The Weekly N&C for September 15th, 2008

There is more to this fight than meets the eye.

I’ll assert, just to set the tone, that Access to Energy has transcended most of the classic threefold concerns of States in the definition of defensible “borders”. The ancient arguments over Territoriality and Access to the Sea (or Lines of Trade) are still important, but they pale in comparison. Only Access to Sustenance (commonly called Food/Water Security now) remains a viable contender for the primary spot on the list of things that cause near-instant dread in the centers of governance when belligerency is on the horizon. The great breadbasket Nations can even toss that concern aside, and usually do. Even more, the developed economies of the world and those undergoing massive industrialization all seem to hold desperate fears, mostly rightfully, that any interruption in the availability of energy supplies will within weeks leave them in economic tatters. But does it always hold that the fears of those that demand the vital goods leave those States at the mercy of those that supply them?

The answer to that can be found in an understanding of the global availability of the vital good in question, and in the security of route available for the transportation of that good. The key to understanding global availability is to understand the meaning, and limits, of fungibility. Fungiblity, or the interchangeable nature of some goods, means in application that if one were in possession of, oh say, one ounce of gold bullion one could offer it in exchange for another ounce of gold bullion of the same grade irrespective to the present location of that second ounce. This is not a particularly useful feature if both traders are sitting in the same room, but as communication has outstripped the pace and price of transportation, it has come to be of some utility. In fact, the key enabling tools of Mail and Banking have grown steadily since the time in which one trader was in Madrid and the other in The Spanish Netherlands in the late 16th Century and both traders had need for the expenditure of said gold in the respective opposite place.

Fungibility matters even more in cases of sourcing and transport, those being the cases where a desired destination requires the delivery of a specified good. Again, were one to be in need of an ounce of gold bullion in hand to pay one’s Italian Mercenary soldiers on campaign in the Low Countries in the 16th Century, one would not particularly care as to whether the gold was from the treasures of the Americas, the hands of a Central European lending house, or was sitting in a bank in Antwerp as receipt for payment of some purchase there. One *would care* greatly as to which source was available, and what time it would take and what expense that would take to get it delivered to the camp of the soldiers, but as to the bullion itself one source is just as good as the other. We shall discuss those cares later.

Gold bullion is a simple case, intentionally arranged by the implementation of standards to make the two items virtually identical. Most cases of fungibility are cases of degree, and the common modern examples are precious metals, some currencies, electricity, and… crude oil.

There are some fairly serious concerns however, were one to be in the refining business, as to exactly *how nearly* fungible crude oil is. The myriad of grades, weights and fractionabilities of crude oil of various sources does imply that there must be a certain pairing of wellhead sources with refineries configured for that particular feedstock. But the implication there is far stronger in the case of the very heavy crude sources like most of what comes out of Mexico and Venezuela. Here is a list for example’s sake, that includes the defining terms of “Heavy”, “Medium”, and “Light”, as well as the “Sweet” and “Sour” measures of sulfur content. In the context of what we are driving at here, the most fungible of crude supplies would be those of the same weight and sweetness acceptable to the widest number of refineries. Generally, that means Light Sweet crude oil that is not so light as to be considered Condensate (very high parts of condensed petroleum gases).

There is then also a consideration, let us coin the term “needstock”, that states that a given refinery serving the needs of a given market base is obliged to produce a given variety of refined products. The primary needstock of North American and Western European refiners is the production of gasoline, followed by diesel and jet fuel products. The production of all the other products is de-emphasized by design, and even so there is often an overproduction of other less needed products. The smaller refiners serving less developed markets are often required to meet a needstock of wider variety. The technology available and the needstock requirements often preclude accepting feedstock that is out of alignment. This is one major part of why countries like Iran lack refining capacity to produce large supplies of motor gasoline from their otherwise readily available crude, or why Venezuela remains a major source of heating oil (for export) rather than having customers waiting in line to buy that particular crude as feedstock to refine it into gasoline. There are more factors in these and similar cases, but needstock requirements are a big part of the measurement of how fungible these given sources are in the world.

