Busting 5 oil myths, and here’s why crude prices will stay up

There is a great enduring myth about the big bird, ostrich. When in danger, it hides its head in sand. Over the years, bird watchers have clarified over and over again that the bird does not do anything like that. But the myth stays and thus has led to the term ostrich effect, implying a situation where one pretends all is well while all hell is breaking loose.

The same thing seems to be happening with the price of oil which is currently shooting up. This is primarily due to people in the Middle East and Northern Africa, getting a step closer to “genuine” democracy and throwing away the American installed autocrats and dictators.

Most of the western press and commentators in the Indian media seem to be suggesting that price levels of $100 per barrel or more for oil are unsustainable.

They have attributed various reasons for the same. But as we shall see that none of these reasons make sense, and in the long run oil prices can only go up.

But Libya produces only 2% of world oil...
This is the most logical argument being put forward by people who see the price of oil not sustaining beyond $100. Libya is the eighth largest producer of oil within the Organisation of oil producing countries (Opec, the oil cartel) and is the ninth largest producer of oil (Russia, the largest producer is not a part of the Opec).

Despite the fact that Libya produces only 2% of world oil, the price of WTI (West Texas Intermediate) crude oil has risen 11% over the last one month to around $98 a barrel. Brent Crude, on the other hand, quotes at around $112 and has risen by around 17%.

What this tells us very clearly is that the world supply of oil is so tight that even the threat of a country which produces only 2% of the world oil being destabilised has sent prices through the roof.  While export of oil out of Libya has not been largely disturbed till now, there have been reports about western oil companies operating in Libya shutting down their operations and moving their employees out of the country.

As a recent report (dated February 23) brought out by Nomura points out “So far, while the Libya National Oil Corporation has said that it has no information about a disruption in production of  crude, Al-Jazeera has reported that Libya’s Nafoora oil field had stopped producing because of an employee strike.” There have also been reports about dissidents taking over oil fields. Libya’s neighbour Algeria has received terrorist threats to its oil infrastructure.
All this does not augur well for the price of oil.

But Saudi Arabia will fill in even if Libya shuts down completely...
In the mid 80s, the Opec realised that it cannot keep producing oil from all its oil fields at full blast. That way, they would run out of oil pretty soon and at the same time not get the best price for their oil as well.

So it started acting as the swing oil producer of the world, trying to produce just enough to fill in the gap between global demand and global supply of oil. Within Opec, Saudi Arabia acts as a swing producer and produces oil from its idle oil fields if the supply from other countries within the Opec shuts down.

So the other argument being bandied around is even if Libya shuts down totally Saudi Arabia can step in. Yes it can. But there is a slight problem.
The crude that Libya produces is perfect feed for ultra low sulphur diesel. The crude that Saudi Arabia will supply to replace it is apparently not of the same quality. Estimates suggest that you need three barrels of Saudi crude to get the same amount of diesel that you would have otherwise got from Libyan crude. At the same time, refineries that process Libyan crude  are not equipped to process Saudi crude.

Also the spare capacity of Opec has been declining over the years. If Algeria and Libya were to shut down completely the Opec spare capacity stands at around 2.3% of the world capacity. That of course does not inspire enough confidence. So we have a problem.

Of course, what happens if protests spread to Saudi Arabia is entirely another story.

But the Saudi king is well entrenched...
Saudi Arabia is the second largest oil producer in the world and the largest within Opec. It  produces nearly 20% of world oil. Are protests likely to spread to Saudi Arabia? Given the information available it is very difficult to assess.
The western press is gung- ho about the Saudi king being well entrenched because several surveys in Saudi Arabia claim to the same. Also, recently the population of Saudi Arabia has received a $36 billion assistance from the Royal family.

But fiscal well being doesn’t always help. Take Libya, which has little debt as well as a lot of export income. It’s per-capita income at $11,852 is nearly double that of Egypt at $6,347. The per-capita income of Saudi Arabia stands at $16,778. What also does not help is the high rate of unemployment among youth in Saudi Arabia at over 30%, making the situation ripe for public protests. Even a hint of protests in Saudi Arabia could send oil prices up even further. As David Rosenberg, a very well respected Canadian economist wrote in a recent report, “If Libya can spark a $10/bbl response, imagine what a similar uprising in Saudi Arabia could unleash. Do the math: we’d be talking about $200 oil.”
The immediate reason that could incite protests in Saudi Arabia is what is happening in Bahrain.

But Bahrain is a small country...
Bahrain is ruled by the Sunni al-Khalifa family since 1782, this despite the fact that Shias being greater in number. Independent estimates suggest that Shias form nearly two-thirds of the Muslims in the country.

Nearly 100,000 Shia protestors took out a pro-democracy rally in Manama (capital of Bahrain). Given the population of 1.2 million, a whopping 8% turned up for the protest.

The fifth fleet of the American Navy, which is responsible for the  US Naval forces in the Persian Gulf, is based out of Manama. So any confrontation in Manama could send the geopolitical risk premium on oil price through the roof. Also, this could inspire Shias in Saudi Arabia who form around 10-15% of the population.

But they still need to produce and sell oil...
Another argument going against high oil price in the near future is that whatever government takes over after the revolts, they still need to sell oil because that’s all they have got. Fair point. But as a recent Nomura report points out, “if a regime change were to happen in the countries, all existing contracts with IOCs could be under threat and may be cancelled or re-evaluated, leading to a drop in supply in the near term.”

Also, it is being assumed that the switch of power will be very smooth, which though is highly desirable may not be possible. For democracy to start and flourish, institutions are needed, which cannot be created overnight.
It also remains to be seen whether the US government allows the protests to continue and regimes to change. Egypt was not very important from the point of view of oil. But Saudi Arabia is. All this means higher risk premium on the price of oil.

Given these reasons it is highly unlikely that the price of oil is going to come down anytime in the near future. As the song goes “turn out the lights, the party’s over. They say that all good things must end...”

The writer works in the financial services industry and can be reached at chandniburman@yahoo.com. Views are personal.