The Return of Iran's Oil

• If approved by all parties the negotiated nuclear agreement with Iraq could affect energy markets both directly and indirectly.
• By adding to the current global oil glut, it would make big oil projects elsewhere riskier, while undermining outdated restrictions on US oil exports.

The signing of a nuclear agreement between Iran and the five permanent members of the UN Security Council plus Germany represents more than a geopolitical milestone. In the context of today's lower oil prices it puts additional pressure on near-term prices, but perhaps more importantly creates the potential for significant shifts within the oil industry. Iran's expanded exports--once the conditions of the deal are met--will arrive in a market quite different from the one that prevailed when they were restricted in early 2012.

These differences include an OPEC that is now engaged in a contest for global market share, rather than one focused on maintaining oil prices at around $100 per barrel. This is the cartel's response to the rapid growth of non-OPEC production, mainly from US shale, or "tight oil" formations. Based on data from the International Energy Agency, non-OPEC production has increased by 5 million barrels per day (bpd) since 2012, while global demand has grown by just 3 million bpd.  The return of anywhere from 600,000 to 1 million bpd of Iranian exports would expand a global oil surplus and intensify competition.

 Iran's oil traders may find that placing additional volumes with refiners will not be as easy as it would have been just a few years ago. As the Wall Street Journal noted, the likeliest home for most of this incremental supply is in Asia, where competition between Saudi, Iraqi and Russian barrels is already keen. China and India have been the largest purchasers of Iranian oil during the sanctions (see chart below) but Iran is not the only producer seeking to expand its output of similar crude oil.  

 

Oil prices have two main dimensions, only one of which is widely understood outside the industry. Media reports focus on the absolute price level, particularly for benchmark grades such as Brent and West Texas Intermediate (WTI). However, differentials--the gaps in price for oils of different quality, or of similar quality in different regions--are nearly as important for producers and often more so for refiners.

Iranian oil is mainly sour (high in sulfur) and so competes principally with other sour grades, including those from Saudi Arabia, which is already at record output, and Iraq, where production is approaching 4 million bpd, compared with just under 3 million in 2012. OPEC's other big producers seem no more inclined to cut output to make room for extra Iranian oil than they were to accommodate surging US tight oil. Meanwhile, refineries in Europe, where sanctions on Iranian oil had the largest impact, are also "spoiled for choice" with various crude streams displaced from US refineries by the shale revolution.

If Iran's restored exports keep oil prices lower for longer, they are also likely to widen the "sweet/sour spread", or premium for light sweet crudes like those produced in the Bakken and Eagle Ford shales, over sour crudes like Saudi medium or Iranian heavy. That would lend greater urgency to calls for an end to 1970s-vintage restrictions on exporting US crude oil, because it would expand the potential economic opportunity for US exports.

As a result of opening the taps in Iran, we could also see deeper shifts in the structure of the global oil industry. OPEC's current production policy may be targeted at US shale, but shale producers have proven themselves much more adaptable than expected to prices in the $50-60 range. The same cannot necessarily be said for new conventional oil projects with price tags in the hundreds of millions to billions of dollars. 

Barring another shift as dramatic as the one that rippled through oil markets last fall, we may have witnessed the end of an era in which low-cost producers in OPEC held back production to drive up prices and, in the process, made room for much higher-cost production elsewhere. Iran appears poised to go beyond its pre-sanctions exports by inviting international investment in new developments that would be profitable at current prices.  If Iran's terms are attractive, the losers won't be shale producers that operate at dramatically lower scales of investment and risk per well, but big projects in places like the North Sea, which has already seen a wave of project cancellations. The recent lackluster Mexican bid round might be another signpost.

Could we end up in a few years with a global oil industry in which prices would be determined mainly by a new balance between a resurgent OPEC and US shale producers? That would be a very different world than we have experienced recently, and probably one with more price volatility.

Of course before any of this could happen, the nuclear agreement with Iran would have to go into effect and be widely seen to be holding. For anyone who recalls the periodic inspection crises with Iraq in the late 1990s, that can't be a foregone conclusion, even if the agreement survives review by a US Congress that asserted its right to scrutinize the deal's provisions and includes some surprising skeptics.

