May 24, 2007

Global Market Brief: Fear, War, Smog, Storms and the Price of Summer Vacation

Source: Stratfor
May 24, 2007 20 26 GMT

Every summer, gasoline prices in the United States go up. This is not because oil tycoons get frisky and realize they can squeeze a little bit more from the people driving to the nearest park with bicycles strapped to the tops of their sport utility vehicles; it is the sum of a variety of mostly structural factors within the U.S. system that are susceptible to natural disasters, along with the risk factors that vary every summer and make the oil market susceptible to unrest, wars and rumors of war.

The good news is that this summer, a few of the key risk factors that inflate crude oil prices with panic premiums could subside -- such as violence in Nigeria, which should wane in the wake of national elections, and tensions between the United States and Iran over Iraq's future, which could be settled in talks soon. If all the stars align, there could even be a rare downward step adjustment in crude prices. The bad news -- aside from the unlikelihood of the stars aligning -- is that a world without strife would still have hurricanes.

Before looking at the specifics of this summer, it is worth reviewing why prices tend to pick up in March and spike around Memorial Day each year, remaining high until they begin to fall in November. Besides the obvious uptick in gasoline demand (first in the spring when farmers hit planting season and then for pleasure driving and vacations as days become longer and sunnier), one culprit for a spike in U.S. prices at the pump is smog -- or rather, how our federal and local governments react to it.

In winter, the standard gasoline is one of about three blends. In the summer, to reduce smog, a crisscross of federal and local government standards mandate special blends. These requirements are not in harmony; myriad blends are mandated and sometimes differ from one part of a state to another (as in California and Texas), depending in part on a location's temperature, altitude and urban density -- that is, the extent to which volatile organic compounds in fuel are likely to evaporate, and the extent to which the air in that place is already unhealthy. Even areas that have similar characteristics request different summer blends.

This variety of requirements results in the inefficient production of boutique blends -- and refineries initially tend to err on the side of caution, producing enough to meet the low end of estimated demand or adding additives to each blend as the trucks are filled rather than ending up with too much of a blend that no one else in the country will buy. Summer additives also tend to be more expensive than winter blend components. (The Environmental Protection Agency and the Department of Energy will release a "Fuel System Requirements Harmonization Study" in 2008. States probably will not want to give up their individual powers to regulate, however -- and new legislative authority would be needed at the federal level to overcome the boutique fuels phenomenon.)

Thus, as the switch is made from winter to summer blends, prices go up. Then, as the summer driving season begins, demand surges and prices stay high. The U.S. system is equipped to handle the boutique blends, so they do not pose the threat of shortages or worse price spikes -- unless there is an unexpected disruption in the supply chain by, say, an immense storm that hits the majority of U.S. refineries in the Gulf of Mexico. The government has demonstrated it can be flexible when a real disaster strikes; after Hurricane Katrina, the Bush administration temporarily waived the air quality standards requiring the variety of blends, which helped mitigate price spikes.

Another factor that can affect summer gasoline prices is oil and gasoline inventories. The Energy Department released its inventory report May 23, and the numbers were not as grim as feared. Although gasoline inventories are still 7 percent below their five-year average for this time of year, they have been climbing rapidly since April, following a three-month period of unexpected refinery fires and other problems on top of regular spring maintenance. Crude oil inventories are actually 7.6 percent above their five-year average, so there is plenty to draw from as refineries play catch-up. There are relatively few giant refineries in the United States, however, so each time one goes offline it is a significant concern. And contrary to the stories of conspiracy theorists, who claim oil companies choose not to build more refineries because they want to keep prices up, the actual reason is the difficulty of overcoming "not-in-my-backyard" campaigns bolstered by environmentalists whenever a new refinery is proposed.

This summer's bad news is that experts expect the hurricane season to be worse than average. Then again, in 2006 these same experts predicted a repeat of 2005 and, instead, El Nino caused a very mild storm season. A direct hit on refining infrastructure still recuperating from Katrina in 2005 is not very likely. However, the possibility remains and makes those who trade on risks jittery -- which brings us to the price of crude.

