Oil Market Fractured

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Thursday night’s decision by the International Energy Agency (IEA) to release 60 million barrels of oil from the strategic reserves of several member nations had an immediate effect on the oil market. Brent crude futures on the ICE futures exchange were down 6.1% to $107.24. Light sweet crude futures on the New York Mercantile Exchange fell by 4.6% to $91.02.

The decision caught the oil market by surprise and leads to an obvious question: who is actually in control of the oil market?

Is it speculators, politicians, OPEC, or oil consumers? Or is something important happening in the world’s energy markets right now?

This bonus weekend Daily Reckoning offers you three explanations the IEA’s surprise move. I’ll tell you what they are and briefly discuss each one. And I’ll tell you why the first is wrong, the second is possible, and the third one could change the world.

  1. Face Value. The first explanation is that you can take the Agency at its word. It says that the disruption in Libyan oil supplies since the U.N.’s non-war began has cost the world 1.3 million barrels of oil per day in exports (of the light, sweet crude variety). That amounts to 132 million barrels in May alone.The IEA said (emphasis added is mine) that, “This supply disruption has been underway for some time and its effect has become more pronounced as it has continued…The normal seasonal increase in refiner demand expected for this summer will exacerbate the shortfall further. Greater tightness in the oil market threatens to undermine the fragile global economic recovery.”This statement doesn’t pass the smell test. First, 60 million barrels is less than one-day’s global demand. That makes the announcement more theatrical than anything. Even though OPEC failed to reach agreement on June 8th to increase its oil production (more on that below), the Saudis and the members of the Gulf Cooperation Council agreed to increase production anyway. The IEA took this action for another reason.
  2. Obama, the Economy, and the Speculators. The second explanation is that U.S. President Barack Obama is in full panic mode with the American Presidential election just 17 months away and the U.S. economy bogged down in bad debt, high unemployment, and high gas prices heading into the summer months. This explanation has legs, so let’s run with it.An important detail of the IEA’s plan is that 30 million of the barrels to be released will come for the Strategic Petroleum Reserve (SPR) of the United States. The whole world benefits from lower oil prices. But as the world’s biggest oil consumer and largest importer (14 million barrels a day in imports), the United States benefits the most. If the Obama Administration can engineer lower gas prices, that’s effectively a tax cut for everyone in America who drives. It puts more discretionary income back in the pockets of consumers, which could lead to an up-tick in U.S. GDP in the second half of 2011. That appears to be the plan (hope), anyway.It could also be calculated to punish speculators who are widely blamed for high oil prices. The surprise certainly wrong-footed oil traders. And if the President is willing to release oil from the SPR for his own political benefit, he’s got 698 million more barrels to play with.The SPR, which is located in the U.S. state of Louisiana, holds 727 million barrels of oil. It’s been tapped three times by Presidents since the 1970s. The first time was in 1996 and 1997, when then-President Bill Clinton authorised the release of 30 million barrels to try and lower oil prices AND reduce the deficit. George H.W. Bush released 17 million barrels on the eve of the Gulf War to calm the oil markets. And George W. Bush authorised the release of 21 million barrels after Hurricane Katrina struck the U.S. Gulf Coast in 2005 and crippled the oil industry.When the SPR is used as a political weapon, it’s a blunt one. The oil market was stunned overnight. But not staggered. It’s also a dubious use of what’s supposed to be an emergency reserve for a true crisis. In fairness, it could be a calculated move to exert pressure on OPEC. Which brings me to the third, final, and most likely explanation for the IEA’s move.
  3. OPEC is losing its grip on world energy markets. In this explanation, the IEA acted because it could, to show OPEC that oil consumers have more leverage than ever thanks to changes in the world’s energy mix. OPEC showed the world that it’s a “house divided” when it failed to reach a production agreement on June 8th in Vienna. That failure exposed two camps in the Middle East that are growing further apart by the day. On the one side are the Saudis and the members of the Gulf Cooperation Council. On the other are the Iranians. With oil “disadvantaged” in a world that’s trying to generate power more cleanly, OPEC is losing clout on the global energy market. As it does, it’s fracturing into two camps and forcing the first major geopolitical realignment of the world’s energy markets since Standard Oil of California won the first concession to drill for oil in Saudi Arabia in 1933.

I’ve spent the better part of three months researching the history of Middle East oil. You’re going to read about what I’ve found in the next week. In fact, last week I published the second half of my report on the matter to readers of Australian Wealth Gameplan. Stay tuned for my video presentation on it next week.

I just finished recording the video and it’s in production now. I’m pretty sure it’s going to upset some people. But we always lose readers when we publish controversial ideas. That’s life in the publishing business. At the very least, I think you’ll find the video informative, even if you’re appalled at the investment strategy I’m recommending.

If you don’t get to see the video for some reason, let me make one of its most important points here and now: the most important energy alliance of the next 50 years is between China and Saudi Arabia.

This relationship – the country’s have agreed to build an “energy superhighway” to connect them – matches up the world’s largest producer of oil with a country that is inevitable going to be its largest consumer. It’s also going to trigger some major changes to the world’s energy markets. And it’s going to lead to some new investment opportunities right here in Australia.

