Through the magic of e-mail, a panel of experts on energy, investing and global economics - energy economist Peter Tertzakian of ARC Financial Corp. in Calgary, veteran portfolio manager Nick Majendie of ScotiaMcLeod in Vancouver, and economist Carl Weinberg of High Frequency Economics in Valhalla, N.Y. - got together with Globe and Mail reporter David Parkinson to delve into what the Libyan crisis may imply for oil, the financial markets and the world economy.
David Parkinson, The Globe and Mail: Libya has obviously hit a nerve with investors - West Texas intermediate (WTI) oil is suddenly flirting with $100 (U.S.) a barrel and financial markets in general are gyrating. Is Libya really a threat that warrants all this attention? Or just an excuse for investors - in oil and elsewhere - to do some repricing that they would probably have done anyway?
Nick Majendie: Libya produces 1.6 million barrels a day, and estimates of the amount that has been shut in vary between 400,000 and 1.2 millions a day. The IEA [International Energy Agency]has said that OPEC spare capacity has nudged below five million barrels a day for the first time in two years. Saudi Arabia's spare capacity is reputed to be four million barrels a day. Thus, the fear of loss of significant amounts of Libyan production is both realistic and significant - particularly in light of concerns that unrest could spread to Saudi Arabia and that Saudi Arabia's ability to increase production rapidly and significantly is questioned by several observers.
Note that global demand has been surprising on the upside, with the IEA revising the 2011 forecast up to 89.1 million barrels a day recently. The threat of loss of Libyan production superimposes the fear of a supply shock on top of burgeoning global oil demand, and warrants repricing by oil market participants.
Carl Weinberg: What is important to global oil markets is not just the quantity of oil, but its quality.
According to sources that I trust, Libya produces a very light sweet oil. When other producers, like Saudi Arabia, offer to produce more crude oil, they are lifting all the light sweet crude that they can from the ground already.
The system is finely tuned, with refineries geared to take in crudes with specific qualities. This can be adjusted, within limits, but not without downtime and re-engineering. In the short term, substitution is impossible, and longer-term substitution of crude stocks is expensive. So simply having spare capacity to produce more "crude" around OPEC does not mean that OPEC can compensate for the loss of Libyan crude to refiners. A shortage of product is likely as/if Libya goes offline.
And for what it's worth in this conversation, Canada's crude oils are not a substitute for Libyan light sweet. In fact, there is a glut of Canadian crude in Cushing, Okla., right now. That is where the pipeline south ends. There is insufficient refining capacity - of the appropriate type - in Cushing to handle all the crude that flows there from Alberta. Thence, there is insufficient capacity to ship the products more than a few hundred miles in any direction. So Canada is experiencing downward pressure on crude oil prices and energy products offsetting at least some of the increase in overall crude prices other countries are experiencing.
In my view, elevated prices for energy products are the second-biggest threat to the global economy in the near term, after a banking and sovereign-debt crisis in Euroland. Since people cannot reduce their consumption of energy products much in the near term, rising energy prices are deflationary: Higher expenditures on more-expensive energy leaves less income to spend on other goods and services, whose prices soften with demand. As long as wages do not rise, an increase in oil prices relative to incomes and other prices - a relative price shift, not inflation - reduces real incomes.
Euroland depends the most on Libyan crude, and Japan buys a good bit of it. North America does not, so the impact on product prices will vary from country to country. So, too, will the impact of higher energy prices on CPI and on consumption of other goods and services.
DP: Does the Libyan situation, then, actually alter your outlook for the oil market for the next year? And, by extension, for the global economy? (Let's talk prices, gentlemen …)
CW: C'mon Dave. You tell me how the Libyan revolt and the crises bubbling up all around the MENA [Middle East/North Africa]countries turn out, and I'll give you an oil price forecast.
Do we get stable governments or unstable factional squabbling? Do we see Western-friendly governments or anti-Western governments? Will they be democracies that U.S. and European liberals can accept, or do we get something less palatable - a government with whom we would not want to get into bed?
From the straight point of view of oil price stability, things will never be as good again as they have been [before]MENA governments started to wobble. That is not to say that the political regimes were not repressive or otherwise ugly… it is only to say that their politics were accepting enough of the Western governments to allow them to trade oil openly and freely with us.
Whether Brent [crude oil]stays at $118, where it was in European trading [last week] is a political question and not an economic one.
Peter Tertzakian: The Libyan situation, and more broadly, the issue of civil unrest occurring on moment's notice in any major oil-producing country in North Africa or the Middle East (and maybe even beyond), is likely to place a lingering premium (crisis option value) on oil prices over the next couple of years. This is akin to the "war premium" that we saw linger during the Iraq war.
Of course, the question is what is the magnitude of this premium, even when the Libyan situation settles. I suggest $10 a barrel is likely, though potentially higher if Algeria or another major producer gets more restless.
There are a few scenarios:
1) The situation in the region calms down: A lingering premium of $10 a barrel above the $80-$90 a barrel that is reasonable in the next couple of years in the context of no geopolitical noise.
2) The situation deteriorates to other major producers, like Algeria: Add another $10-$15 a barrel to the premium in the near term.
3) The situation spreads to Saudi Arabia: Add a lot more! But not for long, because at some point the market will recognize the impact on the global economy and oil demand estimates will be cut materially, moderating price with it. I think that point is not far off, somewhere around $120 a barrel. Not to mention the public will start screaming about higher gas prices.
What to use for 2011 and 2012? The next few weeks will be key. I suggest WTI of $95 to $105, assuming the contagion doesn't spread further. But the higher it goes, the faster it will fall.
