Geopolitical risk has not gone away

Amid the 27% drop in oil prices over the past four months its worth remembering that the security situation across many oil producers has shown little sign of fundamentally improved. Since 2011 Libya has seen the major loss of output and it was the unanticipated return of Libyan exports over the summer that may have been the initial catalyst for the recent downward movement in oil prices.

We have been here before though. Libyan oil production almost returned to normal in early 2012 only for the oil markets fears to swing to Iran, Sudan and Syria. Come mid 2013 though and Libyan oil production rapidly went into reverse. Where will the oil markets attention swing to next?

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Libya remains the obvious choice. According to ANZ “…production has increased in an environment where the overall security situation has deteriorated, seemingly placing them at risk for a sudden reversal in export volumes that could help lessen the burden on the other big producers to turn off the spigots…For now, though, oil has been spared from the rising unrest…How long they can maintain this advantage, however, is very much in question.”

Libya is struggling with two competing governments vying for control. Oil traders are concerned about the uncertainty over who is in charge of Libya’s vast oil reserves after a self-styled rival government (who effectively controls parts of western and central Libya) appointed its own oil minister and took over the official website of state firm National Oil Corp (NOC). Although though the oil industry appears secure for now, the expansion of jihadist groups affiliated to al Qaeda or the ISIL may also pose a threat to the Libyan population and its oil infrasturcture.

Nigeria’s oil surge was primarily attributed to a decline in crude theft and force majeures by companies operating in the volatile Niger Delta. As national elections set for February 2015 approach the oil region will likely become more difficult to control. Again from ANZ “The Nigerian military, underfunded and overextended by the virulent Boko Haram insurgency in the north, will be hard pressed to deal with any uptick in election related unrest and criminal activities in the oil region…In our view, the recent gains in output could quickly become a casualty of Nigeria’s looming game of thrones.”

Related article: Oil supply outages are becoming more common and difficult to predict

In Iraq output from the Kurdish controlled region is currently around 300 thousand barrels per day and are expected to reach 500 thousand barrels per day by the end of the year despite the battle against ISIL taking place nearby and threatened legal action by the government in Baghdad. Meanwhile oil exports from the southern fields which continue to produce without interruption rose to 2.5 million barrels per day. Although the threat to oil output from ISIL appears to have lessened following US airstrikes the threat of disruption by other groups to Iraq’s oil infrastructure by other militant groups remains.

Negotiations over Iran’s nuclear program are ongoing with a current deadline of 24th November. Iran’s fiscal break even oil price is thought to be the highest of the OPEC producers and its unclear whether the recent price fall will bring an agreement closer or push it further away. US involvement in Syria against ISIL has so far been supported by Iran. However, if it is seen to be extended to target Assad himself then Iran may start to pull back from negotiations. Even if something is agreed by the deadline it could be several months before oil exports are resumed.

Elsewhere, instability in Yemen continues to affect oil production and exports. In the past week tribesmen shutdown Yemen’s main oil export pipeline carrying 70 thousand barrels per day. Yemen’s oil and gas pipelines have been repeatedly sabotaged since mass protests against the government created a power vacuum in 2011, causing fuel shortages and slashing export earnings for the country.

The country’s domestic oil production is of little concern in the whole scheme of things though. More so is the risk of disruption to busy oil and gas export routes by al Qaeda militants – Yemen shares a long border with the world’s top oil exporter Saudi Arabia and flanks busy shipping lanes.

In Sudan, responsible for almost a third of a million barrels per day of production outages during 2012 and into 2013, the civil war continues apace. Only last month fighting erupted near several oil fields in Upper Nile state, the largest of which is Palouge. The state is responsible for around 80% of South Sudan’s oil production.

Of course unplanned outages due to geopolitical factors could happen elsewhere. However, of those countries identified as having extreme risk of conflict and political violence almost all the oil producers are already accounted for. For the time being geopolitical oil risk is likely to be continue to focus on all of the above.

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How will shale oil producers react to the rout in oil prices?

The continued growth in US oil production has been one of the key factors moderating global oil prices over the past few years, seemingly mirroring unplanned oil production outages from other large oil producers affected by geopolitical problems. Shale oil production appearing to be more price elastic than from conventional wells. With oil prices (WTI) down by $20 per barrel since June to almost $85 per barrel will output now be similarly flexible in the face of price falls?

