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WHERE ARE OIL PRICES HEADED IN 2012?

For 2012, the Abraham Energy Report is predicting a return to the fundamentals in the oil markets, a welcome change from 2011 that saw a perfect storm of disorder, from chaos in the financial markets to turmoil in the Middle East to an unforgiving Mother Nature, influencing the price of oil.

Looking back at 2011, clearly the volatility of oil prices was the direct result of a handful of these critical factors (detailed below), and while there is no knowing what 2012 will bring, there are early signs that it too could be marked by an unsteadiness in oil prices.

Reviewing 2011. Significant instability characterized oil prices in 2011 (see chart) as a result of three factors:

  • Black Swans. In his 2007 book, Black Swans, Nassim Nicholas Taleb defined a black swan as an unanticipated, low-probability event with dire consequences.  Last year, both the Great Tohoku earthquake and tsunami and the Arab Spring uprisings were so-called black swans. Japan not only lost energy supplies as the earthquake and tsunami crippled the crucial Fukushima Nuclear Power Plant complex, but the catastrophe also stilled production of supplies critical to the automotive and electronics industries in Japan and worldwide. The Arab Spring unrest sharply curtailed Libyan oil exports (mitigated in the summer by an emergency release of stocks by members countries of the International Energy Agency).
  • Economic Slowdowns. As China throttled back growth to contain inflation, the United States flirted with a “double-dip” recession. Meanwhile, Greece and the other countries on Europe’s periphery destabilized the Euro and EU economies. This economic retrenchment caused oil demand in key consuming regions to soften, leading to the retreat of oil prices starting in mid-spring and continuing into the fall.
  • Financial Markets. As equity, debt and commodity markets moved toward a “risk on/risk off” pattern, factors unrelated to oil market fundamentals, such as the strength of the U.S. dollar and prices of other commodities, amplified oil price variation.

Looking Forward. There are a number of factors on both the supply and demand sides in 2012 that could drive prices up or move them down, repeating the pattern of unpredictability in 2011.

Several upside factors could push prices higher in 2012:

Middle East

  • Iran. At the end of 2011, Iran struck back at tightening U.S. sanctions—and proposed European Union sanctions—on Iranian oil exports by conducting naval exercises in the Strait of Hormuz and threatening to block shipments through the Strait, which connects the Persian Gulf with the Gulf of Oman and the Arabian Sea. The nearly 17 million barrels per day of oil that transited the Strait of Hormuz in 2011 from Kuwait, Iraq, Iran, Qatar, Saudi Arabia and the United Arab Emirates represents some one-third of all seaborne traded oil, making the Strait the globe’s most strategic oil chokepoint. Iran’s threats boosted oil prices in December 2011 and could continue upward pressure this year. Even without conflict, EU members—especially Greece, Italy and Spain, all of which currently import from Iran—likely will bid up prices to replace Iranian supplies. This may be offset globally as major Asian buyers of Iranian oil, such as China and India, press for discounts to take additional Iranian volumes made available by the EU sanctions. Iran’s crude oil exports to China jumped 30 percent in 2011 over 2010 levels, reaching some 557,000 barrels per day.
  • Iraq. Failure to achieve a unified government that represents all major regions, and includes both Shiite and Sunni factions, will most likely undermine security, increase tensions with the Kurdish north oil province, and potentially result in more attacks on oil production as well as refining and transport facilities. In a worst-case scenario, the country could devolve into civil war, with oil exports surely plummeting. Declining oil exports would hobble Iraq’s development further as oil sales account for the overwhelming majority of the government’s revenues and some two-thirds of Iraq’s GDP. In 2011, increasing oil production, combined with rising world oil prices, catapulted Iraq’s oil revenues 60 percent above 2010 levels to more than $7 billion.

Asia

  • China. After a two-year policy of strong stimulus to counter the recession in the United States and Europe, China tightened monetary policy repeatedly in 2011 to control inflation in food and property prices. This dropped fourth quarter GDP growth to 8.9 percent and the full-year GDP rose 9.2 percent. Further pressure on private property could take an additional 2 percent off of GDP in 2012, but China’s government is trying to offset this drag with easier monetary policy and massive housing construction to meet the demands of average citizens.  Finally, even if China’s GDP growth slides further in 2012 to 8.4 percent, as forecast by the World Bank, this is a very vigorous rate of growth for the world’s second-largest economy and its 1.3 billion population.
  • India. India’s GDP growth rate fell from 10 percent in 2010 (calendar year) to 7 percent in 2011. The World Bank expects a further easing to 6 percent in 2012 and then a rise to 7.5 percent in 2013. As with China, this still means strong economic growth for a population of more than 1 billion. In addition, disappointing output from Reliance Industries’ D6 field will require additional oil and gas imports.

