hard to see them “speaking with one voice” and cutting back on production. That would leave it up to Saudi Arabia to act unilaterally, which it has done in the past. In scenario 1 the Saudi’s will cut back on its production to prevent a fall in the price of crude however, in the past the most it has reduced its production by in one cut is 1 million barrels a day. That would still leave an extra 1million a day in the market reducing the price to below $100 per barrel. Under scenario 2 the world would be looking at OPEC to increase production. Within OPEC Saudi Arabia has the largest spare capacity of approximately 2 million barrels a day. However, the vast majority of this spare production is heavy sour crude, with up to four times the sulphur content of some of the Libyan crudes. This means that the Saudi spare capacity is effectively worthless to the refineries that are short of light sweet crude and would remain unsold.
Going forward the one big uncertainty for the energy industry, and little mentioned, is the International Maritime Organisation (IMO) decision to tightening marine fuel specifications, reducing the maximum sulphur content in ships bunkers. As of 1 January 2015 the maximum sulphur for ships bunkers in the Sulphur Emissions Control Areas (SECA) of the Baltic, North Sea, English Channel and the US/Canada coastal waters will be reduced to 0.1%, effectively diesel, and globally to 0.5% from 1 January 2020.
While these limits can effectively be met by installing scrubbers on each vessel or refitting ships to use liquidified natural gas, both at a cost of approximately $2 million per vessel, most operators will meet the specifications by using marine diesel, which can be up to 50% more expensive at to-days prices pushing up freight costs considerably. The big question is whether refiners can produce enough diesel to meet the increase in demand? While a lot has changed in the world of refining over the last few years, European refineries closing and large new refineries being built in Asia, if the increase in diesel demand cannot be met we can expect a run up in the price of crude as we saw in 2008 as refiners, with a lack of desulphurisation units capable of using heavy sour crude, chase lower supplies of light sweet crude forcing up the price as happened in 2008.