The price of Nymex crude is hovering around $65 per barrel. The average person can rattle off the reasons for this high price: their names are Iraq, Iran, Nigeria, Venezuela, Russia and Saudi Arabia. Almost every country that produces oil in large quantities is either nationalizing its energy sector (which tends to limit production) or is a political mess (or at risk of quickly becoming one). Then factor in the U.S.-jihadist war, hurricanes, pirates (yes, pirates -- though mostly around Africa and Southeast Asia, not in the Caribbean). And while these concerns about reliable supplies run rampant, world demand is increasing, driven by growing economies worldwide -- particularly China and India, the voracious newcomers to the global resource buffet.

It generally costs less than $32.50 to produce and transport a barrel of oil; the price of oil is floating on a cushion of fear-driven speculation. Even though there has not been an oil supply crisis for more than three decades, when buyers order for future delivery, they are willing to pay top dollar now on the chance that, if they wait, some catastrophe will drive prices far higher.

The circumstances behind anxiety-based oil prices are not likely to get a whole lot worse this year -- and, in some ways, they are getting better. Nigeria is over the worst of the election-driven attacks against oil infrastructure that reduced its output by one-third this year, and that production is beginning to come back on line. After a period of post-election calm, militant attacks are likely to increase later in the summer, but chances are that things will not get quite as bad as they were. In addition, Iran and the United States appear to be finally ready to sit down together and hammer out a deal on Iraq. The first direct and public bilateral talks are scheduled to take place May 28. If this process succeeds -- and, of course, many things could disrupt it -- it still remains to be seen whether the violence in Iraq can be tamed. However, the oil flow from Iraq mostly depends not on peace in the Sunni triangle but on revenue-sharing arrangements among Iraq's various interest groups and regions, which a deal with Iran could help solidify. And, of course, a deal with Iran would decrease the already slight likelihood of a U.S. airstrike against Iran or -- the nightmare scenario -- of conflict in the Persian Gulf leading to an obstruction of the Strait of Hormuz.

Oil traders do not tend to lower prices incrementally as things get gradually better -- only to raise them in fits as their fears are played upon. This means that, from time to time, there is a significant correction -- a sharp drop in oil prices. While we are not prepared to forecast such an adjustment this year, it seems to be more likely than the fruition of the worst fears propping up the current price.

One other thing to note: The Organization of the Petroleum Exporting Countries (OPEC) is back, in a light kind of way. That is, OPEC countries have actually begun pumping below capacity again -- something that has not happened for years. The flip side to this is that OPEC no longer controls nearly as much of total global production as it did in the 1970s. Furthermore, Saudi Arabia does not really want to curtail its production and Venezuela cannot afford to. So, while it is something to watch, OPEC is no longer the main issue.

Overall, while gasoline prices will not be kind this summer, they probably will not behave erratically. The main variables that would disrupt this equation are a very nasty hurricane or relative peace in the Middle East. One of those sounds a little more plausible than the other.

CHINA: China's new State Investment Co. surprised global markets May 20 by announcing a planned purchase of a 9.9 percent stake in U.S. private equity player the Blackstone Group. This move proved China's ability to outsmart the markets (as far as the management of its $1.2 trillion of foreign exchange reserves) and its ability to carry out internal economic reforms while mitigating adverse global market effects. Blackstone is the first foreign equity purchase made with Chinese state foreign reserves, but it will not likely be the last. Watch out for new Chinese foreign exchange reserve-funded purchases in other foreign financial intermediaries next.

RUSSIA: Russian nickel company Norilsk Nickel raised its offer for Canadian mining company LionOre Mining International Ltd. to $6.3 billion May 23, trumping a bid by rival Swiss company Xstrata of $5.7 billion. Norilsk Nickel's bid comes with the blessing of the Kremlin, which is expected eventually to solidify its control over the company and thus ensure Norilsk Nickel has access to whatever funding it needs to expand abroad. Norilsk Nickel already holds around an 18 percent stake in the global market for nickel production. By the time the Kremlin consolidates control over the company, it could find itself with an even larger and richer prize.

FRANCE: France will eventually sell its 15 percent stake in the European Aeronautic Defense and Space Co. (EADS), the parent company of aircraft maker Airbus, French President Nicolas Sarkozy said May 18. Though Airbus has experienced a bout of major setbacks, France's political desire to have a European aerospace champion has almost guaranteed its continued existence, and the company has been subsidized with almost $15 billion worth of EU funds. However, the new French government has promised to reform many of the problems weighing France down. Sarkozy's statement that the French government might pull out of EADS altogether suggests that Airbus' key government support is waning -- and that its lifetime could be limited.

