INSIGHT: Let the oil take the strain

28 June 2011 15:25  [Source: ICIS news]

By Kawai Wong

Oil demand was falling last week. Very large crude carriers (VLCCs) were moored in the US Gulf waiting for buyers. Spot premiums of physical crude were down and crude stocks in the US (not including strategic petroleum reserves) were 36.41m bbl above average, or 181m bbl higher including the strategic reserves.

Yet on 23 June the International Energy Agency (IEA) agreed to release some 60m bbl of oil in response to lost Libyan production.

This is only the third time that the IEA nations have agreed to release oil into the market. The first time was in response to the first Iraq war, in 1990–1991; the second time was when hurricane Katrina damaged offshore production facilities in the Gulf of Mexico.

Production of some 1.6m bbl/day has been lost out of Libya, and some Mediterranean refiners were initially caught short by this, but traders are reporting that refiners in the region are reducing their demand for oil due to poor refinery margins, caused by a combination of high crude prices and relatively low product prices.

When former US President George W Bush sanctioned the invasion of Iraq in 2003, according to the US Energy Information Agency (EIA) the country was producing 2.8m bbl/day – a much higher figure than the lost Libyan production.

This raises the question as to why the IEA decided to release oil from its emergency reserves after Libya ceased production – the US alone agreed to release 30m bbl – when it did not do so during the invasion of Iraq.

The difference is the economy and inflation. Growth out of the 2008–2009 recession has been slow, and the spectre of stagflation hangs over the economies of the developed world.

Inflation is measured slightly differently in every country, but normally factors in crude oil prices or at least transportation costs.

According to the European Central Bank, inflation in Europe was at 2.7% in May 2011, marginally lower than in April 2011, when it averaged 2.8%. In the UK, the Consumer Price Index (CPI) was 4.5%, unchanged from April, according to the Office for National Statistics.  In the US, the figure was 3.6% in May and 3.2% in April, according to Bureau of Labor Statistics.

In May 2010, inflation in Europe was 1.7%, in the US it was 0.1% and in the UK it was around 3.5%.

Inflation is forecast to rise further in 2011 and the figure for the UK is particularly high, with the IMF predicting a 4.2% rise in prices, while in the US average consumer prices are forecast to increase by 2.17%.

Rising inflation has a very real impact. Real wages fall and people tend to cut back on spending. Governments then receive less income in taxes, contributing to government budget deficits.

Any government can raise taxes, and many have, but this is not sufficient on its own to bridge the gap between income and expenditure. And it is hugely unpopular. The riots in Athens are a good example of what tough austerity policies can lead to.

Therefore governments look for the source of the problem and attempt to tackle it – and in this case it is deemed to be high oil prices.

When oil prices increase, practically everything is affected. The mobile phone you hold was probably made in China, possibly by Foxconn if it is a smart-phone. And it is in your hands because it was shipped to your country – and ships use oil.

The fruit, vegetables, pasta and rice that we eat are unlikely to have been produced locally, and all incur transportation costs. Supermarkets will pay for that but they will pass their costs onto the retail price. The bearers are us, the consumers.

The executive director of the IEA, Nobuo Tanaka, said on 23 June: “Today, for the third time in the history of the International Energy Agency, our member countries have decided to act together to ensure that adequate supplies of oil are available to the global market.”

But the IEA nations’ move hardly looks as though it was driven by physical market needs. When oil prices fall – as they did as soon as the IEA decision was announced – global, macro demand should receive a boost. Increased tax revenues from this will more than make up for lower petroleum tax revenues.

When oil prices fall, politicians can avoid further austerity policies that will hurt them at the ballot box. Tax revenues rise, unemployment falls and everyone is a lot happier.

By: Kawai Wong
+44 20 8652 3214

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