Oil Markets Face Contradictory Dynamics

John Kingston, Global Director, Platts Oil

Crude benchmark idiosyncracies, globally varying refining risks, shifting supply patterns, ethanol and currency markets that dance to their own tunes the oil markets don't lack for signals, but discerning where they are pointing won't be easy.

AS OIL MADE ITS CLIMB THROUGH THE $90 mark and then toward the century level through the end of October and early November, it was easy to just focus in on a price march that seemed inexorable. But the outright price of oil is an end product, the final result of a complex brew of under-the-radar developments that impacts the price of a barrel of crude. And beneath the stunning surge in outright prices, many of those less obvious trends were having an impact.

The outright price of crude is an end process, a sort of "butterfly effect" in which a wide range of actions and reactions add toor take away from—that highly-watched number that the morning business report now serves up as a staple. Apart from the primary equationthe millions of barrels of oil produced each day versus the millions demandeda variety of far smaller market transactions all affect oil's final price. Whatever market is having a significant impact now is not necessarily going to have that same clout next year. But for the next few months, and possibly beyond, there are several little-observed factors that are having or, conversely, are not having the impact one might have thought.

The Failing Benchmark has Bounced Back

It's difficult to know the true price of oil if the number everyone looks at is seriously flawed. And that was the case in spring 2007, when the Cushing, Oklahoma delivery point for the New York Mercantile Exchange's light sweet crude contract, which is primarily a mechanism for trading West Texas Intermediate crude, plummeted relative to virtually every other grade of oil in the world.

The problem developed over several months. Beginning in 2006, pipelines were altered to allow some of the growing crude supply from Canada's oil sands to make it to Cushing. That was generally seen as positive for the benchmark, because WTI had been criticized as increasingly unrepresentative of the global market, with a weak link to the Gulf Coast and inland US production declining inexorably.

But that new flow of oil wasn't such a good thing when Valero's McKee refinery in the Texas Panhandle went down with mechanical problems, and a major customer for Cushing's crude went off the market. The result was an enormous buildup of crude stocks which could not move to greener pastures with higher prices for lack of pipelines going out of Cushing. The NYMEX contract plummeted relative to the rest of the world. WTI developed an enormous contangowith prices moving higher as the months went forwardwhile most other benchmarks were in backwardation, with prices declining over time. The result: incessant industry talk, and media coverage, about the unrepresentative benchmark.

That all is very much in the past. As Figure 1 shows, WTI is again solidly above Brent, as it traditionally has been. Stocks at Cushing drew down sharply as McKee gradually came back and shippers stopped moving crude into the weakened Cushing market.

Figure 1. WTI vs. Dated Brent.

Figure 2. New York Ethanol Over New York Gasoline.

Longer-term, there are several plans under study to allow crude to go from Cushing to the Gulf Coast. Canadian crude from the oil sands moving to Cushing is sure to increase, and its shippers don't want to find themselves at an Oklahoma dead end.

If those projects become reality, it would make Cushing a benchmark physically tied to the US Gulf Coast through a north-to-south pipeline, protected from a direct hit by a hurricane, its once-dwindling supplies bolstered by Canadian inflows. That will resolve many worries for the benchmark.

Ethanol Supplies are Growing

A variety of federal policies designed to get ethanol into the US gasoline pool haveno doubt about itsucceeded.

In Congress' most recent energy bill, the new federal mandate for renewable fuel use is 7 billion gallons by 2012. In July, total production was for the month, annualized, was around 6.5 billion gallons, and annualized imports exceeded 700 million gallons, so the total already is nearing that mark (though ethanol imports can fluctuate widely month-to-month). And that's only ethanol. Biodiesel sales in 2006, according to the National Biodiesel Board, were 250 million gallons, with US capacity in early September 2007 of 1.85 billion gallons/year.

Conventional wisdom in ethanol had always been that the price of ethanol should be roughly equal to the price of gasoline plus 50-55 cents, a figure near to the 51 cents/gal tax credit granted ethanol blenders. The premium that Platts' New York harbor ethanol price carried over conventional gasoline between January 1, 2006 and mid-September 2007 averaged about 55 cents.