NM: Obviously, no one can tell at this stage how the Libyan situation will be resolved and how quickly, nor whether unrest/revolution will spread - in particular to Saudi Arabia. Clearly, the markets will impose an uncertainty cost on the oil price until there is some clarity, and that could take a year: Remember that, after the fall of the Shah of Iran in 1979, it took another nine months before the Islamic fundamentalists came to power.
In this environment, $120 a barrel could easily prevail for a few months. Oil at $120 a barrel is the equivalent of 5.5 per cent of global GDP, the level at which the global economy starts to be affected. In 1979, oil's share of global GDP actually got to 8 per cent.
The level of oil prices will be a function then of how long the supply uncertainty in Africa and the Middle East lasts and what further disruption there is. My guess - and it really is a guess, as I am sure that even the King of Saudi Arabia can't predict the outcome for sure - is that this will take some time, and that the odds are high that the crisis will spread further in the region. I would certainly not rule out $150 a barrel in that event. If that happened and there was any sustainability to that price, fears of double-dip recession that we faced last spring would hit financial markets once more. If we got there (to $150 a barrel), there could be a great further short-term move in oil stocks in the interim, but it would be short-lived. Just reflect on 1990 when Kuwait was invaded, the oil price hit $40 a barrel but within a few weeks, the oil stocks in Canada at least had reversed all their gains and then some as the U.S. entered recession.
CW: So let's do some math. From the start of the year to today, we have seen oil prices rise by about $20 a barrel. At 90 million barrels a day of production - that is 32.85 billion barrels per year - the increment to the world's oil bill is $657-billion extra expenditure on oil if [that price increase is]sustained. Unless consumption drops sharply. History says it will drop only gradually. So that means consumers have $657-billion less to spend, which is bit more than 1 per cent of world GDP. Oil producers have incremental income of course. But it is doubtful they will spend their windfall right way, if at all.
For Euroland, where the price increases are the greatest and where there is very little locally produced oil, the impact will be severe. Japan will suffer too, but less than Europe. In North America, the loss to consumers will be offset somewhat by a windfall to local oil producers.
PT: My view is that oil prices above $80 were already forcing changes in demand, especially in OECD countries. So these higher prices only encourage societies to seek ways to get off the stuff even faster. Price spikes like this will strengthen the resolve of consuming countries to "get off oil". Just wait until people start screaming and governments get involved in response. History shows that government responses to high energy prices produce dramatic results within five years.
Yes, a slowing economy due to high oil prices will slow oil demand growth, but that's only a cyclical dynamic. On the other hand, policy implementations, technological advances and societal shifts engender permanent demand mitigation. In fact, technological advances and societal changes are already showing signs of mitigating oil demand growth.
DP: For a country like Canada, with lots of oil production and an equity market overweight in energy stocks, high oil prices are not a bad thing, all other things being equal. In this instance, should Canadians fear the rising oil price, or cheer it?
NM: In the short term, a spike in oil prices would benefit the TSX and its energy stocks. However, one better hope that the spike is temporary and doesn't last beyond a few weeks/couple of months. Otherwise, there will be demand destruction, since the higher oil price would contribute to slower global economic growth. This would be particularly evident in the faster-growing, more energy-intensive economies such as China. A slowdown there would also have broader detrimental implications for other cyclical sectors of our TSX index, through the negative impact on the price of copper and metallurgical coal, for example.
Longer term, I think the events of the last while in North Africa and the Middle East are a strong plus for our economy, our currency and our TSX. Why? Canada is by far the most important source of crude oil supply to the U.S. (23 per cent of their total imports). After Canada, the next 14 exporters in descending order of importance are: Mexico, Saudi Arabia, Venezuela, Nigeria, Columbia,, Algeria, Iraq, Angola, Ecuador, Brazil, Kuwait, Russia, the U.K. and Indonesia. All of these countries except Mexico (despite its drug problems), the U.K. and possibly Brazil have had their share of political problems/terrorism over the last number of years.
In the face of such instability, the risk of which has only increased in the MENA countries since the popular uprisings in Tunisia, Egypt and Libya, It is inevitable, in our view, that Canada will be looked upon increasingly as a reliable, consistent source of crude oil to the U.S. Already, U.S. refineries have been displacing Mexican, Venezuelan and Saudi Arabian heavy oil in favour of Canadian production. Despite the complaints/pleas of the environmentalists in the U.S., we think it is almost inevitable that this trend accelerates over the next few years. In our opinion, the MENA crisis can only add further momentum to what is already a clear trend. This bodes well for the many Canadian oil sands projects that are slated to come on stream over the next number of years. If the transportation of oil to the West Coast becomes a reality in future through the Trans Mountain oil pipeline or a Gateway pipeline and in the interim via CN and CP rail cars, that will only increase the U.S. appetite for Canadian oil imports.
PT: Nobody in Canada's oil industry should be cheering this event. In the longer run, rapidly rising oil prices today will serve to price our commodity out of a transportation market that is quickly growing richer with all sorts of potential alternatives. The higher the price oil goes, the faster it's going to come down.
Also, the higher the price goes the more silly money will come flooding in, driving up the price of labour and services. We are already among the world's highest-cost producers of oil; we don't need to go higher.
While it is true that Canada has displaced Venezuelan and Mexican oil, there is rapidly growing Columbian oil of high quality that is increasingly competing with us in the U.S. market. And it's much lower cost than ours. Cheering high oil prices is not an appropriate corporate strategy for competing in the future.
NM: Just to be clear, I am not cheering higher oil prices. I think the ideal is if they were to ultimately (i.e. if, as and when the MENA situation calms down) stay in the $75 to $85 area, as you will get less long-term substitution globally. However, I do think the U.S. politicians (and the equity markets through valuation) will definitely recognize the long-term reliability of Canadian supply. Currently, the U.S. administration in place has shown little realistic resolve to wean the economy off oil.