Fuel Production: Between A Rock and A Hard Place

NEWS ANALYSIS Fuel Production: Between A Rock
and A Hard Place NEW YORK (June 14, 2006) - Don't expect gasoline prices to drop, let alone stay down. Consumers should get prepared for the opposite, given the convergence of a number of factors that span geopolitical issues, economic and global warming. Jeff Rubin and Peter Buchanan, analysts with CIBC World Markets Corp., have authored a report title "Drilling in Troubled Waters" that makes the case for fuel prices rising sooner than many think. 2006 hurricane season risks As Hurricane Alberto heralds the start of a new hurricane season, weather patterns and ocean current temperatures exist today that combine as a greater risk than at the start of last year. Research by the National Oceanic and Atmospheric Association (NOAA) and Massachusetts Institute of Technology (MIT) climatologist Kerry Emanuel indicates that the stage is set for another active hurricane season, which could hamper Gulf Coast oil production and drive up fuel prices.

Sea temperature anomalies point to a severe 2006 hurricane season.
(Sources: NOAA/CIBC World Markets)

NOAA notes that the current above-average, warm Gulf of Mexico water surface temperatures serve as a precursor to the creation of severe hurricanes. In addition, the NOAA notes that the cold Pacific Ocean La Nina current at the equator compounds the risks of hurricanes forming and is expected to last the duration of the 2006 season. La Nina conditions lead to lower than normal wind shear and less trade wind activity - factors that, under normal conditions, would have had a limiting effect on hurricane formation.

NOAA Administrator Conrad Lautenbacher issued a statement May 22, warning that the NOAA projects a very active hurricane season and urged residents to prepare now: "For the 2006 north Atlantic hurricane season, NOAA is predicting 13 to 16 named storms, with eight to 10 becoming hurricanes, of which four to six could become 'major' hurricanes of Category 3 strength or higher."

Hurricane season severity continues to rise with sea temperatures.
(Chart source: Kerry Emanuel, Nature (2005)/CIBC World Markets)

Supporting the NOAA's concern is research by Emanuel that demonstrates a direct correlation between high sea surface temperatures and tropical storm severity, wherein above average and rising temperatures more than doubled storm activity and severity. While some other climatologists continue to maintain recent storm patterns are just a part of natural climatic cycles, Emanuel points to global warming - in particular manmade emissions.

Domestic oil infrastructure at low tide Domestically, the deep-water Gulf of Mexico is America's largest domestic oil source, accounting for 40 percent of U.S. refining capacity. It is also the only domestic supply source that is growing in production. However, the industry has not yet fully recovered from the damage done during the 2005 hurricane season. A number of offshore rigs are still offline, as are miles of undersea oil pipelines. One or more severe hurricanes could further damage existing infrastructure, which could further reduce refining capacity and result in subsequently higher fuel prices. In a situation worse than this time last year, The U.S. Department of the Interior's Mineral Management Service (MMS) has noted that the industry has a 17 percent "shut-in" level. Shut-in represents oil that would normally be available for production if damage to rigs, pipelines and refineries wasn't present. The office notes that most of the present infrastructure can not withstand a direct hit by a Category 4 hurricane, let alone one rated as a Category 5. Gulf Oil Industry InfrastructureAccording to the American Petroleum Institute's (API) Director of Operation Bob Greco, "In the hurricane alley in the Gulf, there are plenty of oil and gas pins in danger of being bowled over. There are a total of 4,000 oil and gas platforms and 33,000 miles of pipelines in the Gulf of Mexico, and they produce more than a quarter of U.S. oil and a fifth of U.S. natural gas supplies."

