Crude at $175? Oil traders stress test the future
By Javier Blas
Published: April 7 2011 09:39 | Last updated: April 7 2011 09:39
Oil at $175 a barrel; copper at $12,000 a tonne and corn at $10 a bushel. As commodity prices rally, the world's largest trading houses have been busy 'stress testing' to be sure their finances can withstand a "super spike".
The levels are not a forecast – indeed, executives tell me they do not expect such hefty prices – but do signal a "worse case scenario" for which oil, metals and food commodities traders need to prepare.
"Can we reach $175? I don't think so," says a trading executive. "But there is a chance of a spike to that level for one or two days if something happens in Saudi Arabia." The same reasoning justifies tests for copper at $12,000 a tonne (think of an accident at a big mine in Chile) or corn at $10 a bushel, which could, for example, be caused by bad weather during the US planting season in May and June.
The stress tests have became more common at the physical trading houses in London, Geneva and Singapore. There is reason for it. Contrary to popular wisdom, high commodities prices are bad for pure traders: they consume lots of capital as houses need to finance their cargoes and post more collateral with exchanges for their hedges, leading to a decline in returns.
Take oil: when prices were around $50 a barrel in 2009, traders needed just $100m of capital to finance a supertanker. At current prices, they need about $250m. Not surprisingly, trading houses are now on the capital market raising multibillion dollar one- year and three-year credit lines.
Some traders are also tapping the public bond market – Trafigura did last year – while others are turning to private placements in the US.
A banker who works closely with some of the world's largest trading houses jokes that money, rather than oil, copper or corn, is the commodity in shorter supply. Of course, it is an exaggeration: the banks' appetite to finance the houses is very strong and traders are raising money with little trouble. But the comment holds some truth: traders will need lots of credit this year.
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I do not expect that any trading house will run into trouble: the rollercoaster market of 2008 cleared the market of the small players unable to compete because of lack of credit. Traders have also learnt from the experience, with more standby lines with banks.
Moreover, the more vulnerable smaller players that rely on "transactional finance" are protected. Yes, they need more credit, but the value of the commodities they move and that they pledge as collateral has also increased, offsetting the blow.
Nonetheless, trading executives say they are thinking twice about some trades and acknowledge that what was profitable a few months ago on the basis of risk-adjusted return on capital is no longer worthwhile because of higher credit needs.
All in all, the rise in commodities will make the life of chief financial officers and treasurers at the trading houses more difficult. With banks happy to continue lending and credit still cheap, traders will be able to weather the storm. But if access to credit gets tighter, the smaller players, which have been able to grow rapidly over the past five years, will end up as the prey of larger, well financed rivals.
The new geopolitics of oil
By Ed Morse
Published: April 6 2011 13:35 | Last updated: April 6 2011 13:35
A new dynamic has emerged in oil markets that is likely to push prices on to a higher path in the years ahead than almost anyone had forecast a year ago. It relates to the now unfolding critical dimensions of what can be called the "new geopolitics" of oil.
Although the disruption of Libyan supplies has had a tangible impact both in the Mediterranean market and in the global balance between light sweet and heavy sour crude streams, the 30 per cent increase in oil prices since the start of the year has had far more to do with changed expectations than market fundamentals. And while there may be good reasons to believe that oil prices could fall later this year, there are many more to fear rising prices.
Three elements of the new geopolitics are becoming clear.
First, the profile of many oil producing countries has long been seen as precarious. The profile includes a combination of rapidly growing, young populations, high unemployment, skewed distribution of income, geriatric and kleptomaniac leaders with diminishing political legitimacy, and rising public expectations. This is not new news. What is new is the explosive way popular discontent can lead to civil disorder and regime change and spark contagion. The prospect of the largest oil producing countries confronting challenges, such as those seen largely in north Africa so far, is more probable now than a year ago, telescoping the potential day of reckoning and raising the probability of an apocalyptic oil supply disruption.
The oil risk premium is likely to remain high for a long period as any review of potential additional instability and supply disruptions makes clear. This month's set of three weekends of Nigeria elections is likely to bring violence and potential oil disruption. Civil disorder and political fragmentation in Yemen could interrupt 300,000 barrels a day of oil exports and cargoes of liquefied natural gas and could further jeopardise shipping through the 18-mile wide Bab El-Mandab through which 4m b/d of oil flows to the Suez Canal and the Sumed pipeline. Then there's the ever present dangers from terrorist attacks on Saudi oil facilities, political upheaval in Iran, or an awkward combination of simultaneous disruptions in Algeria, Nigeria, Syria and Libya. Or civil disorder could erupt in Venezuela where the socioeconomic political profile doesn't differ much from oil producers in the Middle East.
Particularly dangerous in the short term is a real disruption of light, low-sulphur crude oil from Algeria or Nigeria or both. As has been learnt from the Libyan shortfall, light sweet crude is needed to make low sulphur transportation fuels and there is no capacity to replace that anywhere, whatever the level of Saudi spare production capacity.
Second, in order to ward off popular discontent, oil producing countries are dramatically increasing public expenditures. In Saudi Arabia, King Abdullah has announced two packages of spending equivalent to $125bn, about 27 per cent of last year's gross domestic product, where the important impact is on what Saudi Arabia needs to earn from oil exports. The budgetary break-even price for Saudi Arabia seems to have escalated by 30 per cent to $88 per barrel, with similar impacts elsewhere, according to a recent report from the Institute of International Finance. These spending commitments cannot easily be wound down, and looking at Opec as a whole, pressure for ever higher prices is likely to become a more permanent part of the petroleum landscape.
Third, as part of the pressure to deliver more material goods at home, oil producers are likely to continue domestic subsidies, including for energy, accelerating domestic oil demand and decreasing oil production available for exports. Middle East producers are set to consume 1m b/d more in 2015 than in 2010 with another 1.5m b/d by 2020. That could tighten markets considerably.
There are reactions to future supply disruptions already. Just last week, President Barack Obama appeared to eat a lot of past words on the balance between environmental protection and development of fossil fuels at home, tilting the balance toward oil and gas less than one year after the Macondo disaster. Mr Obama's target to decrease US oil imports by a third by 2022 may well be doubled, given the pace of US discoveries in the Gulf of Mexico and onshore.
Notwithstanding all of the dangers ahead, the price of oil could well fall by summer or year-end, as some of the risk froth comes out of the market. Investors have dramatically increased purchases in high-priced call options for expiry at the end of 2011 and 2012, reflecting a higher probability of increased prices. If short-term stability prevails, their bets will come off the table. But it remains the case that while oil markets are unlikely to face Armageddon this year, it looks like it's coming a lot sooner than it appeared a year ago.
Ed Morse was US deputy assistant secretary of state for international energy policy from 1979-1981. He will join Citigroup in May as global head of commodities research
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