 

A different version of this posting was previously published on the website of Pacific Energy Development Corporation

The Impact of the Global "Sweet" Crude Bulge

• The recent slide in global oil prices has been compounded by the pressure that rising US shale oil production is putting on the price of sweet crude benchmarks like Brent.
• OPEC's producers may suffer as much as those in the US, while consumers benefit from significantly lower fuel prices than last year.

When the US went to war in Iraq in 2003, the price of oil embarked on a trend that took it from around $30 per barrel to nearly $150 before collapsing in the recession in 2008. This time, as a new US-led coalition takes on ISIS with a bombing campaign in Iraq and Syria, the price of oil is falling, down 20% in the last two months. It's not just that global economic growth has weakened recently, or that soaring shale oil output in the US has averted another oil crisis. Oil's current downturn also reflects the fact that new production from the Bakken, Eagle Ford and other shale deposits is particularly well-suited to undermine oil's global benchmark prices, for Brent and West Texas Intermediate, both of which are made up of light sweet crude oil streams.

The numbers for US shale, or "light tight oil" (LTO) as it's often called, are impressive, especially to those accustomed to watching the gradual ebb and flow of different oil sources over long periods. In the 12 months ending in June 2014, US oil production grew by 1.3 million barrels per day (MBD), not far short of Libya's pre-revolution exports. Since January 2011, the US added 3 MBD, or about what the UK produced at its peak in 1999. In fact, since 2010 incremental US LTO production has exceeded the net decline of the entire North Sea (Denmark, Norway and UK) by around 2 MBD, contributing to a significant expansion of Atlantic Basin light sweet crude supply.

The New York Mercantile Exchange defines light sweet crude as having sulfur content below 0.42% and an API gravity between 37 and 42 degrees. That's less dense than light olive oil. The specification for Brent is similar. Much of the LTO produced from US shale formations fits those specifications, and what doesn't is typically even lighter and lower in sulfur.

The current "contango" in Brent pricing, in which contracts for later delivery sell for more than those for delivery in the next month or two, is another sign of a market that is physically over-supplied: more oil than refineries want to process, with the excess going into storage. However we also see indications that the historical premium assigned to lighter, sweeter crude versus heavier, higher-sulfur crude is under pressure.

One example of this is the gap or "differential" between Louisiana Light Sweet, which wasn't caught up in the delivery problems that plagued West Texas Intermediate for the last several years, and Mars blend, a sour crude mix from platforms in the Gulf of Mexico. From 2007-13 LLS averaged around $4.50 per barrel higher than Mars, while for the first half of this year it was only $2.75 higher and today stands at around $3.40 over Mars.

And while OPEC's reported Reference Basket price has been falling in tandem with Brent, its discount to Brent had also narrowed by about $1 per barrel, prior to the price plunge of the last couple of weeks, compared with the average for 2007-13. Considering that OPEC's basket includes light sweet crudes from Algeria, Libya and Nigeria that sell into some of the same Atlantic Basin markets as Brent, that looks significant.

By itself a narrowing of the sweet/sour "spread" of only a dollar or so per barrel isn't earth-shattering. However, because the surge of US oil production is effectively focused on the oil market segment represented by the price of Brent, it compounds the pressure on OPEC, many of whose members link the price of their output to Brent. This might help explain why the response of OPEC's leading producer, Saudi Arabia, has been to cut prices rather than output, in an apparent effort to maintain market share rather than price level.

The Saudis know better than anyone how that movie could end. The Kingdom's1986 decision to implement "netback pricing", linking the price of its oil to the value of its customers' refined petroleum products, helped precipitate a price collapse so deep that it took oil prices 18 years to reach $30/bbl again, by which time the dollar had lost a third of its value.

Whether aimed at US shale producers or as a reminder to the rest of OPEC, which appears to be unprepared to make the output cuts necessary to defend higher oil prices, the Saudi action increases the chances that oil prices will over-correct to the downside, rather than rebounding quickly. If so, the impact of the sweet crude bulge in the Atlantic Basin--only a little more than 3% of global oil supplies--could play a disproportionate role in prolonging the pain producers will experience until oil markets eventually reach a new equilibrium.

