SERIOUS MONEY:BLACK GOLD has been headline news all year as strong global demand and supply disruptions emanating in war-torn Libya coalesced to send the price of a barrel of Brent crude up by more than $30 from its low in early-January to a 2½ year high of $127 in early May.

The price jump, in real terms, to levels that were first registered after the outbreak of war between Iran and Iraq in 1980, stoked well-grounded fears that the tight oil market could short-circuit the fragile economic recovery in the developed world.

Concern mounted following a disappointing meeting of the Organisation of Petroleum Exporting Countries cartel in Vienna on June 8th, which prompted the International Energy Agency (IEA) to take the decision to release emergency stocks from its strategic reserves for only the third time since the autonomous organisation, comprising 28 member countries, was established in response to the 1973-74 oil price shock.

The IEA’s announcement on June 23rd to tap 60 million barrels from its stockpile of 1.6 billion barrels over a 30-day period was greeted with surprise, as the reserves are typically only deployed in periods of extreme supply shock – the two previous instances coming in the immediate aftermath of Iraq’s invasion of Kuwait in 1999 and after the damage caused to offshore oil rigs, pipelines, and refineries in the Gulf of Mexico by Hurricane Katrina in 2005. Several commentators believe the current imbalance is not of sufficient magnitude to warrant such a response.

Be that as it may, the announcement produced the desired effect, as the price of Brent crude dropped $7 a barrel to $108 in an intense day’s trading – a decline that is undoubtedly a welcome relief for the world economy, even though the oil price remains roughly 35 per cent above its 2010 average.

Debate behind the surprise decision got under way some months ago as unrest in Libya meant the north African country’s oil production collapse from a pre-crisis level of 1.6 million barrels a day to little more than 200,000 barrels by early-April.

The production shortfall arising from the shutdown of Libyan oil production is relatively small at just 2 per cent of global output and barely one-quarter of the output loss incurred during the Gulf War in 1990.

It is important to appreciate, however, that Libya produces one of the most sought after crude oils in world markets due to its light gravity and low-sulphur content. No other oil-producing country has such high-quality crude in sufficient surplus to come anywhere close to replacing the Libyan supply.

Although Saudi Arabia has repeatedly stated that it will increase output to compensate for any production shortfall, the kingdom’s surplus capacity consists primarily of heavier, sour crudes that are not a viable replacement for the lost Libyan production.

Given that the IEA’s strategic reserves contain a relatively higher proportion of light-sweet crude versus heavy-sour crude, the decision to draw down stock would appear to be the optimal short-term response to mitigate the potentially disruptive effects of higher prices as demand gathered during the Northern hemispheres “driving season”.

The release of stock from the strategic reserves may keep a lid on the crude oil bull market in the short term, but the action is unlikely to produce a sustained pull-back in prices. First, oil demand remains strong and the IEA increased its global demand estimate for the current calendar year by 100,000 barrels a day to 89.3 million barrels a day in its most recent oil market report, despite the current “soft patch” in the world economy.

Second, there is limited spare capacity available across most oil-exporting countries apart from Saudi Arabia, and the kingdoms true surplus capacity is hotly disputed and widely believed to be well below current estimates.

Third, the action is limited to 30 days while the strategic reserves will have to be replenished at some stage.

Strong demand combined with the lack of available surplus capacity means that the world oil market still faces a serious supply deficit of roughly one million barrels a day during the second half of the year in spite of the action taken by the IEA.

The anticipated supply deficit can be absorbed in the short term through a reduction in the Organisation for Economic Co-operation and Development commercial inventories, which amounted to roughly 60 days of estimated forward demand in May versus a normal target of 52 to 54 days, though a rundown in stocks to below-normal levels is unlikely to place an upper limit on prices.

The IEA’s decision to release emergency stocks from its strategic reserves for only the third time is a laudable effort to offset the potentially disruptive economic impact of higher oil prices that may be precipitated by shortfalls in Libyan production. Careful analysis, however, suggests that the downward pressure on oil prices may well be short lived given the magnitude of the cumulative supply deficit anticipated during the second half of the year.

It is simply too early to conclude that the bull market in black gold is over.

charliefell.com