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COMMODITY PRICING AND RISK
by Elliott H.
Gue
Editor, The Energy
Letter
March 3, 2006
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The fact is that North America (Canada, the US and Mexico) consumes upwards of 24.5 million barrels of oil per day and produces less than 14.2 million barrels. That ever-widening gap is filled by imports from abroad totaling a whopping 10.3 million barrels per day. Much of those imports come from regions of the world that tend toward instability--Nigeria, the Middle East, Venezuela. And when it comes to geopolitical instability, 2006 is already shaping up to be a very busy year. Early in the year uncertainty surrounding Iran's nuclear program kept a bid under crude prices. More recently, attacks on foreign oil operations in Nigeria and a bungled terrorist attack on a key Saudi Arabian oil refinery have kept prices aloft. But the mistake made by many casual observers is to assume that such geopolitical risks and uncertainties are one-off events with impacts that are destined to fade over time. These analysts tend to assume that once the negative headlines on Iran or Saudi Arabia fade, so too will the risk premium priced into the oil market. But this is a naďve view indeed. The geopolitical premium priced into the oil markets is not a transitory phenomenon; regions prone to political instability are becoming ever-more important suppliers to the global oil market. Meanwhile, more developed and politically stable nations such as the United Kingdom, US and Canada are seeing declining oil production; the risk profile of the global oil market is changing. I like to use a simple ratio as a proxy for the oil risk premium.
The chart “Oil Safety” adds up total oil production from the US, Mexico, Canada, the UK and Norway and compares that to total world production; the resulting ratio is depicted as a percentage. These five oil-producing nations are among the most politically stable in the world so the higher their production relative to total world output, the safer the globe's oil supplies. A lower ratio spells a higher oil risk premium. The first notable decline on this chart comes from 1965 through the late 1970s. A few events contributed to the ‘70s jump in the oil risk premium. Chief among those, US oil production peaked early in the decade and the once-prolific Texan fields entered a rather rapid period of production decline. After 1971, the US became gradually more reliant on foreign imports increasing the risks associated with the nation's oil supplies. But the risk premium topped in the late ‘70s (the ratio reached a nadir) and began to decline through the mid-‘80s. The reason for this was two-fold. On the supply front both Alaska and the North Sea saw nice ramp-ups in production at this time. These fields, located in politically stable regions of the world, reduced the risk premium associated with the globe's oil supplies. At the same time, Saudi Arabia was able to scale back production drastically in the early ‘80s. Global demand growth was low as emerging markets like China and India hadn't yet hit their growth spurts; China was actually energy independent at this time. But after 1985 this (admittedly crude) measure of oil security has been in decline. The decline in recent years is more dramatic; as the vast North Sea fields peaked and began to see declining production the world has become evermore reliant on supply from more dangerous locales. And a jump in demand from nations like China and India has forced the Saudis to once again open up their taps to the extent they're able to do so. Global oil risk is once again on the rise. This time around, there are few obvious reasons for this ratio to rise again. It's unlikely there are any big North Sea-like super-giant fields out there waiting to be discovered. Most of the world's main oil-producing regions have been heavily explored; the focus of most new oil exploration is smaller pockets of oil or enhancing production from more mature fields. I see little chance for a supply-side push for geopolitical risk reduction on the scale seen in the ‘80s. While I agree that there's a geopolitical risk premium in oil prices, I suspect that premium could be more persistent than the oil markets suppose. This in part explains how inventories of crude oil can rise to multi-year highs while prices stick at stubbornly high levels. Beyond Oil It's also worth mentioning that the natural gas market could also see the addition of a more permanent risk premium in coming years. The reason is that historically, the US has been able to satisfy all her needs with domestic gas or by importing from Canada. This is no longer the case. As the chart “LNG and Canadian Imports” illustrates, liquefied natural gas (LNG) imported by tanker ship from faraway lands like Qatar and Russia is projected to become by far the most important source of imported US natural gas in the next few years.
As gas transitions from a local to a global commodity, supply risks increase dramatically. Natural gas, like oil, will have to be sourced from regions of the world that are less stable or at least less assured compared to the US and Canada. Moreover, it's a mistake to assume that geopolitics is the only risk that could shake the natural gas market. Last year's devastating Atlantic hurricane season caused considerable damage to gas-producing assets in the Gulf, a key producing region for the US. This weather risk premium was, in fact, the proximate cause for last year's gas price spike to the mid teens. The 2006 Atlantic hurricane season will kick off in just a few months' time. August and September are the busiest months for hurricanes effecting the Gulf and Gulf Coast States. But hurricanes in May and June certainly aren't unheard of. Over the past few weeks I've done considerable research on Atlantic hurricanes using data and papers provided by the National Oceanographic and Atmospheric Administration (NOAA). It appears that we're in the early stages of a cyclical increase in Atlantic hurricane activity. If history is any guide increased hurricane activity is likely for at least another 10 years and most likely for many years beyond that. Similar up-cycles are evident in data I examined going back to the 17th century. LNG imports, Gulf production, gas processing and pipeline infrastructure can all be negatively impacted by tropical weather patterns. If we're truly on an up-cycle of activity, a durable weather premium will inevitably be factored into the natural gas market. In next week's issue of The Energy Strategist, I’ll analyze the unsettling data supporting a cyclical upturn in hurricane activity and the effect of this phenomenon on energy pricing. I'll also be taking a look at what stocks will be affected--positively and negatively--by another powerful hurricane season. I’ll also break down how costs and not sales or pricing growth will be the primary driver for most drilling stocks over the coming months and will reexamine the railroad industry. US railroads are building up infrastructure to meet burgeoning demand for coal shipping. One company is supplying the rails with the advanced technology, spare parts and expertise needed to improve their productivity and meet that demand.
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