Spare Capacity, Oil Prices and Spare Capacity, Oil Prices and the the Macroeconomy Macroeconomy

Dr Bassam FattouhDr Bassam FattouhReader in Finance and Management for the Middle EastReader in Finance and Management for the Middle East

Centre for Financial and Management Studies, Centre for Financial and Management Studies, SOAS, University of LondonSOAS, University of London

& & Senior Research Fellow, Oxford Institute for Energy StudiesSenior Research Fellow, Oxford Institute for Energy Studies

1. The End of Spare Capacity1. The End of Spare Capacity

The end of spare capacity in oil The end of spare capacity in oil production, refining and the entire oil production, refining and the entire oil supply chainsupply chain

Gradual Erosion Of Spare CapacityGradual Erosion Of Spare Capacity

-1500

-1000

-500

0

500

1000

1500

2000

2500

3000

3500

4000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Thou

sand

s, b

pd

Year-to-Year Change in Global Oil Demand

Year-to-Year Change in Non-OPEC Supply

Demand Revised Downward in May 2006 Report

Source: IEA, Oil Market Report

YearYear--toto--Year change in global oil demand outpaced yearYear change in global oil demand outpaced year--toto--year change in nonyear change in non--OPEC oil supply OPEC oil supply in almost every year (exceptions: 2000 and 2002)in almost every year (exceptions: 2000 and 2002)Over the period 1990Over the period 1990--2005, the demand for oil increased by around 17.6 million bpd, w2005, the demand for oil increased by around 17.6 million bpd, while the hile the increase in nonincrease in non--OPEC supply amounted only to around 7.9 million bpd OPEC supply amounted only to around 7.9 million bpd

The China FactorThe China Factor

China

Thousands bpd

300550

860150

350

330980

2320900

900

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2002 2003 2004 2005 2006

China Rest of the World

During 2002-2006 China accounted for almost 40% of the increase in global oil demand

Russia Growth Key to NonRussia Growth Key to Non-- OPEC Oil Supply OPEC Oil Supply GrowthGrowth

40340

520

640

830740

60760

280

660

170260

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1999 2000 2001 2002 2003 2004

• During 2000-2004, Russia accounted for almost 60% of the annual change in non-OPEC supply

• But Russian oil supply growth has slowed down

• 250,000 bpd in 2005 and 240,000 bpd in 2006 (IEA estimate)

Increase in Demand Met By OPECIncrease in Demand Met By OPEC

1100

200

1200

400 400

700 700

1500

500

-1000

1300

-300

-1600

1900

1600 1600

-2000

-1500

-1000

-500

0

500

1000

1500

2000

2500

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Source: IEA; Figures include crude oil condensates, and NGLs

Over the period 1990Over the period 1990--2005, OPEC supplied an additional 10 million bpd with OPEC 2005, OPEC supplied an additional 10 million bpd with OPEC production increasing from 24.8 in 1990 to 33.9 million bpd in 2production increasing from 24.8 in 1990 to 33.9 million bpd in 2005005This increase in production was possible because of OPEC spare This increase in production was possible because of OPEC spare capacitycapacity

Erosion in OPEC Spare CapacityErosion in OPEC Spare Capacity

40

45

50

55

60

65

70

75

80

85

197019721974197619781980198219841986198819901992199419961998200020022004

Millio

ns bp

d

Global Production Capacity

World Total Production

1985: Spare Capapcity of around 10 million bpd

Source: IMF; BP

• Spare capacity around 2% of global oil demand in 2004 despite increase in OPEC production capacity

Saudi Arabia Holds the Bulk of Saudi Arabia Holds the Bulk of Current spare capacityCurrent spare capacity

0

2

4

6

8

10

12

Algeria Indonesia Iran Kuw ait Libya Nigeria Qatar SaudiArabia

UAE Venezuela

April 2006 Production

Sustainable Production Capacity

• Spare capacity in 2006 estimated at 2.3 mbd

•Saudi Arabia holds 55% of OPEC spare capacity

• Production capacity of SA reached 11.3 mm bpd after it began producing from the new Haradh field, which is pumping 300,000 bpd

Cushion of Spare Capacity Declined in Cushion of Spare Capacity Declined in All Parts of the Oil Supply ChainAll Parts of the Oil Supply Chain

World Refining Spare Capacity

World Refining Capacity

World Petroleum Consumption

40

45

50

55

60

65

70

75

80

85

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Millio

ns

of

Ba

rre

ls

Spare Capacity in the Global Refing System Disappeared in 2004

Source: EIA

Oil Tanker Capacity

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004

Demand for tankers

Oil Tanker Capacity

Source: Jeff Currie, “The sustainability of higher commodity prices: The revenge of the old economy.”

