Amrita Sen answers your questions – Part two

In this week’s readers’ Q&A session, Amrita Sen, oil analyst at Barclays Capital, answers your questions.

In this second of two posts, she discusses drilling in the US, national oil subsidies and growing demand from the Middle East.

Earlier, she answered questions on whether speculation is driving up the oil price, whether such an increase could trigger another recession and when “peak oil” might occur.

(NB – Because of a very high volume of questions, we were not able to tackle every question submitted. Apologies if yours was not answered.)

Next week, Michael Bromwich, director of the US oceans regulator, will be answering your offshore-drilling queries. Email questions to energy.source@ft.com by the end of Sunday, April 10th.

But for now, over to Amrita:

Oil subsidies

If nations that have net imports of oil removed their oil subsidies, would that make renewable energy production more competitive in those countries?
Ian Boisvert

This is a very interesting question. There has always been the view that subsidies are distorting oil demand in emerging markets and artificially boosting consumption. While in countries like India and China, there has very clearly been a move towards moving away from subsidies, there are still regions in the world, in particular, the Middle East, where subsidies are large and given the recent uprising, they are likely to stay.

Interestingly, our analysis shows that when subsidies are high, a marginal increase in subsidies leads to a more-than proportional increase in the normal level of consumption (this can be though of as a “waste-effect”, such as leaving the car engine on for air-conditioning while going shopping as is prevalent in the ME).

There has always been the view that subsidies are distorting oil demand in emerging markets and artificially boosting consumption

When subsidies decrease, there might be an initial large decrease in consumption due to a knee-jerk reaction and the easing off any wasteful consumption. However, after this initial decrease, any further decline in subsidies is likely to lead to a much smaller fall in consumption, as in many of these countries, income effects (a $1 increase in GDP) dominate price effects (a $1 increase in prices).

This is because rapidly rising living standards generating strong growth in automobile sales, rising internal trade creating a surge in commercial freight traffic and the orientation of several emerging economies towards energy-intensive industries, including the mechanisation of agriculture, have resulted in a structural shift in oil demand towards countries with low price elasticity and high income elasticity of demand. In other words, the drive for higher standards of living and urbanisation reigns are producing income effects for oil demand that have swamped the negative impact of rising prices.

Solar panelsThe other thing to note is that even if you were to get a reduction in oil consumption in these countries, it would not necessarily make renewables more competitive. Remember in a lot of these countries, coal is the cheapest source of fuel and remains the baseload (70 per cent of China and India’s overall energy consumption comes from coal), while the Middle East uses a significant amount of gas for domestic consumption. Renewable energy remains expensive and with those countries without any explicit targets of reducing carbon emissions, a fall in oil consumption (if any) will not necessarily equate to a rise in renewable energy production.

US domestic drilling

If the US does end up increasing domestic drilling, how do you think the Opec producers will be affected, and how will they react?
Vivien Chin

The US has already increased domestic drilling significantly, so much so that the recent surge in onshore drilling activity has helped to offset dwindling incremental volumes from the US Gulf of Mexico and several ageing basins across the country. The US direct oil rig count rose 83 per cent in 2010. Despite the upsurge in rig utilisation though, the momentum behind US production growth is decelerating, largely owing to a steep slowdown in new supplies from the Gulf of Mexico. As a result, the growth in US oil production is likely to remain biased towards the Midwest, while the Gulf of Mexico and the West Coast continue to decline, with overall incremental growth being negligible.

Even in the unlikely event of a significant upsurge in US domestic production, the growth in demand from emerging market countries would create no excess supply at the margin of the oil market, with Opec volumes already going to eastwards.

The Saudi view of the changing dynamics of the oil market can be summarised well by oil minister Ali Naimi’s statement earlier this year: “Asia will be a huge market” and one that the country no doubt will depend upon.

An increase in US domestic drilling has negligible consequences for Opec, if any at all

Saudi Arabia is the largest exporter of crude to China, while for parts of 2009, Chinese imports from Saudi overtook that of US as the single largest destination of Saudi crude. While the scale of the recession that hit the western world exaggerated the pace of this destination shift in exports, even with the recovery by and large, the lost barrels from the Middle East haven’t entirely made their way back into the US system.

In short, an increase in US domestic drilling has negligible consequences for Opec, if any at all.

US oil refiners

Why do oil refiners in the US run below capacity?
Chinmay Bhide

The refining sector in the west remains plagued by overcapacity, with political opposition slowing the speed of closures in areas where demand growth is stagnating, while the onslaught of new capacity additions in emerging markets continue apace. That is why in countries like the US or in Europe, refineries are running well below their capacity, in order to reduce the amount of output, thereby protecting their refining margins.

Additional capacity continues to come on line in the non-OECD and has dwarfed the ongoing downsizing of the industry in the developed world, as a result of which net refining capacity has actually been expanding globally.

While the period of higher returns in 2007/08 had already set the investment cycle rolling, emerging market economies have also stepped up to capture a larger share of their domestic market and exploit the cost-advantage of cheaper inputs more effectively. With rapidly rising consumption and, in various cases, government support, this has meant that even in a context of low margins, gross refining additions have remained elevated and are likely to proceed at a healthy rate over the next couple of years.

In the US, over the course of last year, about 0.5 mb/d of capacity was shut in while 0.4 mb/d remained idled. A number of refineries have exchanged hands in recent months while some companies – like Sunoco and Murphy – have expressed that they are considering exiting the sector altogether.

But a number of projects are still due to come on line over the next three to five years, while one grassroot expansion of 0.3m b/d is taking place in Texas. As a result, the mismatch between demand growth and refinery capacity addition is capping utilisation rates at refineries.