The total world demand (and current supply enabled, roughly) is about 85 million barrels per day of crude. Here is a reference on that demand and supply. A fair portion of that never hits the world market as it is produced and consumed in the same countries or regions. A lot more of it moves by pipelines dedicated to given markets; much of the very substantial Russian export supply is mainly tied to markets directly. Not surprisingly, the largest portion of the market supply of crude oil comes to the world via the member States of the Organization of Petroleum Exporting Countries (OPEC). That fine example of a price-setting cartel is composed, as of the recent meeting, of the 12 nations of: Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. Note that Angola and Ecuador are new members, and that Indonesia has withdrawn as it is no longer a net exporter of crude oil. In total, they are running just under 37 million barrels per day total, as of the end of the second quarter of 2008. For those of you checking your OPEC quota sheets, that would be roughly 32 million barrels per day planned, plus the unallocated but allowable 3+ million barrels per day exported from Iraq, and then about 2 million barrels per day of quota breaking…

Quota breaking, do you say? Well yes, there has always been some quota breaking by opportunist members of the cartel, and there is also the swing-producer role played by Saudi Arabia that is intended to match supply and demand. Saudi Arabia produces the most nearly fungible crude from a system that has the greatest (by far) excess of capacity in place. In fact, running even as they are, Saudi Arabia has about 2 million barrels per day of excess capacity sitting ready to pump on a few weeks notice. All of Saudi Arabia’s capacity is connected to export terminals, so any change in production immediately becomes a global market commodity.

This gets us around once again to the matters of the enabling tools of trade (Banking and Communication) and that of the time, risk and expense of transport. The Saudis are a superb example of having access to all the enabling tools, and of managing in the main the matters of time and expense of transport. They are subject to risk by their geographic location, but have gone to great efforts in both national defense capability and alliances to mitigate that risk as much as possible. If they chose to produce to capacity, or even to some expanded capacity, there is little short of an act of war that any rival can do to stop them. The same is not true of several of the “bad boy” actors in (and outside) OPEC who are currently fueling trouble by the wealth that spot market crude oil prices in the US$100~150 per barrel was bringing in.

Leaving aside Russia’s production, which is maxed out, declining month by month, dependent on foreign technology and capital flows to keep running, *but* for now assured of a market, there are two particular cases where a case can be made that the supplier is in fact beholden to the buyer, not the other way around: Iran and Venezuela. Both suffer from having crude oil that is far less fungible in market terms. Venezuela is burdened with (in the main) very heavy crude, and Iran produces (again, in the main) very sour crude. Neither have a wide variety of buyers compared to benchmark crude oils, and neither is even close to as fungible as what Saudi Arabia can pour out. Worst of all (for them), both countries have committed themselves to extremely expensive competition with rival nations while being faced with fragile economic and social conditions at home. Both countries are “forced” to become price hawks, willfully engaging with speculator interests to jack up spot market prices and ranting at their fellow OPEC members about production cuts at the first sign of world markets turning down on crude oil futures. They have even claimed victory in the latest OPEC meeting. Some victory it was, as there is more to this fight than meets the eye.

The Saudis have publicly allowed that they are not cutting back. The futures market for crude oil is even now shaking off the worries that come with hurricane season in the Caribbean region. The Brazilians are announcing another large discovery in their wonderful BM-S-11 exploration zone. More is to come, even if it is not such a massive find, as the “Drill, baby, Drill” movement is coming into its own in the United States. The oil speculations running on big money players are watching Lehman Brothers Holdings go into bankruptcy protection, tying up all sorts of capital assets and taking those players to the sidelines.

The possibility of crude oil futures hitting the US$60~70 range in the near term is real, and that scares the heck out of the theocrats in Iran and the autocrats in Venezuela and Ecuador.

It is fair to expect some desperate moves on their parts. Expect the Russians to support them. Expect every manipulator out there to try and disrupt supplies, or give aid and comfort to groups that will do it for them. So be it.

For let us give credit where credit is due: Quiet diplomacy, backed by real capability to do otherwise, has worked. The Saudi Arabian government and the UAE’s government both understand that the alternative of continuing to be complicit in letting the Venezuela-led bloc and Iran’s global ambitions be fueled by excessive crude oil prices will result in more and far worse confrontations. Just as flooding the market in the 1980’s was a key element in constraining Soviet economic options, putting the crude oil futures market into a supply excess now is the best way to defang the particularly destabilizing cooperation that opportunists in both Iran and Venezuela have chosen as their course. Neither Iran nor Venezuela can compete on a worldwide basis with easy availability of Light, Sweet, eminently Fungible Saudi Arabian crude oil.

Just imagine how bad it will get for them when Iraq gets back up to capacity.

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End notes:

The information on Saudi Arabia’s off-the-record position vis a vis OPEC is also cited *here*

One hypothesis predicting Venezuela may interrupt crude oil shipments to try to panic the market is based on observations of *this* but I would caution that it is far more likely that Citgo is looking at more serious access problems at Lake Charles after the hurricanes than is currently being discussed. This is a matter worth watching, however.

One other hypothesis out there, is that speculator interests (nations *or* individuals) are fueling disorder in places like Nigeria. Here is the current Nigeria situation.