He added that no amount of preparation will make them completely safe in the event of another massive hurricane, such as a Category 4 or 5 storm. Last year for example, Hurricanes Katrina and Rita together destroyed 115 platforms and damaged 52 others of the 3,050 platforms directly in their paths. In addition, 22,000 or the 33,000 miles of undersea pipeline also were at risk, with numerous ruptures, some of which still need repairs. Furthermore, much of the exploration season was lost, as well as the time for construction of new infrastructure, such as more rigs and pipeline. In addition, more than current production capacity was affected last year. The severe storm season also substantially hindered and delayed the development of new oil fields and exploration. The "production gap" resulting from this lack of new oil will impact government planning, and even if replaced by other oil sources, the higher replacement costs will impact industry and consumers. By the end of this decade, for instance, CIBC World Markets says there will be a production gap of 1 million barrels per day below what the MMS has projected. Meeting it will mean buying more expensive oil. Today, crude oil prices comprise 60 percent of today's gasoline retail prices, substantially up from 47 percent just two years ago. Contrary to the public and political perceptions related to pricing, the rise in crude prices has limited oil company profits, and one can expect the companies to try to recover some of the lost ground over time, rather than continue to absorb ongoing increases in crude. Like any business, the ability to absorb increases, rather than pass them on to consumers, has a limit.

Left: Retail gasoline pricing broken down by its components. Right: Prices spiked in 2005 as storms shut refineries.
(Chart: CIBC World Markets)

Another industry factor in play is the influence of "crack spreads" - the difference between the price of gasoline and related products verses the cost of oil. Companies are trying to return to traditional crack spreads of $30 to $35 per barrel. This will lead to rising prices in itself, the authors maintain.

One other risk exists today that also wasn't present last year: The tapping into underground national oil reserves by federal mandate to offset some of the impact of recent hurricanes and this past spring's price spike to more than $3 per gallon for gasoline has created a vulnerability to a shortage from any source of supply. Bringing reserves back to 100 percent entails buying oil at higher prices than what was paid to build those reserves originally.

This hurricane season begins with lower national oil reserves than last year. Hence the replacement costs to the reserves is higher using domestic production when a surplus is available. Using foreign oil is more costly in itself, and even moreso if a shortage occurs that fuels an increase in foreign crude.

Feeding the beast The top five suppliers of oil to the United States in order are: Canada, Mexico, Venezuela, Saudi Arabia and Nigeria. Combined, these nations supply nearly two-thirds of the U.S. oil needs today. As domestic production lags in coming years, America will have to rely more on those nations and possibly other less secure countries as well.

A growing supply gap: Import dependence will rise further (left) as production lags demand (right).
(Chart: CIBC World Markets)

However, of the top five suppliers, only Canada has an increasing proven oil reserve base, largely due to oil sands. These oil sands are expected to provide a doubling of exports to the United States. Contrasted to that, the other suppliers are problematic. Mexico's largest oil field reserves are declining at a rate of 14 percent per annum, and new fields are not being found and developed that can keep pace with its domestic demand for oil, which is increasing at a rate of 6 percent per year. The result: Less oil will be available to the United States.

Saudi Arabia has not been able to ramp up production to keep pace with ever increasing U.S. demand. Furthermore, of the country's increased production, much is less desirable and less useful sour crude. Relations with Venezuela have been deteriorating, and the country's president has stated a desire to redirect its exports to China and other developing nations. Nigeria's rich delta and offshore fields face the daily risks of an internal rebellion. For example recent attacks on oil installations, such as the pipeline explosion last month, have forced oil companies to cut back exploration, development and production by over 500,000 barrels/day.

The result is a growing oil supply gap that is forecasted to reach more than 10 million barrels/day (more than 50 percent) of U.S. demand by 2010. Trying to develop alternate supply sources to fill the gap is an uncertain and unstable endeavor. Iran, a major world supplier, as well as other countries, have political risks, predispositions to sell elsewhere and increasing world competition for a dwindling resource.

CIBC World Markets suggests that prices at $3.50 per gallon by summer's end are likely. Substantial hurricane damage and/or foreign supply interruptions would compound the problem, and lead to even further price increases. Regardless of whatever political grandstanding that may ensue, indicators are pointing to a growing gap and an environment of rising prices. Leadership and actions are needed, or Americans may find themselves stuck between a rock and a hard place.

(Sources: CIBC, NOAA, API, MIT)