Philip Verleger on Oil, Natural gas, the Saudi perspecitve and more

A 30+ minute podcast of Philip Verleger interviewed on Bloomberg Radio.  (click the little play button next to the date)  A good overview of the oil, natural gas markets, the Saudis, and more.  He touches on the current use of tankers for oil storage, Exxon's purchase of  XTO, trade balances and the Chinese.

I have been following Mr. Verleger for a while and it is refreshing to hear an analyst say he was wrong.  Predicting the future prices of assets is always very tricky but he at least admits it.  He does reinforce that the inbalances causing him to predict low oil prices in 2009 are still there and do not appear to be abating.

Oil and oil products inventory update. Refining margins and shipboard inventory

It has been a while since I posted regarding inventory levels of oil and oil products.  Here's an update:  Inventory levels have fallen from their highs earlier this year but are still elevated.  Refining margins still stink and a signficant number of tankers in the world are being used as seaborne storage playing the contango trade.

Like a lot of other commodities, oil prices are showing an expectation of further worldwide growth while inventory levels do not yet show such growth.  As the markets quite often attempt to predict the near term future, if this growth does not occur prices may correct to the downside rather quickly.  Of course the Iranian / Israeli situation my heat up and toss all economic factors out the window. 

Even with the recent drawdown in inventory they are still higher than last year at this time.   It is of course unknown if the recent dramatic decline will continue, but considering the cold weather in America it is very possible.

To quote business week:

A 26-mile-long line of idled oil tankers, enough to blockade the English Channel, may signal a 25 percent slump in freight rates next year.

Traders booked a record number of ships for storage this year, seeking to profit from longer-dated energy futures trading at a premium to contracts for immediate delivery . . .

The storage trade is profitable so long as the spread between energy contracts exceeds ship rental, insurance and financing costs. A year ago, the spread between the first and sixth Brent crude-oil contracts traded on the London-based ICE Futures Europe exchange was 23 percent. Now, it’s 4 percent. . . .

ht: The Big Picture blog

Fuel Substitution between energy types

I was reading this article from Sober Look blog a few weeks ago and thought I'd investigate further into the ability to switch fuels from coal, natural gas and oil for electricity generation.  To quote:

Fuel switching is actually quite common at power plants, the biggest users of natural gas. Many modern power plants can switch between gas and fuel oil, and many can switch to coal as well.

In fact cheap natural gas has created an oversupply of coal as well.

EIA: A generating unit capable of burning more than one fossil fuel is referred to as a dual-fired unit. Some dual-fired units can only burn one fuel at a time (that is, the fuels are fired sequentially), while others can burn more than one fuel simultaneously (concurrent firing of different fuels). A sequentially fired unit generally uses one fossil fuel as its primary energy source, but can switch to a second fossil fuel as an alternate energy source.

I perused the Energy Information Adminstrations web site and found some confirmational data. 

Here's the year to date (through July 2009) energy production from various sources

Coal  -13.1%
Natural Gas +1.7%
Petroleum Liquids -8.6%

It is apparent natural gas production has been favored in the US over coal and petroleum based products this year due to the low price of natural gas. Considering the continued drop of natural gas prices I would conclude the share of production from natural gas will increase for the year.
 

Additional data can be found at the EIA website showing total electricity production as well as products consumed.

Electricity production from coal is down and as you can see from the chart, coal inventories are up. (EIA source)

I understood the possibility of fuel switching from a petroleum based product to natural gas, but had always assumed natural gas has always been cheaper to run than petroleum.  So why run petroleum at all?  I'm concluding the petroleum only power plants are older, more expensive and only run when electricity demands outstrips supply from cheaper sources such as coal, natural gas, nuclear, etc.

This is where the mindset of contstant growth can trip you up.  Total electricity production in the US is down so far for 2009.  In that situation, the first power plants to be shut down would be the most expensive, the oil based power systems.   

When electricity demand returns and the less expensive natural gas and coal based power generators are running at full capacity, only then will more expensive additional oil generators will be turned on. 

Sources:
http://www.eia.doe.gov/cneaf/electricity/epm/table1_1.html

http://www.eia.doe.gov/cneaf/electricity/epm/epm_sum.html

Oil inventory levels

Oil inventory levels continue to rise on a year over year and absolute basis.  Considering the seasonality of energy usage I added a graph showing the year over year % change.

Numerous factors are keeping oil prices up (weak dollar, tension in the Gulf, predictions of a recovering world economy, oncoming winter, etc.) but the higher inventory levels rise the harder it becomes for oil prices to remain elevated.

Source:  http://tonto.eia.doe.gov/dnav/pet/hist/wtestus1w.htm

Refining margins are really low

From Platts (2009 September 29) , quoting Verleger:

"Verleger points to a weakening 3:2:1 crack spread on the NYMEX, which settled at $2.28/b on September 25, the 69th smallest of 1,239 observations dating back to January 1986. "[I]t is in the fifth percentile...This is bad, very bad," he said.

Verleger cites not only poor product demand but mounting global inventories of distillate and gasoline."

If the refiners cannot make any money refining, who will buy all the oil?

