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A Look At The Fundamentals Behind The Recent Oil Price Hikes
Malaysia Perspective | 03 May 2011

By: Yeoh Mei Kei

With turmoil in the Middle East and North Africa (MENA) worsening over the past two months, oil prices have risen by over 30% since February 15, 2011. Worries of supply disruptions subsided with the ending of the Egyptian riots, but have since been renewed with the unrest in Libya (which is a member of OPEC).

Can Oil Prices Above US$120 Per Barrel Be Justified?
With all the talk about tensions in the MENA region, let’s take an objective and quantitative look at the potential impact of losing all of Libya’s supply. Libya, although the largest holder of oil reserves in Northern Africa at 41.5 billion barrels, accounts for little less than 5.4% of OPEC’s production. Even if Libya’s oil production capabilities were severely hampered to the effect of literally zero output, OPEC’s spare production capacity is actually more than sufficient to make-up for the shortfall. OPEC’s spare capacity is the additional amount of oil it could produce with a 30 day notice, for a period of 90 days. As of February, the spare capacity measured approximately 5 million barrels per day (mbd), a figure roughly 3.2 times that of Libya’s daily production!

So, are there any justifications for the higher oil price? In this article, we will try to answer this question by looking at the fundamental factors that influence oil prices, namely 1) the demand and supply situation; 2) reserve replacement ratio and refinery capacity of oil companies; and finally 3) the value of the US dollar.

Fundamental Factor 1: The Demand & Supply Situation
Oil demand over the course of 2010 rose by approximately 2.3 mbd from 2009’s average levels, to average 86.6 mbd in 2010. Similarly, supply rose by about 2 mbd to average 86.4 mbd (refer to Chart 1). With no major supply-side shocks, apart from the oil spill incident in the Gulf of Mexico, prices remained within an acceptable band of USD75 to USD85.

Chart 1: Global Oil Demand & Supply in 2010

In 2011 (refer to Chart 2), we expect global demand for oil to grow 3% or 2.6 mbd to reach 89.24 mbd, a demand level roughly equivalent to pre-crisis levels. With the developed nations regaining economic strength, as exemplified by the US which is expected to grow by 3% according to our estimates, such demand levels are reasonable.

Chart 2: Projected Global Oil Demand & Supply in 2011

We are estimating supply-growth to be 1.7%, or around half that of demand growth. Such a conservative rate would see supply rise by 2.8 mbd to 89.2 mbd. With OPEC indicating that it could increase production levels to meet rising demand, industry productivity gains and new field discoveries in Latin America, we remain confident of supply being able to satisfy demand.

Fundamental Factor 2: Reserve Replacement Ratio & Refinery Capacity Of Oil Companies
The oil industry has been doing well in recent times, with the return of handsome profits for most of the big oil companies. Apart from financial health, an important measure of their performance is the Reserve Replacement Ratio (RRR). The RRR, is the percentage of a company’s oil and gas reserves consumed by production during the year that were replaced through either acquisition, improved recovery, or new discoveries.

As at the beginning of 2010, big oil companies were doing well, with RRR’s of 226%, 141% and 131% for the likes of Exxon Mobil, ConocoPhillips and BP respectively. The increase in their reserves was a positive development, as it signified an increase in potential oil supply. This allowed them the option to increase supply when required and if it was deemed profitable to do so. In addition, Barclays Capital forecasted a rise of 11% in spending on exploration and production by oil & gas companies in 2011, further improving the probabilities of further increases in the RRR in future.

The recession caused by the financial crisis witnessed a decline in the number of refineries in operation. The number of refineries currently in operation stands at 137 with 11 idle refineries, a sizeable difference from 2008’s 146 operating with 4 idle. Despite the reduction of refineries in operation, only 2 of the current 11 idle refineries need to be re-activated to match 2008’s production levels. This is because average production per refinery has increased by 4.3%, from 117,895 barrels per day in 2008 to 122,994 in 2010.

Providing supporting evidence to the above, utilisation rates of the refineries currently in operation measured 85% as of January 2011. This provides spare capacity of approximately 761,000 barrels per day, a far cry from 2008’s rate of 89.5% and a mere 146,000 barrels per day of spare capacity during the peak in oil prices in 2008. Thus, an increase in oil supply is possible through the intensification of currently comfortable refinery utilisation rates.

The main reason for the existing comfortable levels of spare capacity despite fewer operating refineries is that the capital investments made by the industry during the peak in oil prices in 2008 are starting to pay off. The investments and upgrades made have allowed the refineries and oil companies to produce more barrels per refinery as well as a broader variety of crude grades to satisfy the regulatory product specifications in the US and Europe.

Fundamental Factor 3: Value Of The US Dollar
As most investors would know, the pricing of commodities in US dollars leads to an inverse relationship between the US dollar and commodities. Broadly speaking, when the value of the US dollar declines, commodity prices tend to rise to reflect their real value.

The DXY Index is a convenient index to use as a simple method for referencing the strength and weakness of the US dollar against a basket of currencies. From Chart 3, one can observe the decline of the dollar when the Federal Reserve halted further purchases (it held USD2.1 trillion) of bank debt, mortgage backed securities and Treasury notes in June 2010. Subsequently, the dollar declined further pending the confirmation of Quantitative Easing II (QE II) which was implemented in November 2010.

Chart 3: Fall of the Dollar in 2010

Currently, the dollar appears to be oversold given the strength of the US economy, with the Federal Reserve raising their forecasts for US GDP growth to range between 3.0 – 3.6% for 2011. It is important for investors to bear in mind that QE II is poised to expire soon, and given the renewed strength of the US economy, there appears to be little downside risk of a further weakening dollar (barring some unforeseen event such as QE III).

Looking forward, the US dollar is expected to appreciate modestly over the course of the year according to Bloomberg’s consensus estimates. Thus, the appreciation of the US dollar is expected to provide one less bullish factor for oil price.

From the fundamental factors mentioned above (i.e. evenly balanced demand and supply situation, increase in reserves of oil companies through higher spending on exploration and production activities, comfortable level of spare refinery capacity, and the higher probability for the appreciation of US dollar), it appears that oil price should remain relatively stable and similar to 2010’s range of USD75-85.

As such, we believe that the spike in oil price to USD120 now is more driven by speculation and fear factors, rather than based on fundamental reasons. Although we have highlighted that there is enough spare capacity by OPEC members (especially Saudi Arabia) to meet any shorthand in supply, investors seem to be speculating that the conflict in MENA region will intensify further into other major oil-producing countries. Based on the current situation, this seems to be unlikely as conflicts remain under control and is now confined to Libya, Yemen, Syria and Bahrain only. Furthermore, the Saudi Arabian government has acted swiftly to please the general public following the start of the civil riots in Egypt. The government has budgeted USD10.7 billion for social spending to improve housing, with other funds made available for education and other social welfare programs. In addition, the Saudi Arabian King has also promised financial assistance for up to 1 year for Saudi citizens who are unemployed. We believe these measures will be sufficient to avoid a civil riot in Saudi Arabia, and this should eliminate the risk of oil supply disruption from the largest oil-producing country in the world.

As a conclusion, we expect oil price to fall back to a sustainable level of around USD80-90 after the political turmoil in the MENA region subsides, based on fundamental factors mentioned above.’

Yeoh Mei Kei is a Research Analyst at

* Disclaimer: The views and opinions in this article are those of the author and/or her employer and do not necessarily represent the views and opinions of Shares Investment Malaysia, its parent or any of its subsidiaries in Malaysia or elsewhere.

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