Saturday, April 2, 2011

Libya, Asia and the Price of Oil

Japan managed to knock Libya off the front pages of newspapers for a while. But now the biggest military action against an Arab country since the 2003 Iraq invasion by the United States and its allies has put Libya and the oil markets front and center again.

The oil market is slowly coming to the realization that this may be a long, drawn-out affair which may keep Libyan oil off the market for many months. Worse yet war could damage, either by accident or by deliberate actions by Gaddafi, the country's oil facilities.

Libya's Importance

Libya is the world's 12th largest oil exporter. Before the crisis, it produced 1.58 million barrels of oil per day. But now that flow has slowed to a mere trickle.

The stock market has shrugged its shoulders at this and said “So what? Libya only produces a small fraction of the world's daily output. Saudi Arabia can easily make up for Libya's oil production shortfall.”

It should be noted here that the stock market historically has underestimated the impacts of conflicts involving oil producers in the Middle East. And it looks to be doing so again.

However, Libya producers some of the highest quality, 'sweetest' crude oil on the planet. Its crude oil is easily refined into gasoline and diesel. It is also lower in sulfur, making it cleaner to burn.

The fact that you can't substitute one grade of oil for another easily is being ignored by the market. Most Saudi oil is of a lower quality than Libyan oil. It is 'heavier' and has a higher sulfur content.

So one cannot simply substitute one barrel of Saudi oil for Libyan oil. For example, it takes three barrels of Saudi oil to make as much diesel fuel as Libyan oil.

In addition to these direct, short-term effects of Libya on the oil market, Wall Street also seems to be ignoring some rather important long-term effects. One such effect is occurring in the developing economies of Asia.

China and India Shores Up Their Oil Reserves

As oil prices move higher due to the turmoil in Libya, developing countries across Asia are getting a wake-up call. These countries, led by China and India, are shoring up their strategic oil reserves against the risk of a prolonged supply shock.

China is the world's second-largest oil importer while India is the fifth-largest. Shockingly, the pair lack a large strategic petroleum reserve that can be tapped during an oil supply crisis.

Needless to say, the additional buying of oil from these countries to establish a strategic petroleum reserve could easily propel crude oil prices higher than most on Wall Street expect.

The extra demand will certainly further tighten global oil markets. And it may very well test the limits of spare production capacity among members of the OPEC cartel.

China's thirst for imported oil has grown rapidly. Oil imports as a share of the country's total oil demand grew to 54 per cent in 2010. This is up from 30 per cent in 2002. And remember that during the 1990-91 Gulf War, China was an oil exporter!

The country only began its strategic reserve program in 2006. It completed a first phase 102 million barrel build-up two years later. The second phase of the program will build a further 168 million barrels of reserves by the beginning of next year.

It was expected to finish filling its reserve by 2020. When completed it will hold about 500 million barrels of oil. This is roughly equivalent to three months of imports and will be the second biggest stockpile in the world. The Libyan crisis, it is believed, has only accelerated China's stockpiling of oil.

India is way behind China, holding only about 10 million barrels of oil in stockpiles. But it is even more vulnerable to a supply shock than China. It imports about 80 per cent of its oil consumption.

The country is targeting a reserve of about 40 million barrels by the end of 2012. This is equivalent to only two weeks of imports. But if India were to build up a stockpile of oil similar to China's, it will need to buy from between and 200 million and 250 million barrels of oil over the coming years.

Long-Term Effects

There are two key takeaways for investors from all of this. One is that the additional buying from the emerging economies to build strategic stockpiles will, at the least, put a floor under oil prices. Second is that the added buying may send oil prices much, much higher than many on Wall Street are currently forecasting.

Soozhana Choi, an oil analyst at Deutsche Bank in Singapore, summed up the situation nicely by stating that China's [and India's] strategic stockpiling “is likely to be a feature of of the global oil market not only this year but this decade”.

A feature, I might add, that is not factored in to current stock prices. Such a scenario with much higher oil prices will likely inflate the stocks of oil producers, but deflate most other stocks.

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