In the meantime, US consumers are benefiting from gasoline prices that are already $0.15 per gallon lower than this week last year. Today's wholesale gasoline futures price for November equates to an average retail price well below $3.00 per gallon, after factoring in fuel taxes and dealer margins, compared to last year's average retail price for November of $3.24. After factoring in lower diesel and heating oil prices, the fall in oil prices could put an extra $10 billion in shoppers' pockets for this year's holiday season.

A substantially different version of this post was previously published on the website of Pacific Energy Development Corporation

How Falling Oil Imports Doubled the US Strategic Petroleum Reserve

• Falling oil imports have greatly expanded the capability of the US Strategic Petroleum Reserve to replace oil imports in a crisis, although prices would still rise.

• The SPR remains an imperfect backstop. Post-Syria, it is high time for Congress and the White House to address its gaps after four decades of change.

Last week's deal between the US and Russia defused the threat of an attack on Syria's military installations, along with the risks of unintended consequences for Mideast oil exports. However, we shouldn't lose sight of an important energy-related observation in the Wall St. Journal's “Heard on the Street” column as the crisis was peaking. It concerned the extraordinary degree to which reviving US oil production and weaker US energy demand have boosted the effectiveness of US oil inventories, including the US Strategic Petroleum Reserve (SPR).

Without adding a drop — the SPR actually shrank a bit in 2011 — the reserve’s potential to replace daily oil imports in a crisis has soared as those imports have declined. This could prove extremely helpful should the complex talks over securing Syria's chemical weapons break down, and the US and France proceed with missile or air strikes. Longer term, it serves as a further reminder that the existing SPR was designed for another era and is overdue for a major rethink.

Having 700 million barrels of oil available in federal facilities along the Gulf Coast has tempted presidents and other politicians, who saw opportunities to benefit from using it to attempt to crush periodic gasoline price spikes. However, the recent situation came much closer to the scenarios the SPR was intended to address when it was begun during the Ford administration, to provide a backstop for our vital energy supplies in emergencies involving the physical interruption of supply. When it comes to uses of the SPR, I’ve always been a purist, perhaps because I can recall sitting in gas lines and participating involuntarily in the bizarre “odd-even” rationing-by-license-plate scheme introduced during the oil crisis following the Iranian Revolution in 1979.

Here’s how the benefits of tapping the SPR in an actual crisis have improved, based on the rapid recent drop in US oil imports. In 2007, the SPR could have replaced just over half of our crude oil imports from countries other than Canada or Mexico for 165 days, at its maximum draw-down rate of 4.25 million barrels per day. With its current inventory and this year’s average crude oil imports through June running at around 7.6 million barrels per day, the SPR could substitute for 100% of our non-North American imports for 163 days. The value of such an insurance policy is rarely appreciated until it is needed.

Of course in practice the situation would be more complicated, mainly for reasons that support the case for rethinking the current 1970s-vintage reserve. One problem is that the oil stored in caverns near the Gulf of Mexico wouldn’t provide much immediate assistance for east coast refineries or for the West Coast, which has become increasingly dependent on imports as production in both Alaska and California declined steadily. Then there’s the issue of quality. Nearly 40% of the SPR oil is light and sweet (low in sulfur), while much of the oil we still import is heavy and sour (higher sulfur), to match the requirements of current refinery configurations. With production of light sweet crude in Texas and North Dakota booming, releasing sweet crude from the SPR could compound regional imbalances and possibly result in reduced refinery utilization. Any redesign of the SPR should take these important shifts into account.

Oil prices jumped just at the thought of a cruise missile attack on Syria, so it’s worth recalling what a back-up supply from the SPR can and can’t do. It can buffer the US economy from the impact of a serious interruption in the flow of crude oil cargoes from the Middle East or elsewhere, for some months. US refineries would continue to operate, as would the planes, trains, trucks and ships they fuel, and on which commerce depends. However, consumers wouldn’t be insulated from the price increases that would accompany any major disruption in Middle East oil exports, because the SPR oil must be auctioned to refiners at market prices. The resulting situation at gas stations might look a lot like price-gouging, with social media rapidly spreading outrage and conspiracy theories. The fallout from that could be disruptive, too, if somewhat less so than widespread fuel shortages and “out of gas” signs.

A different version of this posting was previously published on Energy Trends Insider.