2. The Impact of Loss of Spare 2. The Impact of Loss of Spare Capacity Cushion on PricesCapacity Cushion on Prices

Accelerating Global Demand

Accelerated rise in oil prices

OPEC Spare Capacity Reduced

Global oil system’s ability to respond to shocks weakened

Low Non-OPEC Supply Growth

Volatility in oil prices

Bottlenecks in Downstream Occasional

spikes in oil pricesCycle of

UnderinvestmentGeopolitical shocks

Impact of shocks magnified in absence of spare capacity

Weather shocks

Refinery fires

Speculators

Shift Upward in the Distribution of Oil Shift Upward in the Distribution of Oil PricesPrices

010

020

030

0Fr

eque

ncy

10 20 30 40oilprice

SPOT WTI 1/1/1991-31/12/2002

020

4060

80Fr

eque

ncy

20 30 40 50 60 70oilprice

SPOT WTI 1/1/2003-11/11/2005

Shift Upward in the Distribution of Oil PricesShift Upward in the Distribution of Oil Prices

2.992.99KurtosisKurtosis37.2037.2099% 33.9399% 33.93

0.570.57SkewnessSkewness36.8836.8895% 30.3595% 30.35

24.2524.25VarianceVariance36.5336.5390% 28.3890% 28.38

36.1836.1875% 24.3875% 24.38

4.924.92Std. Dev.Std. Dev.LargestLargest

21.2521.25MeanMean50% 20.350% 20.3

10.8810.8825% 18.0625% 18.06

10.8310.8310% 15.3310% 15.33

10.7810.785% 14.15% 14.1

10.7310.731% 11.751% 11.75

SmallestSmallestPercentilesPercentiles

2.162.16KurtosisKurtosis69.8269.8299% 67.2199% 67.21

0.560.56SkewnessSkewness69.4869.4895% 63.9195% 63.91

130.00130.00VarianceVariance68.9568.9590% 59.8690% 59.86

67.5867.5875% 50.9175% 50.91

11.4011.40Std. Dev.Std. Dev.LargestLargest

42.2942.29MeanMean50% 39.1950% 39.19

25.7325.7325% 31.9825% 31.98

25.6825.6810% 29.7310% 29.73

25.4825.485% 28.635% 28.63

25.2325.231% 26.281% 26.28

SmallestSmallestPercentilesPercentiles

Can the Spare Capacity Cushion Be Can the Spare Capacity Cushion Be ReRe--established?established?

Spare capacity not outcome of ‘rational’ investment decision

Spare capacity outcome of an historical developments in 1970s & 1980s

International Oil Companies will not hold spare capacity

Few players today able or willing to invest in new spare capacity Who should bare the costs of

spare capacity?

Face several years of capacity constraints even if new investments are made todayNo short-term relief for oil market

Any increase in spare capacity in the coming two years arise mainly due to sharp slowdown in demand rather than increase in production capacity

3. Refining Bottlenecks3. Refining Bottlenecks

Capacity shortageCapacity shortageStructure of refining plants: limited deep Structure of refining plants: limited deep conversion and deconversion and de--sulfurizationsulfurization facilitiesfacilities

Incremental crude oil production is of Incremental crude oil production is of heavy/sour varieties heavy/sour varieties Strong increase in demand for light end Strong increase in demand for light end petroleum products such as gasolinepetroleum products such as gasoline

Strong Growth in Consumption for Light Strong Growth in Consumption for Light ProductsProducts

Annual Growth in Demand by product Type

Gasolines

Middle distillates

Fuel oil

Others

-5

-4

-3

-2

-1

0

1

2

3

4

5

2000 2001 2002 2003 2004Perc

ent

Source: BP Statistical Review

'Gasolines' consists of aviation and motor gasolines and light distillate feedstock (LDF)

'Middle distillates' consists of jet and heating kerosines, and gas and diesel oils (including marine bunkers)

'Fuel oil' includes marine bunkers and crude oil used directly as fuel

'Others' consists of refinery gas, LPGs, solvents, petroleum coke, lubricants, bitumen, wax and refinery fuel and loss

Price Differentials Between Light Price Differentials Between Light and Heavy Widenedand Heavy Widened

WTI Spot Cushing / Heavy Iranian Price Differential

00.5

11.5

22.5

33.5

44.5

55.5

66.5

77.5

88.5

99.510

10.511

11.512

12.513

13.514

14.515

15.516

16.517

17.518

02/0

1/19

95

02/0

7/19

95

02/0

1/19

96

02/0

7/19

96

02/0

1/19

97

02/0

7/19

97

02/0

1/19

98

02/0

7/19

98

02/0

1/19

99

02/0

7/19

99

02/0

1/20

00

02/0

7/20

00

02/0

1/20

01

02/0

7/20

01

02/0

1/20

02

02/0

7/20

02

02/0

1/20

03

02/0

7/20

03

02/0

1/20

04

02/0

7/20

04

02/0

1/20

05

02/0

7/20

05

$/Bar

rel

Average (Daily Data) 1995-2002: $3.508 Average (daily Data) 2003-2005YTD=$7.58

4. Oil Prices: Short4. Oil Prices: Short--Term OutlookTerm OutlookThe Bullish View The Bearish View

•More supply shocks

• Spare capacity cushion would remain thin

• Refining bottlenecks

• Robust growth demand for oil; Rise in oil prices have not depressed oil demand so far

• Will Russia deliver? Non OPEC supply?