Brent vs WTI

What do you make of the future of Brent as a benchmark for the oil price?
Sergey Popov, researcher, Energy Systems Institute

WTI has always been a global benchmark, with two-thirds of world trade done on it. To a large degree its pricing signals are doing what they are intended to do – reflect conditions at the margin at the contracts delivery point of Cushing – but those conditions are significantly decoupled from the global market. With major Opec producers having moved away from WTI as the main element in their pricing formulae for term contract sales to the US following the dislocations in 2009, the impact on producers and consumers of such dislocations is more limited than it used to be.

However, the latest dislocation has seen a clear and discernible shift among both the consumer and producer base globally (and in particular the US) to move towards benchmarking more of their exposure towards Brent, the more representative global benchmark, in an attempt to reduce exposure to the intricacies of the nuts and bolts of US Midwest logistics.

Eventually, as in the past, the Midwest flows tend to sort themselves out through some normalisation of flows from Canada and because of a higher bid from the rest of the country, especially if inventories are lower than usual in other US regions.

This is not to say that WTI should be abandoned as a global benchmark or to raise the issue for whether there is a need for a global benchmark in the first place. Other benchmarks, including Brent, have come under scrutiny, too, and there is no such thing as perfection in this context.

Eventually, as in the past, the Midwest flows tend to sort themselves out through some normalisation of flows from Canada and because of a higher bid from the rest of the country

However, the greater the dislocations the more we expect such issues will be raised, if nothing else so that traders gain a sense of precisely what risks they are trading, and how and to what extent those risks are related to the global market. Equally, this also lends itself favourably to the view that to take a position on global oil market developments, Brent would tend to be the natural vehicle, while position taking in WTI requires a view on some very specific regional balances in case there is possibility of a dislocation opening up again. As a result, the future of Brent as a benchmark has improved significantly over the course of the past few months.

Canada

With the world’s second largest oil reserves, is Canada seen as a global player or will it just continue as the primary resource for American import?
Andrew Cashin, CI Energy

Canadian oil sands mineCanadian oil sands have embodied the industry’s thrust to overcome the impact of a shrinking conventional supply base. On the one hand, oil rig utilisation in the Western Sedimentary Basin has now reached unprecedented high levels, significantly easing the scale of output declines in this geologically mature area. On the other hand, following the plunge in activity two years ago, oil sands projects are returning to the drawing board, although with an evident preference for bitumen-only rather than fully integrated operations.

Despite a series of hurdles, the continued development of Canadian oil sands looks almost inevitable to us. With conventional crude production prospects largely grim outside Opec, the oil supply mix in the future will have to include increasing levels of non-conventional oil to bridge the gap between demand and supply. It is here that Canada’s oil sands are likely to be the most prominent candidate to rise to this challenge and thus, Canada will increasingly become a global player in the market.

The continued development of Canadian oil sands looks almost inevitable

However, in the short term, Canada is constrained my infrastructure and hence serves primarily as a resource base for the American market. The pipeline system currently carries crude from Canada to the US without any outlet through either the US or in Canada itself, to the outside world.

The building of the Keystone XL pipeline in 2013, which should enable Canadian crude to reach the Gulf Coast and hence be shipped to the wider world, will make Canada a global player in the oil market, rather than the current totemic role it plays of symbolising the frontier of unconventional energy sources. Potential pipelines from Canada connecting directly to Asia will also help in that process. However, until those pipelines are functional, Canada will remain a primary resource for American import.

Middle Eastern oil demand

How will oil demand pan out in the Middle East over the next ten years?
Tarun Mehrotra

Over the past decade, the growth in Middle Eastern oil demand has been a staggering 55 per cent or an average of 250,000 b/d per year. With the growth in population and vast infrastructure projects aimed at the development of this region, oil demand is likely to remain extremely well supported over the course of the next decade, like most developing countries.

Lebanese petrol stationGasoline subsidies already make car ownership in this region extremely high, even resulting in some waste at the margin, and these are unlikely to be removed anytime soon given the ongoing wave of political unrest underpinned by inequality in income levels and basic rights.

Direct crude burn for power generation has also been on the rise. The petrochemical industry in the Middle East is likewise experiencing very high rates of growth, with the region becoming the world’s large producer of petrochemicals in 2005. The rise is driven by the desire of the Middle Eastern countries to increase domestic employment and their manufacturing base, alongside feeding the higher standards of living throughout the population.

Indeed, the problems of the recent enormous surge in Asian, and especially Chinese, oil demand, together with the decreasing certainty of incremental non-Opec supply barrels in the future, are compounded by rising population and aspirations for higher living standards in Opec countries’ own backyards. Increasingly, the challenge for several Opec nations is not limited to simply filling the mismatch between demand and non-Opec supply, but also whether to preserve their abundant reserves for future generations or to extract them now and invest the proceeds.

IOC/NOC relationships

How do you see the relationship between intrernational oil companies, national oil companies and exploration and production service companies developing in the next five years?
Parmi Kanda

The NOC/IOC relationship has become a subject of increasingly intense debate and discussion in the oil and gas community over the past few years. Post-2003 increases in oil and gas prices, availability of technology from service companies, and increased confidence and competence of NOCs, have all contributed to a phenomenon generally regarded in the market as “resource nationalism”.

However, increasingly, with new production being brought on stream at a much slower pace compared to which demand is growing and more from challenging terrains, together with an increase in environmental stresses, NOCs and IOCs face common challenges. Thus, together with service companies, I would expect them to work more closely in terms of sharing technological expertise (without NOCs necessarily opening up domestic resources to IOCs) to overcome these challenges in the next few years.

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