Sic Semper Tyrannis

With pullback in the oil and gasoline markets in the past month, the related Amaranth blow-up, and OPEC talking about output cuts again, it is worth taking stock of the energy market. In this post I pull together a couple of pieces of information and some reflections and try to figure out where things might be headed for energy.

(1)

With OPEC alluding to possible output cuts, attention has been drawn once again to the Saudi-led cartel. Having recently noticed that the Saudis seem to be running into some trouble keeping production up (despite dramatically stepping up rig count), I wondered what the current situation was. Here is the picture I came up with, polling JODI (http://www.jodidata.org/) for the latest data:

(click for full-size chart)

If you ask me, this chart casts serious doubt on the Saudi claim that they can produce 12 mbpd of output--or even that they can produce 10. It looks like 9.5mbpd is the magic number, and to even approach it briefly really "takes the wind" out of their oil fields (which are chiefly the Ghawar mega-field). This makes perfect sense and is what you'd expect from a peaked field, because to rapidly draw oil from such a field creates voids and lowers the pressure, which takes time to fill in again (or to be filled, e.g., with seawater) at the extraction points.

The other thing to notice about this chart is that the oil price has not diverged much, if at all, from its uptrend of the past three years. In fact it looks like we have only a minimal "crash" beyond the usual end of the summer season high demand (and hence prices) cycle. Most of what consumers are seeing at the pump is actually a gas-market rather than oil-market phenomenon.

The Saudis have not been blind to this up-trend, and seem to have been fighting a losing battle against the unrestrained increase in oil price.

(2)

The Russians have revoked Shell's ecological clearance for the Sakhalin project (Sakhalin is an island off the coast of Russia, north of Japan). Analysts have not been fooled by the Russian government's sudden display of sympathy for the local fauna:

Analysts have said Russia's ultimate goal is not to withdraw production licences or paralyse the project but to help the state get a stake in it on better terms.

The increased pressure comes amid attempts by gas monopoly Gazprom to secure 25 percent in the project.

Being a state sure is handy in negotiating (and re-negotiating) commercial contracts. Russia seems to be reveling in their new leeway as a major global petro-power--the rest of the world is still learning.

Just how much of a power are they? Well, if you thought that Saudi Arabia was the world's largest oil producer, you would be wrong. While the numbers do fluctuate, since late last year, Russia has typically been outputting more crude than Saudi Arabia. The numbers for last month (again, from JODI):

Russia - 9.7 mbpd; Saudi Arabia - 9.2 mbpd.

If anything is saving the world from an immediate peak oil shock, in my opinion, it is Russia. They have made impressive strides in sustained output in just four years, going from 7mbpd to almost 10. The question is what kind of output they can attain, and can it make up for the declines in the other major producing nations (e.g. Iran, Iraq, Saudi Arabia, Mexico, and Venezuela). As Russia moves inexorably towards state control of its energy resources, this likely means its production will be lower and less efficient than it otherwise would be (with some cases especially bad).

Update, 2006-09-24: Russia also just grabbed an offshore field from ExxonMobil. You know, it never ceases to amaze me how some people will insist we have so much more to fear from corporations than government. Yet, when it comes to a face-off like the one we're seeing in Russia today, the corporations predictably cave very quickly to the men-with-guns. Even Big Evil Oil Companies (tm) aren't immune to old-fashioned state-sponsored coercive force.

(3)

So what can we expect from the energy market in the near term? I don't have specifics, but here is quick case for why I still think the market will be strong:

1. The market had been dominated by hedge funds, trading at ridiculous nominal values (by using leverage), thus dictating how the prices move due to sheer volume.
2. They have now all poured out of the market at the same time, crashing contract values. The collapse of Amaranth was both an effect and a catalyzing factor in this (the initial shock was the mild inflation and growth data).
3. Anyone taking delivery will get a great deal--probably below long-term fundamentals. Same goes for anyone buying in around here.
4. The losses are transferred to the financial sector; consumers and industry win (but you'll see the deficit show up in hedge funds and investment bank proprietary trading returns).
5. However, after this interval, there should be a counter-rise in prices as all the "hot money" players have flushed out and fundamentals take over again. This is because producers selling into the futures market (and other forms of forward contracts) will be looking at fundamentals, and very quickly drive the price to where it should be naturally ("crash" event notwithstanding).

There's usually softness in the crude market for a few months between the summer and winter seasons. Likely all the shorts will be flushed out by the time we're entering the peak winter season, late December to early February. Of course, mild weather and a severe production slowdown could temper this. The effect of a global slowdown on the "Asian tigers" is a big question mark.