United States

  • Economy. Despite flattening demand during and following the recession, the United States remains the world’s largest oil consumer. The World Bank recently lowered its forecasts of 2012 economic growth, but still sees the U.S. economy rising 2.2 percent compared with 1.7 percent in 2011. If this growth is accompanied by broad employment gains, look for a boost in domestic oil demand.
  • Dollar. The recurring issues with the euro in 2011 pushed up the value of the U.S. dollar, although it declined against China’s yuan and the Japanese yen. If the euro zone can reach an agreement that stabilizes the euro, this will boost its value against the U.S. dollar. As internationally traded oil generally is denominated in U.S. dollars, a declining U.S. dollar in 2012 will tend to push up oil prices.

Global demand

  • The International Energy Agency expects global oil demand, which rose 0.7 million barrels per day in 2011, will gain another 1.3 mmb/d in 2012 to 90.3.

Extreme Weather Events

  • While the evidence points to an increase in the frequency of extreme weather events, their impact on global oil prices varies greatly. Clearly the greatest impact comes from direct effects on oil production, such as the 2005 hurricanes that affected U.S. Gulf of Mexico oil and gas production, transportation and processing considerably. The great damage the 2011 earthquake and tsunami caused to Japan’s nuclear power industry—directly and indirectly—pressured oil prices from the demand side as Japan sought replacement fuels. When and where severe weather will strike cannot be foreseen, but the potential for significant, if only short-term, influences on oil prices remains.

The downside factors influencing oil prices in 2012 include:

Slow Growth

  • In January the World Bank cut its forecast of 2012 global economic growth from 3.6 percent (in June 2011) to 2.5 percent.  Crucially, the World Bank sees growth in the euro area going slightly negative for 2012, with several European countries facing recession, and growth among developing countries of 5.4 percent (vs. 6.2 percent in June).

Europe

  • A recession in Europe would cut both industrial and consumer demand for oil directly, and will have knock-on effects in Asia as European demand for Asian goods declines.

Middle East.

  • Iraq. If the central government can increase stability and reduce factional tensions, oil production could increase by 500,000 barrel per day to about 2.6 mmb/d.
  • Libya. As in Iraq, if political and social stability can be maintained, oil production here also could climb 500,000 b/d in 2012.
  • Increasing production by Libya and Iraq would depress prices, but possibly lower Iranian exports in the second half after EU sanctions take effect might have a slight offset.  OPEC likely would respond to any significant price weakness by lowering members’ production quotas.

United States

  • Production. Increasing production of oil from tight sands and shale already has vaulted North Dakota to 4th in producing states and lowered U.S. net oil imports from a peak of more than 60 percent of consumption in 2005 to less than half in 2010 and some 45 percent in 2011. The United States was a net exporter of petroleum products in 2011—the first time since 1949. Domestic production is expected to rise about 200,000 b/d in 2012, similar to 2011.
  • Stocks. U.S. commercial crude oil stocks ended 2011 at about 329,000 barrels, down from the end of 2010, but still at the upper end of the five-year average. Distillate stocks are expected to end 2012 lower, but gasoline should be higher.
  • Infrastructure. Plans to reverse the direction of the Seaway pipeline in 2012 to bring oil from Cushing, Okla., to the Gulf of Mexico already closed the gap between WTI and Brent prices in 2011. The Keystone XL pipeline, a political football for much of 2011, could get a U.S. government approval—for its revised routing—in 2012. In any case, Canada may push ahead for the Northern Gateway crude pipeline to carry Alberta tar sands oil to the British Columbia coast. From there, it could reach Asian oil markets. All three of China’s oil majors—PetroChina, Sinopec and China National Offshore Oil Corp.—have made significant investments in Canadian oil sands projects over the last two years.

Bottom Line. Unlike 2011, in which financial markets often drove oil prices—independent of oil market fundamentals—the fundamentals will matter more in 2012. Open interest in crude oil futures and options dropped 20 percent from their 2011 peak in March to 2.2 million contracts at the end of the year—the lowest level since May 2007.

