1990 energy outlook: back to the future?

1990 energy outlook: Back to the future?

Oil futures prices exploded in the final week of trading of 1989 as January 1990 heating oil futures prices rose an astronomical 17 [cents] per gal. in just two trading sessions.

Such an upswing in prices was more reminiscent of episodes

Leading up to the Arab oil embargo in 1973-74 and the oil price spiral in the late 1970s, relatively low oil prices induced consumers to expand their use of petroleum products. The rise in demand for petroleum products led to higher demand for oil from the Organization of Petroleum Exporting Countries (OPEC). As a result, excess production capacity within OPEC was disappearing even before it was eliminated when political events effectively reduced "available" capacity (see OPEC capacity graph).

OPEC excess production capacity is shrinking fast once again, brought on by a similar revival of petroleum product demand worldwide. Once again, this demand increase has followed an erosion in world oil prices that started in 1981 and culminated with the ultimate collapse in prices that occurred in 1985-86.

In the United States, petroleum demand rose by an average annual rate of 2.1% from 1985 to 1989. World demand rose by 2.3% per year over the same four years.

Meanwhile, on the supply side, the collapse in the world crude prices, coupled with extreme price volatility, almost destroyed the incentive to search for new oil in the United States. By late 1988, U.S. production in Alaska, which had been rising and partially offset production declines in the "lower 48," peaked, causing a rapid decline in the U.S. crude oil production rate. In 1989, crude production was down 6% from 1988.

The lack of incentives to find new oil in other parts of the world resulted in a similar fate. By 1985, OPEC, with its vast excess production capacity of 37%, was poised to meet the growing appetite for oil worldwide. Consequently, by the end of 1989, OPEC's excess capacity had been reduced to less than 20%.

In fact, the rise in the demand for OPEC oil accelerated so fast during 1989 that it more than offset the usual seasonal dips in demand that had typically led to price softness. As a result, the oil industry was continually surprised by the world's ability to absorb ever-increasing output by OPEC.

The market thought crude prices were always about to fall. This was evident in the backwardation seen in crude futures prices throughout 1989 and was illustrated by futures prices as of the end of 1989 (see crude futures price chart).

In 1990, the degree of excess OPEC production capacity is expected to fall further, even based on what may prove to be conservative assumptions. Two key uncertainties could have major impacts on the supply-demand balance in 1990.

First, rapid economic expansion caused petroleum product demand in areas outside the United States and Western Europe -- the Pacific Rim, for example -- to rise faster than had been expected during the latter half of 1989. That trend could continue through 1990.

Second, Soviet production was off in 1989 compared to 1988, and there have been indications that production and exports there and in Eastern Europe could erode even faster due to severe economic problems.

The trend in crude oil futures prices has been rising rapidly since late 1988 (see crude price chart). The average crude futures price at expiration was $15.85 per barrel for 1988 and rose 25.4% to $19.87 for 1989. At the end of 1989, crude futures prices for 1990 delivery averaged $20.62, though this was based on the expectation that prices would erode throughout the current year.

As a function of the further narrowing in excess OPEC crude production capacity and the outlook for U.S. crude imports and inventories, crude oil futures prices could average $22 per barrel for 1990.

Assigning a standard deviation of $2 per barrel to that price assessment implies a 68% subjective probability of being within plus or minus $2 of $22. Under these assumptions, there is a good chance OPEC will actually raise its official price target or minimum by $1 or $2 per barrel from $18 during 1990 to capture the higher value of their crudes, particularly given that eight of the 13 OPEC members were producing at or near their capacities at the end of 1989. This would be the first OPEC price increase since it raised the marker from $32 to $34 in October 1981.

Full-speed refineries

U.S. excess refinery operating capacity is also shrinking. As petroleum product demand rose in the United States, refinery operating rates also increased (see refinery graph). By the summer of 1989, refinery utilization reached--and briefly exceeded--the maximum sustainable operating rate of 92%.

As refinery utilization approached this key rate, the industry tried to maximize throughput and profits. Refinery problems proliferated. Because of the decreasing excess capacity, refinery mishaps representing only a minor part of total capacity caused relatively major effects on inventories and, therefore, on "crack spreads" in the futures market. These mishaps began with the Shell refinery explosion in the summer of 1988 and continued through the Exxon explosion in the last week of 1989.

Compounding this problem of dwindling excess refinery capacity was the industry trend toward carrying leaner inventories. This "just-in-time" approach stemmed, in part, from the trend toward lower product demand in the first half of the 1980s but also from the need to minimize inventory carrying costs in a highly competitive industry.

The rise in product demand in the latter half of the decade, therefore, created even lower inventory-to-demand ratios, increasing the market's reliance on refinery output and imports to meet seasonal swings in demand. The result was unprecedented volatility and levels for gasoline-crude spreads during 1988 and 1989 and for heating oil-crude spreads in 1989 (see gasoline, heating oil charts).

In at least the first half of 1990, these market conditions are likely to continue. U.S. distillate stocks have been drawn down to their lowest levels in recent history (for this time of year), and gasoline stocks are expected to trail last year's levels due, in part, to the cold weather that temporarily reduced U.S. refinery activity in late 1989 and early 1990.

As a result, the heating oil market will be competing with the gasoline market for the continuation of high distillate refinery yield during the first quarter of 1990. Given the relatively low level of gasoline stocks currently expected in March, the gas market will compete for a high gasoline yield in the second quarter.

The competition will be waged in the futures market, as relatively higher heating oil-crude cracks provide an incentive for refiners to maximize distillate yields, whereas high gas-crude cracks provide an incentive to maximize gas yields. In between the heating oil and gasoline seasons, U.S. refiners will have to reduce throughputs for maintenance purposes.

Also aiding potentially strong NYMEX crack spreads this spring will be the anticipation of environmental regulations affecting gasoline that would cause higher production costs and could alter the level of gasoline that could be produced.

Demand is concern

A major uncertainty in the equation is, of course, what will happen to petroleum demand in 1990. Gasoline demand growth in 1990 may be negligible and is unlikely to be greater than 1%. Distillate demand growth is also likely to be minimal -- less than 1% -- assuming normal weather, because diesel fuel demand (the major growth component in distillate demand in recent years) appeared to be moderating in 1989.

This outlook is further susceptible to the impact of changes in the U.S. economy and in oil prices, and the economic outlook for 1990 is cloudy.

In a January survey of 40 economists, the Wall Street Journal found the mean expectation for U.S. gross national product growth for the first half of 1990 was just 1.3%. The standard deviation of the estimates was 1.2%. The range ran from a high of +3.1% to a low of -3.5%. For 1990 as a whole, you can calculate a mean of 1.7% and a standard deviation of 1.1% for those estimates.

But exactly how distillate and gasoline supply and demand are likely to come together to determine inventories in 1990 depends on how prices unfold to correct anticipated supply-demand imbalances (see sidebar for a description of an approach used to forecast for trading purposes). [Graph 1 to 5 Omitted]

Robert Boslego is president of The Boslego Corp. in Winchester, Mass., a firm that provides analytical, electronic information and risk management consulting services to major participants in the oil market.