Sunday, March 20, 2011

Market Chatter on ‘Crude’ effects of Instability

As allied forces start bombing Libya and the full damage – both physical and reputational – to the nuclear generated power industry in wake of the earthquake in Japan is known, it is time to move beyond ranting about how much instability premium is actually there in the price of crude oil to what its impact may be. Using the Brent forward month futures contract as a benchmark, conservative estimates put the premium at US$10 but yet looser ones put it at US$20 per barrel at the very least.

It is also getting a bit repetitive to suggest that fundamentals do not support such a high price of crude, even if the geopolitics is taken out of it. Thing is even profit taking at some point is not likely to cool the hot prices in the short term and the market has already started chatting about the impact. The tragic earthquake in Japan has added another dimension. Until nuclear power generation gets back on track in Japan, in order to meet their power demand the Japanese will increase the use of hydrocarbons as they have no other choice.

Regarding the latter point, Ratings agency Moody's says that displaced demand from Japan's nuclear shutdown will shift to Asia-Pacific thermal-energy producers such as Australia's upstream Woodside Petroleum (Moody’s rating Baa1 negative), Indonesia's thermal-coal miner Adaro (Ba1 stable), Korea's refiner SK Innovation (Baa3 Stable), and Thailand's petrochemical firm PTT Chemical (Baa3 review for upgrade).

Renee Lam, a Moody's vice president in Hong Kong, says, "These firms and others in the region can capitalise on near- and longer-term displaced demand as Japan must now rely more on non-nuclear fuel." Lam also expects global crude prices to remain high, despite a near-term drop from dislocation in Japan.

She further notes, "Refinery shutdowns in Japan, accounting for 9% of Asian capacity and 2% of global capacity, have pushed up Asian refining margins. Strong margins benefiting non-Japanese, regional refineries should continue at least in the near term. We expect strong results for our rated refiners in the first half of this year."

Additionally, Fitch Ratings says airlines and European Gas-Fired Utilities Unprepared for Current Oil Spike and that the substantial increase in oil prices in a short time frame has caught many corporate energy consumers off guard, as they are not properly hedged to cope with such high oil price levels. In a scenario of sustained high oil prices, corporate issuers that are heavily exposed to oil-related commodities feedstock are likely to face a direct impact on their earnings.

In the agency’s view, management teams may be reluctant to hedge the oil price at these high levels, in anticipation of a softening in the oil price once geopolitical tensions subside. Fitch also considers it possible that banks might be less keen to finance oil option contracts at such high levels, as they do not want to take the risk of a continued rally in the price of crude.

As oil price volatility remained fairly low in 2010, airlines seem to have been hedging less and are now more vulnerable to the current spike. In the current high oil price environment, an increasing number of airlines are taking a wait-and-see approach in anticipation of a softening of the oil price and perhaps due to higher hedging costs. In Fitch's view, sustained oil prices well in excess of US$100 per barrel could negatively affect the operating performance and creditworthiness of high intensity corporate energy consumers and may also hamper the global economic recovery.

Analysts at SocGen CIB note that the forward curve for Brent is currently in backwardation (nearby premium, forward discount) for the next 5 years, reflecting concerns over growing physical tightness in the crude markets. Especially, in light of the NATO/allied forces bombardment of Gaddafi forces last night, the market is pricing in an extended Libyan shutdown of crude exports. About 1 million barrels per day of crude oil production has been cut and Libya’s major exporting ports are now closed.

As Nymex WTI-ICE Brent spreads have been less weak, SocGen analysts note that the front month spread has traded around -US$9.75/b on Tuesday vs -US$15/b one week ago. They opine that the recent strength of the WTI / Brent spreads has not really been due to the decreasing risk-premium of Brent, but more to very strong inflows of money on WTI-linked instruments.

In a note to clients last week, they note and I quote: “Indeed, the last CFTC COT report shows that the net position of the non-leveraged investments on WTI hit a new record high. This is so large that even the swap dealers now have a negative net position on WTI futures.”

I feel it is prudent to mention (again!!!) that this blogger, all main ratings agencies and a substantial chunk of commentators in the City believe that a large portion of the current oil price spike has been driven by speculative activity rather than supply fundamentals. Oil supply has remained more or less balanced as most other oil producing nations have raised their production levels in order to keep overall production largely unaffected – so far that is!

Finally, here’s an interesting segment of CNBC's Mad Money programme, where Jim Cramer talks oil n’ gas in the US state of North Dakota. It’s relatively small from a global standpoint, but could be important from an American one.

© Gaurav Sharma 2011. Photo: Oil Drill Pump, North Dakota © Phil Schermeister, National Geographic Society

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