US Oil Production and Hurricanes: Insecurity of Demand Trumps Insecurity of Supply?

Featured Blog Comments

“ Why are we talking about demand? Well, demand has an effect on prices, and what we're really are worrying about is prices. As demand fluctuates, so do... more ”
By Anonymous 08-31-2008

See all blog comments

Oil markets have been on hurricane watch this week, with the path of hurricane Gustav possibly passing much of Gulf of Mexico oil development.

Via Bloomberg (August 30) "Oil producers have shut at least 6.6 percent of output in the Gulf of Mexico, according to U.S. government figures at midday yesterday. Shell plans to halt 510,000 barrels a day and BP said it will stop about 290,000 barrels."

The Gulf of Mexico now accounts for 26% of US oil production and 12% of natural gas production so shutting down such production will definitely have a short-term effect. Any long-term effect on supplies (and prices) will depend on the storm's severity and trajectory and what effect if any it has on onshore and offshore infrastructure.

In the worst case scenario, production and transmission could be knocked out for some time. In the best, there will be temporary effects of the shut downs. Six refineries accounting for 7% of U.S. refining capability are shut down. Via Global insight  oil imports may also fall temporarily as fewer tankers are making delivery. The net result is that refiners on the Gulf Coast may be forced to rely, as they have done in recent weeks, on their own inventories. While Gustav could avoid oil installations, many of them are untested by a large storm.  But so far there doesnt necessarily seem to be a shortage of supply, despite low inventories. But with falling demand in the U.S. and increased refinery capacity, as well as strengthened and reinforced oil platforms, this could have limited effect - and I'm sure many of the people evacuating hope that.

This potential (and I stress potential) supply disruption does reveal a new dynamic -despite the prospect of supply disruption (both in the U.S. and lingering worries about Russian supplies to Western and Eastern Europe) demand seems still to be at the upper hand of price moves. In fact despite an intra-day increase of $3.17 for WTI crude futures, the market closed at yesterday’s level. UPDATE: The NYMEX opened up its electronic and over the counter trading a few hours early on Sunday - and oil rose about $2.50 at the open but as of later on Sunday night it has risen less than $1.50. Gasoline Futures rose about 7 cents or about 2.5%. End Update Why has there been little reaction? Perhaps because investors are waiting to see the effects. Furthermore despite the potential of local shortfalls, there might not be a major supply shortage.  The IEA and US government reminded wary investors that stockpiles are available in the case of a major supply disruption has been cited as dampening fears, keeping oil within its recent trading band. In fact such a disruption is a reason why we keep stockpiles.

The timing has prompted much comparison with Hurricane Katrina and Rita just about three years ago. Taking aside the projected storm and somewhat different trend pattern.  how much have things changed in the last 3 years?

The Gulf of Mexico now accounts for a greater share of U.S. oil production and an even larger share of new supplies, offsetting falling production in Alaska and onshore in the rest of the U.S. And going forward, its role will be more significant. The EIA suggests that in 2009, total U.S. petroleum production is projected to increase to 5.36mbd, due mostly to the Thunder Horse and Tahiti platforms in the Gulf of Mexico which will coming on-stream in late 2008 and 2009, respectively.

Even as the Gulf of Mexico makes up a greater share of production CIBC warns that , the number of large storms in the area that could knock out production has increased – suggesting a vulnerability, which may give more heat for more drilling in non-storm prone waters. Furthermore, they suggest that that oil and gasoline inventories are much lower than they were several years ago – and even with the recent opening of the long-delayed thunder horse field, production is still nearly a million barrels a day below early US government projections.

Hurricane Katrina had a much greater effect on gasoline (+60%), natural gas and other oil product prices than on the spot price of crude oil (+7%). In fact power shortages contributed to much of the natural gas production and distribution being offline for some time.

Natural gas markets are different than a few years ago.  Not only is natural gas production up in the U.S. but the supplies are somewhat more diversified. U.S. Natural gas production has been increasing, especially that sourced from unconventional and onshore supplies such as Barnett Shale. The increase in supplies, especially this summer has contributed to the swift fall in natural gas prices and cushioned the U.S. from rising global gas prices (for LNG).

Also unlike in 2005, U.S. demand for oil and oil products is slowing or even falling - rather than rising. Furthermore, global demand is slowing. While many eyes remain on China’s post Olympics, it seems likely that with slower growth and slightly less energy intensive growth, its commodity demands may also slow - despite an ever rising gasoline consumption. But demand destruction in the OECD and perhaps in some emerging markets albeit not in energy producing ones mean that global demand growth is much slower than in 2006 and 2007.

All of which means, fundamental picture might be looking marginally better and a price surge seems less likely. Yet, there isn’t that much new supply coming online and a lot of what is onstream is expensive - and new supplies are looking costly. So there may be a fairly high price floor.

However, even if demand is being destroyed, that doesn’t mean that its is going to fall precipitously. Even in the U.S. EIA numbers (which could understate demand destruction) suggests that gas demand has fallen only around 2% from last year. a noticeable decline for sure - perhaps because of lack of alternatives.  Given these dynamics, energy policy may be even more of a campaign issue in the fall than the summer. And oil drilling may yet dominate headlines.

But the wild card will remain China and China's demand. Although its demand pales in comparison to the U.S., it and other emerging markets, especially oil exporters have contributed much of the demand growth. And it is that growth and the expectation of future growth which have been driving the oil boom. We will have to watch closely in the next few months to see any shifts in China's oil and oil product imports, diesel will be a key one. With prices as they are now, even China is reluctant to fill its strategic reserves