Recently, the International Energy Agency (IEA) released a statement lowering its global crude oil demand forecast. Several subscribers have written asked what impact this has had. Given the sideways action in the energy sector today, this seems a good time to address those questions.
The IEA announced last week that it was cutting its forecast for global oil demand, citing slower economic growth as a factor in levels of oil product consumption. The actual revision amounted to only 100,000 barrels a day through 2013, but that was enough to start a retreat in oil prices.
The decline has accelerated a bit over the past two days, but is by this point largely a combined result of some profit taking and the need to readjust futures options.
Now, the revision stems from two overall supply and demand observations from the IEA. First, the agency continues to read inventory figures and U.S. production volume as depressing any further expansion of prices.
Second, the agency maintains that economic recovery in both Western Europe and the U.S. remains at levels insufficient to offset unemployment. The result is the now-familiar refrain that demand will be constrained, which will make further price increases unlikely.
All of this is the traditional approach to estimating petroleum prices.
Unfortunately, such a view no longer explains what is actually happening in oil. Most markets can be expected to reflect supply and demand pressures, and while those pressures are certainly present in oil, there’s a huge caveat.
Oil prices trade on forward projections, not on existing market balances. In the latter case, the connection between paper (futures contracts) and wet (actual oil consignment) contracts requires as close to a balance as possible. Otherwise, one or the other side of the equation will create a premium or deficit that throws off exchange.
That trading (actually convergence) inequity triggers a need to hedge on one side, which results in a heavy pressure in that direction.
If this becomes too pronounced, as is currently often the case when market participants overreact to events or headlines, the emotional response magnifies direction and causes a spike or dive that’s not justified by the underlying conditions.
May and June of this year is a good case in point. The actual market conditions telegraphed a 9% correction in crude oil prices. But the over-compensation gave us a more than 21% movement, followed by a rapid recovery of all and more in the weeks following.
Here’s What Really Distorts Pricing Dynamics
For the record, IEA projections still have worldwide demand coming in at almost 90 million barrels a day, the highest usage in years, a figure expected to rise at least 500,000 a day in 2013. And that is discounting significant indicators that non-OECD markets will continue to require additional oil.
In short, even if the new projection ends up being correct, the IEA is still estimating that demand will rise, not decline.
Here, the IEA is once again making two mistakes that have caused its projections to be wrong in the past. First, it still relies on OECD demand levels. These are the developed countries, those who still command the largest consignments and visibility. The agency has attempted to change its base, but their data continue to be skewed toward Western Europe, North America, Japan, and other “traditional” dominant economies.
While there are new initiatives at IEA to factor in demand increases from other parts of the world, that largely ends up being China, India, and East Asia. There, concerns about a decline in Chinese economic expansion are factored into hasty conclusions that “new demand” is less able to offset expected sluggishness.
That Chinese expansion, by the way, has “cooled down” to 7.4%. That level, in itself, will provide an ongoing demand driver, not a downward pressure.
The second point, however, is the gravamen for my ongoing disagreement with colleagues at IEA. If you take nothing away from today’s column, remember what I am about to say. It determines the upward move in oil prices more than it does the downward move.
Upward pressures on oil prices result from marginal increases in fringe markets.
There is a great deal of rather dense reasoning behind this, but let me give you the bottom line. This is, after all, one of the reasons why the Energy Advantage Portfolio has been performing so much better than either overall markets or the energy sector as a whole.
When you have a commodity like oil, the little changes in secondary and tertiary markets distorts the pricing dynamics. In these markets, it costs more to deliver and distribute. That means they must pay a premium to normal Brent rates (used now far more often as the benchmark than New York’s West Texas Intermediate, or WTI).
In a tangential market, that premium results in an upward movement in overall prices in a tight global oil exchange environment.
By continuing to discount the marginal markets where both demand and price premiums are taking place, IEA misses the most important ingredient. We do not need such markets to provide consistently increasing demand levels to realize increasing prices. The rise will take place because of the premiums paid, even if import levels remain constant.
Of course, this does not translate into straight lines. There will be moves in both directions. But the dynamics continue to oblige increasing upward pressures. Remember, it is the forward element that makes IEA predictions so off the mark.
Perception of Future Supply Won’t Offset Pricing Concerns
That introduces an important final point. One would expect in a “normal” market that additional supply injections would be able to offset any additional demand pressures.
Well, remember this rise in prices does not simply require a significant increase in demand. As I have already observed, there are other factors at work. But this would still only make sense if the perception of future supply was sufficient to offset pricing concerns.
True, there is more unconventional supply coming on line in the U.S. than ever before, and that has been largely the reason why American import needs have been declining. But recall that neither North America nor Europe drive the global market, and have not done so for years.
This comes down to the adequacy of worldwide excess supply reserves. By June of next year, even the IEA acknowledges that we will be within about three million barrels a day from exhausting those current reserves.
This is not a peak oil argument because new supply can be brought on line to offset it. However, there will be a time delay in making the two pieces fit, and this will be more expensive oil to produce and process. Both elements increase overall prices.
Recently, Bernstein became the fourth report released over the past twenty-four months indicating the excess supply will be exhausted within the next two years. One of the early reports came from IEA itself, following a major five-year study of the 500 largest oil fields in the world, from which three-quarters of the available oil is derived.
We are, therefore, left with this conclusion. The IEA estimate requires a continuing slow economic recovery, since the agency uses the traditional demand-dictates-supply approach. Any improvement in either Europe or the U.S. throws the entire foundation of the estimate under the bus.
And that’s without factoring in any of the developments contributed by any other part of the globe.