Don't Cry for WTI

Oil market pricing formulae and the benchmarks used in those formulae change over time as crude production that had been the basis for individual wells declines or the components of a blend change. Changes also occur when what is perceived to be an improved benchmark emerges.

A number of years ago, Saudi Aramco ceased using the day-end settlement of ICE Brent crude as a benchmark and switched to using a weighted average of Brent prices throughout each trading day. This new benchmark is called BWAVE (Brent Weighted Average).

Now, Saudi Aramco (which is a larger player among the hundreds of oil companies using WTI and other benchmarks) is switching from using Platts WTI to using Argus, a Platts competitor's, benchmark for US gulf coast sour crude.

The New York Mercantile Exchange (NYMEX) has tried in the past to launch a sour crude futures contract to compliment its less sour WTI. This may now give life to such an effort. A few years from now there may be two highly liquid US futures - WTI and Gulf Coast Sour.

Some have mentioned that this is a snub of NYMEX WTI futures or proof that WTI is "broken". On the contrary, I see this as a natural progression and fine tuning of benchmarks and formulae over time and something the NYMEX itself has embraced.

The Saudi decision is more of a win for trade journal Argus over its competitor Platts.

For more on oil pricing and benchmarks see Oil 101.

Thanks to the very interesting heatingoil.com for picking this up.

Update (Oct 30): As expected, the CME (parent of the NYMEX) is going to launch futures contracts based on the Argus Sour Crude Index. My guess is that this Saudi announcement will result in net increased volumes for WTI futures rather than less.

Tale of the Curves

In each of the past four years the spot oil market has traded around US$80 per barrel (see chart 1 below). Over that time, we have seen a high of US$147.27 and a low of US$32.40.

Chart 1: NYMEX WTI Crude Oil 1st Month Price (click chart to enlarge)

What is interesting is the change in the shape of the forward curve each time we have traded at or close to US$80 (see chart 2 below).

For example, December 2015 was US$69.07 on September 14, 2007 (point A in chart 2 ) and is currently US$93.95 (point B). In other words, the expected price of oil in December 2015 has risen by almost US$25 per barrel in the past 2 years.

Chart 2: NYMEX WTI Crude Oil Forward Curves (click chart to enlarge)

The back end of the oil curve has risen steadily due to three reasons: 1. the expected marginal cost of future supply has increased over the past two years; 2. the US dollar is expected to weaken in oil terms; and 3. an early 1980s-type efficiency drive is expected to make demand more resilient to higher prices than demand has been over the past twenty years.

As you may be aware, oil forward curves have historically not been a good predictor of future prices. Forward curves are a summation of current market expectations. Expectations change over time as new information becomes available.

I don't think that the current forward curve correctly reflects the most probable oil price scenario over the next ten years. However, humility in the face of market expectations and an understanding of those expectations is essential before one can disagree with them.

For an explanation of forward curves, look at Chpt. 18 of Oil 101.

Vehicle Purchasing: Value...not Brand

Vehicle brand loyality in the US is dead (NYTimes). The shift in vehicle purchasing considerations toward value and efficiency and away from brand identity could have a significant impact on US oil consumption over the next 5-10 years.

Bloomberg TV This Afternoon

I appeared live on Bloomberg TV earlier today to discuss oil.

Oil may rise to $95 a barrel this year as demand for heating fuel kicks in and OPEC sticks to its output reductions...  "The oil market is in a glbal supply-driven price rally," said Morgan Downey...  "As we head toward the winter season, and so long as OPEC continue to hold oil off the market, the higher prices are likely." 

Opec, responsible for about 40 percent of global crude production, is due to meet on Dec. 22 in Luanda, Angola.  The December meeting  "may coincide with prices reaching the $85 to $95 price level, at which point they will increase production," Downey said.

Downey is the author of "Oil 101," a history of oil exploration and trading.  In March, when crude traded around $43 a barrel in New York, he correctly predicted that prices would rebound above $60 a barrel two months before it happened. (source: Blomberg, October 16, 2009)

Financial Sense Newshour

An audio interview I had with the highly respected Jim Puplava of Financial Sense Newshour is here.

Toward the end of the interview Jim says:

“I’ve read many books on oil and I have to say that your book is in my top five...It’s one if the best books I’ve read....I highly recommend you pick up a copy.”

Oil Market Break Out

(click chart to enlarge)

Crude oil hit a new high for the year 2009 today, crossing above US$78 per barrel.  We have finally broken out of the summer doldrums as we head into what is seasonally the highest demand period of the year for oil. 

OPEC members' publicly stated price target is US$70-$80 per barrel.  However, once OPEC members increase production prices tend to fall rather than move sideways.  So US$85-$95 per barrel is likely the level which has enough of a price buffer to be the range at which OPEC will increase production.  OPEC meet next in December and this may coincide with prices reaching the US$85-$95 price level at which point they will increase production.

One of the questions asked in feedback was where do I think the oil market is going longer term (3-5 years).  Over such a long time frame it is really only possible to estimate boundaries.  It appears unlikely that oil will price above US$150 per barrel in real inflation adjusted terms (2009 dollars) over any 12 month rolling average even if there is a supply shock or long term decline in supply.  On the downside, given that the marginal cost of non-OPEC production and the required oil price to balance OPEC government budgets are at least US$60 per barrel it is unlikely prices can persist beneath this level.