But what that doesn't say is that when Mtbe was being phased out of environmentally-friendly reformulated gasoline (RFG) in favor of ethanol in the spring of 2006, to replace the octane lost through Mtbe's elimination, ethanol in New York harbor got as high as $1.12/gal more than gasoline. But through September and early October of this year, ethanol supplies soared as plant after plant opened throughout the US, and ethanol in New York dropped to more than 30 cts under gasoline.

This has several implications. In terms of consumption, it now becomes economical to blend ethanol into non-RFG blends, such as the conventional gasoline that most of the US consumes. That could be a bearish factor for gasoline, and may be a reason why refining margins fell in the late summer and early fall. By early October, according to EIA statistics, US production of conventional gasoline with alcoholwhich is what ethanol essentially ishad surged toward the 2 million barrel/day mark. A year earlier, it was about 1.1 million b/d.

Whether this has had an impact on prices is more difficult to discern. Ethanol only gets into the gasoline pool at the wholesale level, just before delivery to a retail station, due to logistical issues. So comparison of spot gasoline prices to crude or other product prices does not necessarily reflect ethanol's impact.

The overall picture is inconclusive. For example, as Figure 3 shows, the price of retail gasoline as measured by the US Energy Information Administration has come down sharply relative to crude. Normalized to barrels, the national average reformulated gasoline price on June 1 was 74 cents over crude; by early October, it had dropped to 39 cents, a 47% decline.

Figure 3. Retail Gasoline Over Crude.

But refining margins fell even more. Based on Platts' spot prices and the Turner Mason/Platts Daily Yield model, the cracking margin for Light Louisiana Sweet in the US Gulf Coast fell by 59% over that period. So a basket of products fell worse relative to a key crude benchmark than ethanol did to WTI. This may undercut the argument for ethanol's having a significant impact on US gasoline retail prices.

Regardless, ethanol now makes up approximately 2.1% of US consumption, and 4.6% of gasoline supplies, so its day is clearly here.

But that growing use is also one reason long-term questions are looming about ethanol's run of success. The price of corn has not dropped significantly from its highs of earlier this year and the so-called "crush spread"the difference between using corn as feed and using it for fuelis increasingly ugly for ethanol blenders.

It also raises the question of whether the most ebullient projections of ethanol consumption in the US15 billion gallons has been tossed about as a goalcan ever be met. Can the agricultural sector produce enough corn to meet such requirements and still serve as the "baseload" food of the US food chain? And will the long list of ethanol refineries on the board be winnowed down as the economics become increasingly unfavorable?

Refining Margins Can Still be Battered

After years of horrendous returns on capital, recent years have been very kind to refining companies. The stock of Valero, for example, has risen from close to $22 in October 2004 to a 52-week high this year of more than $78. As Morgan Stanley said in a research report on Valero, the refining and marketing industry trends will remain "above mid-cycle levels in 2007-09, with (Valero) growth projects supporting positive performance," and the "refining margin environment suggests earnings estimates will have to move higher in the near term."

But refining is still a volatile business worldwide, subject to shutdowns that drive margins higher, inflows of products from traders seeing arbitrage opportunities, shifts in season specifications that can make for some bumpy times during the transition. It's not a business for the faint of heart.

One of the ironies in looking at refining margins during the past year is that Asian margins, right in the heart of the area showing the biggest percentage increase in demand, have been the most stable. As shown in Figure 4, the margin between the spot price of Dubai and the Platts/Turner Mason cracking netback for Dubai refined in Singapore has only swung in about a $7 range between low and high. As analyst Andrew Lipow noted, one factor keeping margins in check in Asia is the fact that so many retail prices in that region continue to be at least loosely regulated by national governments.

Figure 4. Margins in Three Regions: Singapore, Urals, US Gulf Coast.