The cost of production is often thought to be the floor for many commodity prices, but in reality this may not be true, at least not in the short term. As a general rule of thumb, if prices start to fall below the 90th percentile in the cash cost curve then production is likely to be curtailed. However, there are numerous cases in the commodity world when a market price remained well below the cost of production for months or years at a time.

Even if a particular mine or oil well is operating at a loss, there is a good chance it will continue to operate for some time. The primary reason for this is that it costs a significant amount of money to close and eventually re-open a mine or a well — so producers will tend to keep operating it for much longer than they would ideally want to. The question is will US shale oil producers react in the same way?

According to IMF estimates, oil from shale formations costs $50 to $100 a barrel to produce, compared with $10 to $25 a barrel for conventional supplies from the Middle East and North Africa. Estimates from Deutsche Bank suggest that as much as 40% of US shale oil production would become uneconomical below $80 per barrel.

Given this high cost business model many of US shale oil producers are likely to have hedged against oil prices falling below their marginal cost. Although this may delay a supply reaction, the length of the price protection clearly depends on how long it is in place. However, given that oil prices have been incredibly stable over the past few years this may have lured many into believing that oil prices would continue to stay high, forgoing price protection.

In contrast to conventional oil production, shale oil producers are likely to react much more rapidly to lower prices. Aside from the relatively low engineering and cost impact from curtailing output from a well relative to conventional oil production, the high level of leverage among US shale oil producers may also serve to hasten a supply reaction. The high depletion rate of shale oil wells has meant that producers have had to go on a drilling treadmill, funded largely by debt in order to maintain production volumes.

Investors have been beguiled by the US shale revolution and have ploughed billions into shale – $156 billion in 2014 alone according to estimates from Barclay’s. Of the 97 US energy exploration and production companies rated by S&P, 75 are rated as below investment grade. According to an analysis of 37 firms junk-rated exploration and production companies spent $2.11 for every $1 earned last year. With US interest rates set to increase in 2015, raising the cost of borrowing and lower oil prices reducing returns a switch in investor sentiment may yet force shale oil producers hand.

Related article: Oil prices unlikely to see a sharp rebound

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What the new order in commodity trading means for buyers

Developments in commodity trading have the potential to spark market disruptions and higher commodity price volatility according to a report from Oliver Wyman. The report “The Dawn of a New Order in Commodity Trading – Act III” highlights the risk that changes in the commodity trading environment could have for both producers and consumers of commodities as well as an opportunity for investors.

Virtually all agricultural, energy, and industrial commodities must undergo a variety of processes to transform them into things that we can actually consume. These transformations can generally be grouped into the following categories; space, time and form. Firms that are involved in commodity trading attempt to identify the most valuable of these transformations, undertake the transactions necessary to make these transformations and engage in the physical and operational actions necessary to carry them out.

This process has a number of benefits for consumers, mainly smoothing out supply and demand imbalances that could otherwise cause a supply disruption or increased commodity price volatility. To illustrate their importance for commodity supply chains the leading independent energy trading houses – Vitol, Glencore, Trafigura, Mercuria and Gunvor together handle more than enough oil to meet the import needs of the US, China and Japan. Agriculture is similar with ADM, Bunge, Cargill and Dreyfus thought to handle about half of the world’s grain and soybeans trade flows while Glencore and Trafigura controls as much as 60% of some markets, such as zinc.

Related article: Geopolitics and oil price volatility

However, the report notes a number of trends which if they coincide could introduce more uncertainty into many commodity markets and increase the risk of disruption. Commodity markets are maturing and becoming more efficient reducing the margins available to intermediaries. Taken together with the exit of many of the worlds largest Western investment banks from commodity trading has meant that commodity trading is likely to become more homogenous. Companies will only operate in those markets where they can create significant value from their existing positions, e.g. large commodity producers, such as oil majors and national oil companies, are increasingly establishing trading activities so that they can monetize their upstream production and gain greater control over their value chains.

In order to compete in this new world many of the independent traders have been loading up on debt to secure physical assets. This has caught the attention of rating agencies and increased their cost of capital, reducing the incentive for them to make volumes of inventory readily available to head off supply disruptions. Traders are also abandoning some markets or reducing their activities, resulting in less available liquidity for hedging products. Ultimately this could mean that commodity prices will be more vulnerable to sudden disruptions than they have been and fewer tools available for businesses to help manage the risk of disruption and volatile prices.

Related article: Is food price volatility about to return with a vengeance?