Oil Moves Over $100 Around the World

Jim Brown
 
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U.S. West Texas Intermediate crude or WTI may have taken a tumble last week to $88 but other grades of crude around the world are moving in the opposite direction. Prices for WTI are being impacted by several factors that are not present in Europe, Asia and Africa.

Nigeria's Bonny Light crude, the grade that other African crudes are measured against moved to $100.12 last week and moving past $100 for the first time since October 2008. Malaysia's Tapis and Indonesia's Minas crudes had already broken through that level with Tapis at $103.36 and Minas at $103.21.

The International Energy Agency is going nuts on worries the triple digit oil prices are going to squelch the global recovery and push us back into a recession. They are literally begging OPEC to increase production to prevent any higher prices.

A JP Morgan analyst said the risks of OPEC taking action are growing as rhetoric from consuming nations begins to heat up in the coming weeks. Behind the scenes political pressure will also mount. The analyst warned investors to take profits and cut risk. "There is a rising risk of coming into the office one Monday morning to find OPEC has unexpectedly raised output dramatically."

The IEA warned that even if prices remained in their current $95-$100 range the pressure would increase on consumers around the world. In the U.S. a penny increase in gasoline prices costs U.S. consumers $40 million a day.

The IEA claims there is still enough oil on the market with global inventories in developed countries around 2.742 billion barrels. That is near the top of their five-year range. The problem is the accelerating demand in Asia and other developing nations. Without increased production it would only take a few months to push those supplies below a safe level. Forward cover, the time it would take to deplete the stocks at the normal consumption rate, is about 60 days. OPEC likes to see it more in the 50-52 days of cover.

The problem in Africa and Asia is the availability of low sulfur crude. I have written about this many times before. There is plenty of oil capacity in the world but not enough of the right kind of oil. The low sulfur oil is easier to refine and produces higher yields of gasoline and jet fuel. As those low sulfur grades become shorter in supply the prices will rise as refiners compete for the available supply.

The reason the U.S. WTI prices are so much lower is the amount of storage available at Cushing Oklahoma. The WTI contract calls for delivery of 1,000 barrels of light sweet crude at Cushing OK. Cushing has been at record inventory levels since September. When inventory levels are high and storage is limited the cost to store additional oil goes up. When storage prices go up that depresses the price of WTI because traders and buyers have to factor the storage costs into the equation. The front month futures contract should be a combination of the cash price of the oil plus one months storage cost plus carrying costs and transaction costs.

The spot price should be roughly equal to the other grades of like crude from around the world after an adjustment for transportation costs. For instance if Brent crude is $100 a barrel and it costs $2 a barrel to transport WTI to Europe then WTI should be worth about $98. There are a few more factors but you get the idea. There are large trading rooms that constantly weigh these factors and decide when it makes sense to buy one grade somewhere in the world and ship it somewhere else in order to take advantage of the inequality of prices.

With Brent crude in the $98 range and WTI at $89 today there is some money to be made moving oil to Europe. This kind of imbalance will not last long before the arbitragers manage to equalize supply.

A bigger problem is the long-term viability of Cushing storage as the historical delivery point for WTI contracts. Most analysts expect the Nymex to change the contract to allow for delivery in other locations in order to keep the WTI contract as the world light crude benchmark. When half a dozen other grades of sweet crude are already over $100 there is a serious problem.

With prices already moving over $100 around the world it will probably not be long before we see $100 on WTI despite the storage problem.

Schlumberger (SLB) reported earnings on Friday and their share price quickly lost ground. The company said gas drilling in the U.S. was declining because of surpluses and oil drilling, although it was increasing, was not increasing fast enough to compensate for the decline in gas wells. SLB also said they did not expect a resumption of drilling in the Gulf of Mexico in 2011.

The EIA is projecting a decline in gulf production of 120,000 bpd in 2011 and as rising to 250,000 bpd in 2012. Deepwater wells deplete quickly and we are going to lose roughly 20 months of drilling if permits are not released until 2012. With six of 18 rigs already moving out of the gulf for other countries that will also delay future production that was already on the schedule. It will be 2-3 years before those rigs come back, if at all.

Analysts are now predicting a major consolidation wave in the drilling sector because the new rules will prevent all but the largest companies from being able to qualify for permits. They will have to use the highest quality state of the art equipment with the best-trained crews and have access to billions of dollars of containment equipment in the case of another blowout.

Seahawk Drilling (HAWK) CEO Randal Stilley said in a Businessweek interview this week they were canceling plans to upgrade and diversify their fleet. "If we can't be more diversified, I would rather sell the company to somebody else and let them try to do it." A company the size of Seahawk with a market cap of $100 million can no longer compete in the Gulf. It is going to boil down to Transocean Offshore (RIG), Diamond Offshore (DO), Seadrill (SDRL) and Noble Corp (NE) as rig suppliers and Noble may be too small. Anyone under $10 billion in market cap is doomed to be acquired.

Rowan (RDC), Ensco (ESV) and Pride International (PDE) are prime takeover candidates. Seadrill is a likely acquirer of at least one of these companies. Seadrill just ordered two ultra deepwater rigs with a total cost of $1.2 billion. Seadrill already owns a 9.4% stake in Pride. Let the horse-trading begin!

Jim Brown

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