The crude oil conundrum

Investments may flow into exploration, and there may be greater emphasis on renewables

The global crude market could see extreme volatility over the next two years. Both supply and demand are looking uncertain and the global energy mix is changing. Prices through the next two years will be likely to trend up, but with sharp swings in both directions. Brent oil futures all the way up 2024 are running above $60/barrel. 

The demand for crude doesn't vary too much with price. Demand is driven by economic growth, which causes greater power consumption and more transport activity. Even a tiny shortfall in supply can lead to a huge price spike and vice-versa, a tiny excess supply can cause a sharp price drop. 

Global supply is dependent on Organization of the Petroleum Exporting Countries (OPEC), which has managed to keep a production cap in place through 2017 and 2018. Now, Iran could be taken out of the equation as an exporter. Among other producers, Venezuela is a basket case, while Iraq, Libya, etc are not stable. 

There is a ‘swing’ producer – the shale industry. If the price is right, shale could add 10-12 per cent to global capacity. As prices climb over $75/ barrel, shale becomes highly profitable. Unlike conventional mining, shale operations start up fast, and produce crude in a matter of months. However, shale is expensive and there are serious environmental concerns. Shale operations can close down in a few months, if prices drop below cost.  

Saudi Arabia and Russia are considering ramping up production at the current rates of $78-plus. But Saudi Arabia is also considering taking Saudi Aramco, the corporate entity that produces oil in the Kingdom, public by selling 5 per cent stake by end-2018 or early-2019. Aramco revenues are in the range of $450 billion, and the Saudis would like to keep the price of oil high until the IPO. 

Crude oil demand has risen through the last 18 months or so, as the global economy has grown faster. However, Trump's tariff war with China and the European Union (EU) could affect global trade and growth. Growth may also slow in the EU and Japan. If demand slows down, it could mean falling prices. There are long-term changes in energy mix. Renewables are replacing thermal power, on-grid and off-grid. By some estimates, India is replacing 300,000 barrels/day equivalent with solar capacity expansion, while China is replacing even more crude capacity with solar.  

While India uses little gas/naphtha on the power grid, energy is energy, and the changing mix will lead to replacement of crude. For example, road transport currently accounts for about 50 per cent of global crude consumption. Electrical vehicles can run on solar, and both vehicles and solar have become cheaper. Even middle-class users can afford a hybrid or electrical vehicle and rooftop solar. Some ships have started using rotary sails, which generate power from wind, like wind turbines. Among major Indian consumers, the railways is trying to go green. So is the telecom industry. 

Changes in the maritime industry will trigger yet another shift in supply-demand. By January 2020, merchant ships will switch to low-emission fuels, from high-emission bunker fuel oil. The shipping industry currently contributes 3-4 per cent to global crude consumption. 

Ships run on cheap fuel oil refined from cheap, high-sulphur crude. High-sulphur has a weight of 72 per cent in India's crude basket. As shipping switches over, there will be changes in the demand for the crude mix. High-sulphur crudes may become less expensive and low-sulphur crudes more expensive. Net-net, the changeover could make crude more expensive.

The last two months have emphasised the political sensitivity of petrol and diesel prices. The government must make painful policy decisions if crude prices stay up. It will be politically unpopular if taxes stay at current levels. If taxes are cut, or public sector units (PSUs) forced to sell at a loss, it will damage already-stressed balance-sheets. 

The share prices of PSU refiners-marketers could breakdown if prices stay persistently above $65 and they are not allowed to pass on the costs. Private sector refiners will do better but may see falling margins. PSU oil and gas producers will not be allowed to maximise profits, if history is any guide.  However, there may be investments flowing into exploration, and there will be a greater emphasis on renewables. That could create room for investors to switch.