Libya's Ripples for Energy Markets

The unrest that began in Tunisia and Egypt has now destabilized a country that exports important quantities of petroleum, and the oil market is reacting in earnest. With Libya in violent turmoil, UK Brent crude traded above $108 per barrel today, and even West Texas Intermediate (WTI), which has been massively discounted due to excessive inventory at its Cushing, OK delivery point, hit $98 in early trading before falling back to the mid-$90s. Unless events in Libya resolve quickly and positively, oil's price moves will shortly translate into higher gasoline prices. As I considered these events over breakfast, it also struck me that GM and Nissan could turn out to be very lucky indeed in launching their electric vehicles now, instead of a year or two ago when gas prices were lower and less volatile.

The media commentary I've seen so far concerning Libya's oil production has missed some key details that explain why a disruption of exports that in theory can be covered by OPEC's ample spare capacity--currently at a multiple of Libya's output--could be disproportionately large. Instead of focusing on Libya having Africa's largest oil reserves--a fact that is important for the long run but essentially irrelevant in the current situation--what matters is production and exports, and especially the location and quality of the latter. Libya produces around 1.7 million bbl/day of crude oil and exports much of that, due to its small domestic market. As oil companies evacuate personnel, that output will drop, and exports from Libya's ports are at risk of disruption by the chaos unfolding there. The majority of those exports stay in the Mediterranean, where they are key inputs for Italian, French and Spanish refiners. Very little of it comes to the US, for which Libyan oil made up less than 1% of our imports in 2009. So any effect on US markets will be indirect, but no less dramatic for that.

On the surface, OPEC is more than capable of making up for the loss of a bit over 1 million bbl/day from the market, if it wished. However, most of the cartel's roughly 5 million bbl/day spare capacity is on the Arabian peninsula--near another focus of instability in Bahrain, which is no longer an oil exporter. Nor is most of OPEC's remaining capacity of a quality comparable to the typically light, sweet crude types that constitute most of Libya's output. These crudes are well-suited for making the diesel favored in Europe, and it would be difficult for many European refiners to switch on short notice to a diet richer in Saudi grades that are higher in sulfur.

Various analysts have noted that US gas prices were already reflecting higher world oil prices, rather than the lagging WTI indicator. With April gasoline futures trading above $2.75/gal. on the NYMEX this morning, that would yield an effective average US retail unleaded regular price of around $3.45/gal, after factoring in excise and sales taxes and typical dealer margin. That's well above the $3.18/gal. average that the Lundberg Survey reported for last week. It would also be the highest average at the pump since October 2008, when prices were unraveling from their $4-plus peak of that summer.

It's too soon to predict an imminent return to those heights, although no one can gauge what will happen next in Libya, where it's not even clear who's in charge at the moment. (It does seem safe to predict that the US will not lead a NATO invasion of Libya, as Fidel Castro has apparently warned.) Still, it is worth thinking about how consumers might react if the current chaos persisted. The last time gas prices rose sharply, we saw significant drops in both US vehicle miles traveled and gasoline consumption. We also observed a noticeable increase in the sales of hybrid cars, which have lagged recently. There were no mass-market electric vehicles available at the time, but it doesn't require a leap of faith to envision a healthy boost in EV sales from their low initial levels, too. That would be good for both GM and Nissan, which have invested enormous sums--and their corporate reputations--bringing their Volt and Leaf models to market. It might not be so positive for sales of clean diesels, despite their high efficiency, if constraints on Libyan oil tighten European diesel supplies and drive up world diesel prices.

Events in North Africa and the Middle East will determine how high oil and gasoline prices rise in the weeks ahead. If Libya's dictator departs as readily as President Mubarak did, things could settle down quickly, unless the unrest spreads to another major oil producer. It's still too early to call this a new oil crisis, but it's not too soon to consider our options if it proved to be one. Although that would be a very unwelcome shock to an economy just regaining some momentum, we have many more options than in 1979, when the Iranian Revolution sent oil prices to levels that it took nearly three decades to exceed, in real terms.

Renewable Energy and Egyptian Unrest

It's hard to watch the current turmoil in Egypt and not wonder what it means for us, particularly with regard to energy. Although Egypt's oil production roughly balances its consumption, the Suez Canal and the Sumed pipeline, with its Mediterranean terminus west of Alexandria, represent important transit routes for Eastern Hemisphere oil going to Europe--though not as important as in the past. And while some politicians have already cited this situation as a "wake-up call" and indication of our energy insecurity, the risk of a serious supply disruption appears low, unless the protests spread to the major oil producing countries of the Middle East. Yet even short of that extreme, renewable energy stands to benefit from the uncertainty these events create, as reflected in higher crude oil prices.

I don't claim any unique perspective on the events in Egypt or their likely outcome, although some of the scenarios I can envision are extremely worrying. I've read heaps of articles and op-eds on the subject and listened to a media conference call from the Council on Foreign Relations, but if there's a consensus view I haven't found it yet. What I do see, however, is that since the protests started on January 25, and without any actual disruption in oil deliveries, the price of UK Brent crude--currently a better indicator of global oil prices than West Texas Intermediate--has climbed by around $5 per barrel and now trades solidly above $100. And while that might reflect other factors in addition to an Egypt risk premium, currency exchange rates don't seem to be one of them.

If the present instability persists or spreads, oil prices are likely to go even higher. Renewables such as ethanol and other biofuels could benefit from that in a way that they haven't from the general increase in oil prices since the middle of last year. That trend was mainly attributable to resurgent global economic growth, particularly from developing Asia. China's GDP grew by more than 10% last year. Along the way, the prices of renewable energy products that compete directly with oil went up, but so did the cost of inputs such as grains and oilseeds, as part of a general surge in global commodity prices. As a result the "crush spread", the margin for turning corn into ethanol, has contracted since mid-2010 and currently stands at essentially zero on the basis of prompt ethanol and corn futures. Biodiesel margins should have experienced something similar, if soybean oil prices are any indication. These products stand to gain if oil prices are driven up by factors that don't also push up the prices of the commodities from which they're made.

Of course that's not the only possible outcome. This week's Economist even notes the potential for a scenario yielding the opposite result. They see other Middle Eastern countries stockpiling grain to avert protests of the kind that have spread from Tunisia to Algeria, Egypt, Jordan and Yemen, and driving up its cost in the process. However, that element of the scenario is more credible than the accompanying suggestion that the region's oil producers might boost production to pay for that extra grain, thereby sinking oil prices. At current levels, the region's oil exporters are already earning on the order of $1.5 billion a day, and even a small producer like Oman should be taking in around $20 billion a year. Even at $9 per bushel the entire 2009/10 wheat imports of Lebanon, Iraq, Iran, Israel, Jordan, Kuwait, Saudi Arabia, the UAE and Yemen barely top $6 billion.

It's worth recalling that if the recent rise in oil prices is reminiscent of 2007 and 2008, OPEC has far more spare capacity in reserve this time. It has done a remarkable job of avoiding the temptation to pump more to gain market share. Even with some cheating around the quotas, they've kept the market tight. If OPEC changes that policy, it seems likelier they'd do so to avoid stalling the global recovery than to cover some additional grain imports for which they already have ample cash on hand. Stay tuned.