The next 5 years is also likely to be an era of extreme divergence within the hydrocarbon business.  Some areas are heading for distressful times.  Other areas are primed to do very well.  We are witnessing a replay of some of the same themes from the early 1980s (see Oil 101).  However, this time there will be the twist of a supply crunch and periods of little if any spare capacity.

Feedback 101

Do you have ideas to improve Oil 101 and/or this web site? The primary goal of the book and this site is to improve understanding of energy issues in order to provide the basis for informed debate. Please email ideas to: morgan@morgandowney.com  I respond to every email quickly and am keen to hear advice for improvement or any comments.

Clunker Flunker? An Observation In Hindsight

The US cash for clunkers program was designed to stimulate economic growth through the auto industry by encouraging individuals to trade in old vehicles for more fuel efficient models.  The US$3 billion program ran from July 24 through August 24, 2009.  The program resulted in an additional 690,114 cars being traded in. The average fuel efficiency of trade ins was 15.8 mpg and the average for the replacements was 24.9 mpg. Those receiving the clunker subsidy are supposed to be taxed on that benefit so the entire US$3 billion is not lost.

If you do the math, the saving in oil spending over the lifetime of the new vehicles could be great enough to justify the US$3 billion of taxpayer money spent.  However, critics point out that the taxpayer is out of pocket for donating this one off efficiency saving to fortunate clunker owners without any benefit in return.

Now that the program is over, the data show that there may be a single unexpected long-lasting benefit.

The month after the clunker program ended, consumers continued to purchase more cars and small vehicles rather than larger light trucks and SUVs.  Perhaps vehicle dealers realized that efficiency is the new best selling point - particularly as US consumers are in an increased saving mode following the severe recession? Maybe it took the surge in efficient vehicle sales during the clunkers program for this realization to become widespread?  This efficiency trend, if it persists, will help the US economy better survive future oil price spikes.

Let's take it to the charts. Chart 1 shows the brief recovery in US auto sales during the short lived clunkers program.

(click to enlarge chart)

Chart 2 below shows the numbers of cars sold in the US as a percentage of total.  The clunkers program achieved what US$147 per barrel could not: 57% of vehicles sold during August 2009 were cars rather than SUVs/Light trucks. This exceeded the 55% number of May08-July08 as oil prices hit record highs.  What is most interesting is that the share of car sales has not collapsed to pre-clunker program levels: in September 2009 car sales accounted for 54% of total US sales.

(click to enlarge chart)

Another criticism of the clunkers program was that it encouraged the purchase of imported vehicles rather than domestic.  Chart 3 clearly shows that the trend toward sales of imported vehicles has been in place for a long time and that the clunkers program barely made a difference to the trend.

(click to enlarge chart)

Conclusion: While the benefit to taxpayers may not be immediately significant, the cash for clunkers program appears to have had a halo effect on efficient vehicle sales in the US.  This efficiency will strengthen the US economy against future oil price shocks and if the trend continues it is a welcome unintended benefit of the clunkers program.

Is Natural Gas the New Oil?

Source: EIA and IEA data.  Chart from Page 7, Fig. 1-3, Oil 101

There have been a number of stories over the past week about the growth potential of natural gas in the US.  The optimism over supply has resulted from the application of a technique which fractures natural gas bearing shale rock. The fracturing process involves pumping fluids at high pressure into wells to break the reservoir rock and permit natural gas to flow which would otherwise never move across the tight formation to the well.

The fracturing ("fracing") of tight shale formations is now being investigated for use in Europe and other areas outside the US.

Estimates as to how much additional natural gas can be extracted using such techniques vary extremely widely. Some say that natural gas could become an increasing alternative transport fuel to liquid hydrocarbons (crude oil) in certain applications and certain regions of the world for several decades. Natural gas may also increasingly displace solid hydrocarbons (coal) as a baseload (running all the time) electrical power generation fuel.

What is certain is that the industry is in a state of flux which could turn the oil and gas industry upside down over the next 10 years.

In fact, there is a now frantic effort bubbling to the surface in the US to try to avert a natural gas crisis due to prolonged oversupply and low prices. The effort is focussing on expanding alternative uses for natural gas and if possible linking natural gas prices to liquid hydrocarbon (crude oil) prices which are expected to trend higher due to global supply constaints.

Oil Demand Destruction Destroyed

The IEA this morning raised its 2010 forecasted oil demand by 0.35 million barrels per day (Mb/d) to 86.1 Mb/d. This means 2010 oil demand will be 1.7% (1.5 Mb/d) above 2009. Almost all of the growth is coming from non-OECD countries with OECD oil demand growth expected to be flat.

Floating Storage Sinking

A great story by Brian Baskin in the Wall Street Journal about the financial risks involved in storing oil. While storing oil on an opportunistic basis was common earlier in the year. The Journal story shows that in free markets such arbitrages only exist for brief periods:

"Storing oil is rapidly becoming a losing proposition...companies will find it difficult to extricate themselves.." (WSJ)

CNBC This Afternnon

On CNBC's Closing Bell live today I spoke with Maria Bartiromo about commodities.