AFRICA: The Common Market for Eastern and Southern Africa (COMESA) approved a common external tariff system May 23 at a meeting in Kenya. The agreement lowers tariffs for COMESA countries to 10 percent for intermediate products and 25 percent for finished goods, and eliminates tariffs on capital goods and raw materials. The agreement brings COMESA closer to implementing a customs union in 2008 that would allow the 20-state bloc to operate commercially like the European Union. Seven COMESA states have yet to join the free trade area launched in 2000, citing revenue losses and competition from more advanced states. The common tariff system will make trade among member states more efficient, and a customs union would improve COMESA's ability to compete with larger economies.

AUSTRALIA: Australian Prime Minister John Howard announced May 22 that Australia will transfer monopoly control of wheat exports from the scandal-engulfed AWB Ltd. (formerly known as the Australian Wheat Board) to a grower-owned company by mid-2008. An independent task force is investigating a claim that AWB paid $224 million in bribes between 1999 and 2003 to former Iraqi President Saddam Hussein's government. Though the move will benefit farm groups by transferring ownership back to the growers, the continuation of the single-desk structure likely will anger the U.S. farm lobby, which has long opposed the system. The move will benefit Howard domestically by strengthening his coalition and bolstering support from farmers in an election year. The group most negatively affected by the new deal will be nongrower investors in the AWB, who will have no stake in the new company.

IRAN: Gasoline prices in Iran increased by 25 percent May 22. Iranian state news agency IRNA reported that Interior Minister Mostafa Pour-Mohammadi said rationing will begin around June 5. The increase -- which follows a May 20 announcement that the government would not raise fuel prices -- is part of Tehran's efforts to reduce state subsidies for gasoline and discourage smugglers who have been buying fuel at Iran's relatively low price and sneaking it out of the country to sell. The pragmatic conservative establishment, led by Expediency Council head Ali Akbar Hashemi Rafsanjani, likely designed the move to create problems for Iranian President Mahmoud Ahmadinejad's administration as part of an effort to weaken his faction's influence in the government.

IRAQ/U.S./UAE: Halliburton is considering $80 billion in projects around the globe as it rethinks its exit from Iraq, Halliburton CEO Dave Lesar said May 22. Lesar forecasts Halliburton investments in the Eastern Hemisphere -- including the Middle East, Russia, Africa, East Asia and the North Sea -- to hover around 70 percent of total capital investment over the next five years. Halliburton also has shown a willingness to sign deals with certain state actors or companies in the Middle East and Russia that the international community frowns upon. Lesar's hint that the company will reconsider its exit from Iraq indicates Halliburton is expecting a political settlement in Iraq that will allow energy majors to re-enter the reconstruction process.

MERCOSUR: Mercosur members' foreign affairs and economy ministers announced some details about the proposed Banco del Sur on May 22. Most important is that the development bank will have equal representation and capital share from its seven members, with the initial capital likely totaling between $2 billion and $3 billion. At least initially, the bank will be capable of development lending, but not of bailing out countries in the event of a serious economic shock. This is a blow to the vision of Venezuelan President Hugo Chavez, who -- with support from Argentina, Ecuador and Bolivia -- has for months proposed Banco del Sur as an alternative to the International Monetary Fund, World Bank and Inter-American Development Bank. Brazil's involvement in Banco del Sur has created the terms to keep the bank tame.

BOLIVIA/BRAZIL: Bolivia said May 23 it will compensate Brazilian state oil firm Petroleo Brasileiro $112 million for the nationalization of two refineries by June 10. Brazil indicated May 21 that it would accept natural gas instead of cash as payment, but then said unless the first payment is made by June 11, the matter will be tabled. Talks over the compensation were troubled; Brazil threatened to suspend investment in Bolivia if fair compensation was not offered, while Bolivia threatened to expropriate the facilities if its offers were rejected. The compensation agreement is important to both countries, but more so to Bolivia: Brazil is a key investor in Bolivia and purchases about 25 million cubic meters of natural gas daily -- nearly two-thirds of Bolivian output.

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