Oil pricing – a tale of speculators and OPEC

With the only risk of substantial market movement seen on the upside, the Organisation of Petroleum Exporting Countries (OPEC) backed off from any action at its latest meeting. In its following weekly review Barclays Capital noted that “the meeting underscores the inability of OPEC as an organization to contain the upside in prices”. In truth it is more an unwillingness to act than an inability. If the price risk was on the downside unity of purpose would quickly result in cartel action.

It is OPEC budgets that determine any willingness to intervene, and those budgets have become much thirstier for oil revenue in the wake of the “Arab Spring”, alongside rapid population growth. King-pin Saudi Arabia has hiked public spending dramatically in an effort to head off domestic political unrest. This must be paid for through oil revenues, and prices need to average US$80/bbl if it is to balance its newly-inflated budget, according to Jadwa, a Riyadh-based investment firm. Levels of US$110/bbl might be needed by 2015, compared to only US$25 a decade ago. The International Energy Agency (IEA) expects OPEC’s total earnings to top US$1000bn for the first time this year, up on the US$965bn peak set in 2008, and 32.5% higher than last year.

In defence, Riyadh and others members widely accuse speculators of being responsible for pushing the market higher – denied by most banks and speculators themselves. In truth, the willingness of many people to bet on future higher prices, and the consequent price rally the additional demand creates, represents an important signal to markets that anticipated supply is insufficient. Of course demand from speculators pushes the market higher, but such movement is well-founded and the speculation has triggered an important market price signal. It’s the way markets work.

But on the other hand there is no real shortage of oil, just a lag in its development. What is amazing is that supply has managed to keep up as much as it has with the massive unanticipated demand shocks of recent years – no-one expected developing economies to grow by the rates they have over the last 10 years, and outages in Iraq and Libya have been largely absorbed without major disruption. In addition, there has been considerable uncertainty among oil investors over the willingness of countries to impose carbon emissions targets – which has largely been laid to rest after the shambles of Cancun.

Oil prices rose further after the meeting. Barclays noted that “producer price aspirations have likely moved some US$25/bbl higher, and we see this US$90-100 level as the price floor for OPEC crude”. A US$25/bbl jump for doing nothing seems like a pretty good outcome for many OPEC members right now. And the world economy looks as robust as ever, particularly outside Europe and the US, although there appears little concern from OPEC over whether it can withstand additional energy costs without damaging growth. OPEC behaviour, as with that of any parasite, will tend to push its host to the limit, and is only inclined to desist to avoid killing it off completely.

In any case, the task of balancing market strength has essentially rested in Saudi hands for many years. As seasonal demand picks up in the second half of the year Saudi Arabia must decide whether to increase production further, should Libyan production remain largely shut in.

Despite the resignation of oil minister Shokri Ghanem, and recognition of the rebel government by OPEC members UAE and Qatar, Libyan rebels were not permitted to represent their country at the OPEC meeting, and so a change in Libyan policy towards OPEC or any redistribution of Libya’s quota were avoided. Within OPEC, tensions between Iran and Saudi Arabia have been heightened by sectarian unrest in Bahrain, while power struggles among Iranian leaders has further muddied the waters as they squabble over the oil ministry. Ali Naimi, ex-long serving Saudi oil minister no less, and founder of the Global Centre for Energy Studies (GCES), proclaimed the meeting one of the worst ever.

For the time being, consumers will need to be satisfied with unilateral decisions from Saudi and other smaller holders of spare capacity to dampen market sentiment, along with draw-downs in inventories. But recent indications that Libya may resolve its internal issues in favour of the rebels could mean OPEC has more of a problem on its hands in the longer term. “When you start to look out over the horizon, their [OPEC] ability to create more flexibility in spare capacity increases tremendously,” Goldman Sachs said in a recent note.

Libya has the largest oil reserves in North Africa and has been starved of investment for years under the Gadhafi regime – Iraq is also increasing production outside OPEC limits and other regimes are also feeling the winds of change from the Arab Spring. A more pro-western Libyan government that wants national development post-Gadhafi is likely to be keen on accelerating oil development, probably under rather more reasonable terms than have been in place to date. Perhaps the accusation of western interference in Arab affairs for their oil wealth could actually ring true eventually, if not in terms of direct exploitation.

The EIA expects oil markets to tighten further to late-2012 given projected world oil demand growth and slowing growth in supply outside OPEC. A fresh oil price spike is likely before collapsing into a crisis, according to a senior portfolio manager of Robeco’s huge Natural Resource equities fund. At the same time Goldman Sachs is suggesting Saudi spare capacity is topping out as it covers some lost Libyan output and approaches 10mbbl/d – both these statements from traders in oil derivatives could be attributed to an inclination to hype the market before any major downside fundamentals kick in, in order to enhance volatility and trading income.

But then again, there is always the possibility the Arab Spring will further stretch Saudi production, or even disrupt it directly, which would produce a price spike the like of which the world has never known. Could that be worth a punt?