(click here to view on CNBC's site if it doesn't open below)

Oil and The Ugly Currency Contest

A story in the UK Independent claims that an international agreement ("confirmed to The Independent by both Gulf Arab and Chinese banking sources in Hong Kong" - from the news story) is in place among many nations to begin a nine year transition toward trading oil in currencies other than the US Dollar.

However, once again, and as I mentioned here and here, I tell you that the inefficiency of trading a global commodity in many different paper currencies (crossing many currency bid/offer spreads) is far worse than the current USD oil trading system.

Every time this debate arises because some confuse a transactional currency decision with a reserve currency decision. First, the transaction currency decision: the currency in which oil is traded should be the one which is most liquid and widely traded. This minimizes costs for consumers and maximizes revenues for producers.

What consumers and producers do once they own this highly liquid currency after the oil transaction has been completed is a completely separate second decision - a reserve currency decision. Countries are free to sell their liquid currency reserves and immediately buy anything they want, including other currencies or hard assets. This is a separate decision which has nothing to do with why it is best to trade oil in dollars - the most liquid and widely traded currency.

I am not blindly biased in favor of the US Dollar. All paper currencies tend to lose value over time. As Anatole Kaletsky put brilliantly in a Times article a few months back:

"The currency game is not a beauty contest but an ugly contest, in which investors must choose the currency that is least ugly."

For oil trading, the least ugly currency is still the US Dollar.

Final Brazilian Oil Use Observations

On my way to the airport, a few final interesting transportation observations about Brazil which you are likely to be familiar with if you have been here.

Video One: A significant number number of trucks have the ability to lift some of their wheels off the ground when not fully loaded (to save on fuel). You don't tend to see this to the same extent in other countries.



Video Two: Motorcycles quite commonly create their own unmarked lane between car lanes in which to speed by in convoys. Cars have to be very careful about changing lanes.

Petropolis and the Brazilian Ethanol Subsidy

This past week has been a big one for Brazil. It was announced that the country will host the 2016 Olympics in Rio de Janeiro.  Brazil had already being chosen to host the 2014 soccer World Cup. This was also a week of optimism about Brazil's petroleum sector with large expanded claims about deep offshore oil fields being made.

Although the US is the largest producer of ethanol by volume, ethanol accounts for a larger percentage of Brazil's transport fuel use.  Ethanol is the same alcohol in beverages (don't drink from the fuel pump though as there are many often poisonous additives - see footnote below about the bottle in the picture to the right).

In Brazil, most ethanol is made from sugarcane. In the US most ethanol is produced from corn, which is a less efficient energy-wise and a more expensive process. The US does not have the same Brazilian Amazonian conditions to grow such large sugar volumes.

One of the observations I made during my time here was that ethanol prices are extremely low at Brazilian pumps compared to gasoline.  I wondered: how this could be with twenty year high sugar prices (US24 cents per pound) and moderate petroleum crude prices (US$70 per barrel)?

A little background first:  all gasoline at Brazilian retail stations must by law contain at least 25% ethanol, with the other 75% being petroleum-based gasoline.  This blend is known as E25.  Most Brazilian retail stations have two pumps: one for E25 snf one for ethanol. All gasoline in the US must contain at least 10% ethanol (E10) and it tends to be only in the US midwest corn belt that second pumps offering high (E85) ethanol blends exist.

The US has a 54 US cents per gallon tariff on ethanol imports.  The US tariff is to try to prevent non-US ethanol producers from taking advantage of the hefty 51 US cents per gallon subsidy which ethanol producers in the US receive in order to kick start and scale up US ethanol production.

The US ethanol tariff effectively eliminates the ability of Brazil to export ethanol to the US. Brazil has no import tariff on ethanol.

Brazil has no ethanol subsidy now (it did until the 1990s) and Brazil has called many times for the US to remove its 54 cents per gallon import tariff.

However, in reality Brazil does subsidize ethanol by heavily taxing gasoline.  E25 Gasoline in Brazil is roughly US$5.15 per gallon at the retail pump at the moment (BRL 2.40 per liter).  Ethanol in brazil is currently US$2.95 per gallon (BRL 1.39 per liter).  This equates ethanol to 58% of the cost of E25 gasoline.  Ethanol should be around  of 70% the cost of E25 gasoline based on the mileage it permits.

The high Brazilian tax on E25 gasoline is effectively a clever ethanol subsidy.

You may wonder why everyone in Brazil doesn't switch away from petroleum gasoline to ethanol?  They are, with around 94% of new vehicles sold being flex fuel vehicles capable of burning high ethanol blends.  It tends to be imported luxury vehicles and older non-luxury vehicles which still use E25 gasoline.

(note on the picture above: the bottle contains a mineral water from the Brazilian city of Petropolis, which is named after Pedro, the second and last Brazilian Emperor, rather than petroleum.  I can vouch from my one bottle that the water is tasty and does not contain any hydrocarbons.)