Despite less financial sector speculation in oil markets, Middle East turmoil may support continued oil price volatility. Barring a major issue with Iran, which could send prices spiking to $150 and above, prices should ratchet up slightly from 2011 levels on the back of increasing developing country demand to track between $85 and $120 per barrel (WTI), averaging $105-110 over the course of the year.

By Robert S. Price, AER Energy Analyst

Fortifying Our Energy Security

By U.S. Rep. Fred Upton, R-Mich., newly selected chairman for the House Energy and Commerce Committee in the 112th Congress, and former Energy Secretary Spencer Abraham

When the new Congress convenes, the central questions before it, and between Capitol Hill and the White House, will be how to improve America’s economy and maintain U.S. national security. The answers to both questions are, in no small measure, the same: We need to strengthen our energy security.

Without an affordable, sufficient energy supply, our economy cannot make the forward strides required to put the recession behind us. America’s economy has never grown at a strong clip without adequate supplies of reasonably priced energy — and this remains true.

Moreover, without affordable, domestic energy supplies, America is likely to continue to face the geopolitical vulnerability that comes from being at the mercy of other nations for such a disproportionate share of our energy supply.

Energy security must be at the top of Washington’s agenda, or we will continue to face serious economic and national security threats well into the future.

Fortunately, it is within our power to address these challenges. The United States remains blessed with large quantities of domestic energy supplies. The issue is: Can we take advantage of them?

Monday marks the 50th anniversary of the northeast corner of Alaska’s designation as the Arctic National Wildlife Range. This area, home to large quantities of natural resources, has been off limits to energy production.

We had a unique opportunity 15 years ago to change course and fortify our nation’s domestic energy supply. But it was derailed. In 1995, President Bill Clinton vetoed legislation that would have allowed environmentally responsible exploration for an estimated 10 billion plus barrels of oil in a tiny sliver of ANWR. This action deprived our nation of what could now be about one million barrels of oil per day—an amount that would allow us to reduce our imports by almost 10 percent.

And that’s not all. Astoundingly, huge percentages of additional U.S. oil resources remain off-limits to exploration. According to federal estimates, there is enough oil in deep waters many miles off our coasts and on federal lands to power more than 60 million cars for 60 years. In addition, if we advance the commercialization of the nation’s 2 trillion barrel oil shale resource, we could meet U.S. oil needs for more than two centuries.

If we are permitted to use our vast domestic energy reserves, prices would fall, new jobs could be created and the United States could achieve a greater level of energy security.

Inexpensive energy helped build our economy into the most powerful and prosperous in the world. High energy costs, along with growing dependence on foreign sources, take us in the opposite direction.

And, it is not just oil. We have not licensed and built a nuclear power plant in decades. Ignoring advances made in nuclear safety and the deployment of nuclear plants in the rest of the world, U.S. policymakers have thwarted development of nuclear energy despite its obvious benefits.

Nuclear plants are a terrific source of job creation and economic development. Expanding nuclear power could create thousands of good-paying permanent jobs and provide yet another domestic source of vitally needed energy.

Oil and nuclear are not the only energy sources we need more of. The current situation demands an “all of the above” strategy — diversifying our energy portfolio, and pushing development of our own natural resources. That means not just more oil and nuclear, but more coal, natural gas and renewables. Sooner rather than later.

Unfortunately, in the past two years Congress, along with Obama administration regulators, have promoted policies likely to push prices even higher, by creating disincentives for energy production in the United States. The glaring consequence of reducing new domestic energy production is greater dependence on foreign energy, coupled with higher commodity prices.

Enough is enough. The days of such policies must come to an end.

Congress has a duty to pursue a broad, visionary, comprehensive approach to energy security. Everything must be on the table. Neither our economy nor our national security can be adequately protected if we continue to declare various forms of energy, or areas of energy production, “off limits.” Instead, we need to pave the way for more nuclear power and for the extraction of more domestic natural resources.

If we do this, we can have adequate supplies of affordable energy and end the increasing demand for energy imports. If we do not, we will find our energy more expensive and less available. Our economy is likely to suffer and our growing dependence on foreign energy will jeopardize U.S. security.

The choice is clear. We owe it to all Americans to make the tough decisions and take the bold actions they expect and deserve. It is time to get back on track to protect our nation and expand our economy.

Special column by U.S. Rep. Fred Upton, R-Mich., who was elected chairman of the House Energy and Commerce Committee in the coming 112th Congress by House Republicans Dec. 7, and former Energy Secretary Spencer Abraham. This column originally appeared in Politico on Monday, Dec. 6, 2010.