It might not be obvious to everyone else yet, but the Saudis need China. Why?

Well, America has been Saudi Arabia’s best customer and the world’s biggest consumer of oil in the entire Age of Oil. But with the shale gas revolution in the States, the U.S. has begun to actually lessen its dependency on Middle East oil. For the U.S., shale gas has made oil less important.

For China, this is a golden opportunity. It does not have neighbours with large oil reserves like the United States does with Canada and Mexico. China is even more dependent on Middle East oil exports than America. The shale gas revolution in the States has given the Chinese the perfect opening to forge a long-lasting relationship with Saudi Arabia.

Energy politics makes for strange bedfellows. This brings up one interesting point about the relationship between the two countries: their complete indifference to popular opinion and global pressure. You might think that a Kingdom governed by Sharia law and an officially atheist, nominally communist state would have philosophical reasons for not doing business with one another. But they’re both pretty practical.

What’s more, both are willing to put strategic economic interests ahead of political philosophy. They would rather make business deals than meddle in each other’s internal affairs. For the Saudis, this might make the Chinese better long-term business partners than the Americans have ever been. A history of the relationship shows that the Saudi-Chinese alliance has actually been growing for years:

  • Saudi Arabia and China establish formal diplomatic ties in 1990, as the Saudis build up international support for the coming war against Saddam Hussein’s Iraq.
  • In 1999, then Chinese President Jeng Zemin makes a state visit the Kindgom of Saudi Arabia and announces a “strategic oil partnership” between the two countries.
  • In 1999, Saudi Arabia’s Aramco Overseas Company provides a $750 million investment – 25 percent of the total project – in a petrochemical complex in Fujian capable of processing 8 million tons of Saudi crude oil per year.
  • In January 2004, the China Petrochemical Corporation (Sinopec) outbids Western oil companies for the right to invest in a natural gas project termed Saudi Gas Initiative 2 (SGI2). The terms of the deal are highly favourable to the Saudis and cause one analyst to note that, “the SGI-2 winners seem more interested in establishing long-term strategic relations with Saudi Arabia than they are in reaping any immediate economic benefits from their SGI-2 projects.
  • In 2005, bi-lateral trade volume between China and Saudi Arabia reaches $14.5 billion, with a goal of $60 billion by 2015
  • Saudi King Abdullah makes the first trip by a Saudi King to China in history in January of 2006 and signs five bi-lateral agreements, including one on “oil, natural gas, and mineral cooperation.” Saudi Foreign Minister Prince Saud al-Faisal, accompanying the King, tells the world press that “China is one of the most important markets for oil and Saudi oil is one of the most important sources of energy for China.”
  • In 2009, Saudi oil exports to China reach a million barrels per day (bpd), double from the previous year. U.S. imports of Saudi oil fall to less than million bpd for the first time in twenty years.
  • Bi-lateral trade volume hits a record $43 billion in 2010, up 33% from the year before.
  • In 2011, China becomes the world’s largest energy consumer, according to the International Energy Agency, and ranks second only to the United States in oil imports.

There is a lot more to the Sino-Saudi relationship that oil. The Saudis are building refineries in China and the Chinese are building infrastructure in Saudi Arabia. And most importantly, both countries are looking beyond oil to other energy sources…like natural gas.

This is probably the most telling aspect of the new energy alliance between the Saudis and China: it acknowledges that the Age of Oil is giving way to the Age of Gas.

This will have huge implications for Australia’s energy industry. It will also have huge implications for energy investments in Australia. You’ll read more about that next week. But for now, let me leave you with two images taken from the IEA’s most recent World Energy Outlook.

Next week, I’ll tell you exactly what I think it means for Australia. You may not agree with me. And you may not like what it means if I’m right. But either way, it could be the biggest energy story to hit Australia in 50 years. You don’t want to miss it.

Regards,

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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4 Comments on "Oil Market Fractured"

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Pete
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“For China, this is a golden opportunity. It does not have neighbours with large oil reserves like the United States does with Canada and Mexico.”

…Russia!?

Apparently they have more oil than the Saudi’s, and more gas than anyone.

Pete
Guest

Re above:
“I’ve spent the better part of three months researching the history of Middle East oil.”

Look north…

Incidentally, and you may bring this up in a future article anyway, but there is a potential oil/gas pipeline from the Middle East to China.

Guess which country is smack in the middle of such a pipeline? Afghanistan.

Any wonder the US wants to control it?

Ever notice that China never says anything bad about Iran?

Stuart Davies
Guest

Hate to tell you Dan, but you have been suckered if you buy this BS about a shale gas “revolution” in the US. The evidence has been available for a while now that the gas companies know that the high initial yeilds they get from most fracked wells very quickly diminish… these are not anything like sustainable yields even for the short term in most cases. Now it is finally making it into the mainstream media… check out this link: http://www.alternet.org/newsandviews/article/625509/enron_redux_industry_insiders_say_natural_gas_drilling_is_a_ponzi_

Ross
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