• Resolution of any geopolitical factors knock down risk premium

• Mean Reversion: Question is when? To which average?

• China achieving a soft landing is not certain

•Non-OPEC supply will respond to higher oil prices

•Global demand for oil would ultimately decline in response to high oil prices

Oil Price ForecastOil Price Forecast

0

1 0

2 0

3 0

4 0

5 0

6 0

7 0

8 0

9 0

1 9 7 3 1 9 7 7 1 9 8 1 1 9 8 5 1 9 8 9 1 9 9 3 1 9 9 7 2 0 0 1 2 0 0 5 2 0 0 90

1 0

2 0

3 0

4 0

5 0

6 0

7 0

8 0

9 0

S o u r c e : O E F

$ /b a r r e l $ /b a r r e l

R e a l( 1 9 9 5 U S p r ic e s )

N o m in a l

O i l p r i c e

F 'c a s t

Cycles or New Paradigm?Cycles or New Paradigm?

New cycle will emerge and prices eventually drop? Entered a new paradigm that breaks with the past?Both have elements of truth

Oil market is cyclicalPrices go up, production increases, demand slows and prices come downMarket will remain cyclical

Prices different compared to 1986-2002, when the price per barrel fluctuated between $15 and $25Prices fluctuating in a higher range

6. Oil and the 6. Oil and the MacroeconomyMacroeconomy

Oil price hikes often preceded global recessionsOil price hikes often preceded global recessionsIMF: a 10% rise in crude prices reduces global growth by 0.1 to IMF: a 10% rise in crude prices reduces global growth by 0.1 to 0.5 0.5 percentage points percentage points Asian Development Bank: Escalating oil prices could cut economicAsian Development Bank: Escalating oil prices could cut economicgrowth across Asia by at least 0.6%growth across Asia by at least 0.6%G8:G8:"Overall global growth remains solid and this is "Overall global growth remains solid and this is expected to continue in 2006. Risks remain, including expected to continue in 2006. Risks remain, including high and volatile energy prices"high and volatile energy prices"Samuel Samuel BodmanBodman, the U.S. energy secretary, the U.S. energy secretary

"Am I concerned about the impact of high oil prices on the "Am I concerned about the impact of high oil prices on the economy? Sure. Having said that, it hasn't happened yet in a economy? Sure. Having said that, it hasn't happened yet in a meaningful way." meaningful way."

Will oil prices Choke growth this Will oil prices Choke growth this time?time?

Past oil shocks resulted from restrictions in supply Past oil shocks resulted from restrictions in supply unlike the current shock which is driven by rapidly unlike the current shock which is driven by rapidly growing demandgrowing demandPart of the rise in oil price to recover past price Part of the rise in oil price to recover past price declines declines Oil is relatively less important to OECD economies Oil is relatively less important to OECD economies than in the pastthan in the pastMonetary policy response is differentMonetary policy response is different

Impact of oil prices on core inflation has been mild relative toImpact of oil prices on core inflation has been mild relative toprevious shocksprevious shocksCentral banks have not had to raise the interest to reduce Central banks have not had to raise the interest to reduce inflationary pressureinflationary pressure

Oil IntensityOil Intensity

6 0

8 0

1 0 0

1 2 0

1 4 0

1 6 0

1 8 0

1 9 8 0 1 9 8 4 1 9 8 8 1 9 9 2 1 9 9 6 2 0 0 0 2 0 0 4 2 0 0 86 0

8 0

1 0 0

1 2 0

1 4 0

1 6 0

1 8 0

G l o b a l : O i l i n t e n s i t y

S o u r c e : O E F

J a p a n

U S F ' c a s t

2 0 0 0 = 1 0 0 2 0 0 0 = 1 0 0

E u r o z o n e

U K

Oil Price and InflationOil Price and Inflation

1 0 0

1 2 0

1 4 0

1 6 0

1 8 0

2 0 0

2 2 0

2 4 0

2 6 0

2 8 0

3 0 0

3 2 0

1 9 7 3 1 9 7 5 1 9 7 8 1 9 8 0 2 0 0 2 2 0 0 4 2 0 0 61 0 0

1 1 0

1 2 0

1 3 0

1 4 0

1 5 0O i l p r i c e ( L H S )

C o n s u m e r p r i c e s ( R H S )

O i l p r i c e a n d O E C D C P I

1 9 7 3 - 7 6

1 9 7 8 - 8 1

2 0 0 2 - 0 6