You can play with the data shown above at Bloomberg

So far, no hurricanes this year

Sometimes it is what doesn't happen that can make news. While todays action in the oil market is due to rising fuel inventories [zerohedge] I'd like to point out what those on the Gulf of Mexico already know: so far there has not been a major hurricane strike the continental US.

As I have mentioned previously (Aug 13, 2009) a significant percentage of the pumping and refining capacity for America is in the Gulf of Mexico. Not having a hurricane stomping around will keep the oil and natural gas flowing.

Let's see if we can make it through the entire hurricane season without any damage. Look for solid bids on reinsurance stocks and debt if this happens.

Verleger on oil

Philip Verleger has some interesting things to say on why we had a spike in oil prices last year and when it could possibly happen again.

Philip Verleger, February 19,2009 at UCSD 59min 25sec

While it is an hour long presentation I strongly suggest watching it if you are interested in the energy markets.

The gist of his talk is how environmental regulation changes regarding low sulpher diesel excacerbated energy prices in 2008. The upcoming cleaner requirements for low sulpher shipping fuel may possibly create a simliar situation by 2020.

Oil as a financial or physical asset?

The recent news of Deutche Bank shutting down their their Oil Fund elucidates the interplay between the financial and physical.

Here's an interesting article from Philip Verleger in late 2007 on the interplay of oil as both a physical asset used and consumed by the entire world as well as a financial asset. His prediction of $90 oil by 2010 was not extreme enough price or time wise!

Weather and Oil

It is fascinating how the financial markets and real world are so intertwined. Take for example, the weather. Recently reading about the hurricane season I realized I had not added that as a factor for oil prices. Duh!


The chart you see here shows the frequency of hurricanes throughout the year. A nice FAQ from NOAA explains the various colors. The majority of severe hurricanes occur in August and September.


By mid August we should be well into the hurricane season and yet we have not had any major storms in the Atlantic. The National Hurricane Center shows in real time any storms and their predicted tracks. As of today there are no major storms threatening the Gulf of Mexico. Storms travelling up the East Coast will not have the same influence on the energy markets as one that enters the Gulf of Mexico. The Gulf is home to a large number of oil and natural gas pumping operations as well as a large portion of the refining capacity of the United States. Not only did Hurricane Katrina (which made landfall on August 29, 2005) devastate New Orleans, it severely hampered the energy capabilities of the U.S. for several months.

Keep an eye on the National Hurricane Center web site. If you see a storm forming with a high probability of entering the Gulf, you'll see oil prices perk up.

Oil Inventory Followup -- Offshore storage

I do not know of any centralized database tabulating all the floating oil and oil products inventory so one only has anecdotal evidence to go on. A Hellenic Shipping News article provides an estimate on the oil and refined products sitting offshore. The estimated 140 million barrels offshore is over 10% of the entire US inventory, not an insignificant number. . .

Oil in storage -- Someone else is noticing

The WSJ must be reading my blog already :) WSJ:OPEC Braces for Decline in Crude Prices

The Organization of Petroleum Exporting Countries is bracing for a sharp drop in
crude prices in coming weeks, as huge reserves of oil-based fuels continue to
pile up and the space to store them runs out.

Considering the current high correlation between oil and stock prices it will be curious to see if/when oil prices drop how much of an affect it will have on stock prices.

Fill er up! Where's all the oil going?

The oil markets are always fun to watch and while the popular media concentrates on how much higher oil can go, I'd like to point out some bearish data.

Oil and oil products in America are on the rise and nearing levels not seen in at least 20 years.

While the I do not have access to the raw data for the OECD, graphs from the International Energy Agency show the same trend.

(If you have access to additional data on inventory levels in America, OECD or emerging markets I'd love to see it.)

I present this information not to buttress a prediction for lower oil prices but to highlight some info that contradicts the current outlook.

Some additional factors for oil:

+ Peak oil - We'll eventually run out of the oil we pump out of the ground. When production will fall off and how much is finally extracted is up to debate. LONG term I am of the opinion prices will be much higher than they are now, the path to those higher prices is unknown in my mind.

+ Geopolitical - The Israeli / Iranian situation could heat up at any time and if the missiles start flying oil prices will rise.

+/- Oil is priced in dollars - Concerns regarding a weakening US Dollar have played a major factor in daily oil price movements.

- Excess supply - OPEC has cut supply and has the capability of pumping more. The timing and extent of their supplies are entirely up to them but for now that excess supply is available.

- Cheating by OPEC members - Cheating does happen by the member countries.

- Floating storage - Oil tankers are being used to store oil and refined products throughout the world. While some of this storage is due to the contango trade earlier in the year, the profitablility of storing then reselling has dropped dramatically.

Additional reading: http://ftalphaville.ft.com/blog/2009/07/22/63186/nothing-bullish-in-crude/


Sources:
http://tonto.eia.doe.gov/dnav/pet/hist/wtestus1w.htm
http://omrpublic.iea.org/stocks/stkxs_oc.pdf

Disclosure: Personal account: long RDC, client accounts: short USO call spreads, long RDC

[edit 07/23/09 12:40pm: cleaned up the prose a bit, added position disclosure]