By contrast, the US and European markets are far more of a free-for-all. So the cracking margin for Urals in North West Europe, according to the Platts/TM model, has ranged from about $3.50/b to more than $17.90/b. In the US, LLS' coking margin at the US Gulf Coast has swung from $3.30 to more than $17, and been on a constant up-and-down ride over the course of the last two years. Permanent good times still seem elusive.

Not Everyone's Paying Higher Prices

It is often comical to hear some US politicans call for China to more freely float its currency in an effort to hinder the flow of Chinese goods to America. They seem to forget that such a move could strengthen China's competitiveness by lowering its oil import bill.

That gift of dollar-fueled falling crude prices has been enjoyed by numerous countries around the globe in the last year. With a few exceptions, internationally-traded crude and petroleum products are priced in dollars. A company that imports products or crude for refining, and sells the output in a currency that's stronger against the dollar, benefits from the greenback's slide.

So, for example, Japan has not received much of a break. Its currency stood at approximately 119 yen to the dollar in early October 2006. A year later, it had strengthened all of 2 yen. By contrast, it took 0.78 Euros on October 1, 2006 to buy $1 worth of dollar-denominated crude; a year later, it took only about .70, an increase of about 12%. If oil prices were frozen, it means that a buyer in Euros got a 12% cut in its oil import bill, which could be a factor in why global demand for oil has not fallen further as prices moved into the $80 range. Not everyone got hit with the surge.

China's "float" of its currency has been limited in scope and done little to alter the dollar-yuan relationship. So unlike Europe, it has not seen its oil bill magically decline.

Of course, there's one little problem with this argument. Chinese demand continues to post annual double-digit gains while western Europe has seen demand slide.

OPEC's Recent Production Increase May Land with a Thud

Most of the general business media long ago stopped pretending that the forward curve of a commodities contract represents what traders "think" a price will be in a few months. Instead, they know that it is a complex brew not just of supply and demand, but with heavy influence from interest rates. The end result is a curve that gives guidance on whether the market should build inventories. A market burdened by excessive inventorieslike last spring's Cushing marketwill be sharply in contango, encouraging physical players to buy a nearby month, sell the out month, and store the oil if storage costs are less than the carry. Conversely, it discourages financial players from holding positions that must be rolled every month.

A market like the current one, with steep backwardation, discourages stock building. On October 9, the first three months of the NYMEX crude contract, for November-December-January delivery, settled at $80.26, $79.54 and $78.83/barrel, respectively. The steepness of the backwardation actually had lessened from just a few weeks earlier, when the October contract expired at almost $2 more than November.

But that slope is why economist Philip Verleger wrote, of OPEC's September decision to put another 500,000 b/d of oil on the market: "Integrated oil companies, independent refiners and others will no doubt make the same decision: why buy incremental oil if the financial returns are terrible?" Verleger also cited the credit crunch as a reason not to tie up cash in inventories.

So what can OPEC do? Verleger's answer: OPEC should "move oil to storage facilities near consumers and be prepared to sell it to dampen price hikes." The negative returns of the curve would be transferred from buyer to seller, and stocks could be moved into processing units quickly, an advantage when backwardation reigns.

Europe's Gasoline Length is not Wedded to the US

Europe has become structurally longer in the gasoline market, and the US has become shorter. A balance can be achieved by growing gasoline exports from Europe to the US. But arbitrage still exists, and the size of that flow is variable.

Consider Figures 5 and 6. The spread between New York harbor gasoline and European non-oxygenated gasoline, basis Amsterdam-Rotterdam-Antwerp, fluctuates wildly. But the next chart shows average monthly US imports of gasoline from non-OPEC countries, the vast majority of them European. And it shows that the numbers are just as variable, with the fluctuations in the import graph "smoothed" by the fact that they are monthly averages, rather than daily movement.

Figure 5. New York Harbor Gasoline vs. Europe.

Figure 6. Total Non-OPEC Gasoline Imports.

Ultimately, US gasoline prices need to remain high enough to attract a steady supply of European gasoline, and declines in the value of US gasoline relative to European gasoline will not be sustainable over time. Because if those prices are not high enough, Europe's gasoline has other places to go.