Something big unfolded on my trip to Frankfurt last week.
It began with meetings in Germany over natural gas prices, but morphed into an interesting sidebar on the impact government subsidies have on energy prices.
As I noted last week, a recent International Monetary Fund (IMF) staff report concluded that public-sector support largely created more harm than good.
This IMF report argues for increased taxes on energy, hardly a recommendation likely to sit well with public opinion. However, the report singled out pre-tax concessions – those largely provided by governments to producers in oil exporting countries – for particular criticism.
And that led four of us to leave Germany, fly to Dubai, and discuss the matter first hand with some of the folks responsible for those tax benefits. Expected was the standard response. What we did not expect was what they actually told us.
In the West, we view another rise in crude oil prices as one that benefits the price makers (the guys pumping the oil, primarily in the Middle East) and not the price takers (consuming countries faced with paying for increasing import prices).
This time, it is not playing out that way.
What greeted us at the Shangri-La Hotel in Dubai was the “something.”
And this could change everything in the global energy markets.
Remember, you heard it here first…
The WTI-Brent Spread Continues to Narrow
This oil market is changing and so are the fortunes being made off of it. We may be in another round of price increases. But the guys who normally smile when that takes place are very concerned this time around.
Located on Sheikh Zayed Road, a direct 15-minute ride from the airport and smack in the center of town, the hotel is my normal location for meetings in a city that the skyline still boasts more building cranes than anywhere else in the world.
The surroundings may have been familiar, but the tenor of our colleagues was not.
This time, conditions in the oil market have the normally dominant producers worried. Prices are rising faster in New York than they are in London.
Through last Thursday (and the last trading day of the shortened Easter week), West Texas Intermediate (WTI; the NYMEX benchmark crude rate) had risen 5% for the week and 7.7% for the month. However, London’s Brent benchmark had risen only 2.4% for the week, while posting a virtual flat performance (down 0.05%) for the month.
As a result, the spread between the two – measuring the difference as a percentage of the WTI rate (the more precise way of looking at it) – has narrowed to 12.9%, the lowest since July 5 of last year. Brent may still be at premium, as it has in every single trading session since August 16, 2010. But that is providing a declining value to the producing countries.
This is because oil is still sold for dollars, but the increase in an entire range of imports is primarily coming from Europe. And that means the costs to the oil exporting nations is playing out in euros. More of that trade is coming down on the wrong side of a currency exchange. Despite Brent also being denominated in dollars, the narrowing spread to WTI is decreasing the effective (and traditional) balance of payments benefit when an expanded range of imports are considered.
The Arab Spring Still Has Repercussions
I had noted this problem before when commenting on what the Arab Spring actually meant to the Gulf producing countries. A year ago, I filled you in on the real cost of the uprisings for those producing countries not directly hit by the first wave of protests. Some of the same folks sitting around the table this time in Dubai told me then that preventing social unrest has a rising cost.
That cost translates into expansive domestic program expenses, further heightened subsidies (our primary interest in this meeting), and a staggering requirement for imports. All of this resulted in the need for producers to maintain high prices in Brent terms to keep the local populations content.
With real term national unemployment well into double digits and over 60% of the region’s population under the age of 26, popular discontent can quickly turn ugly.
Just ask the Egyptians.
The current situation, on the other hand, was moving in the wrong direction, prompting central bank misgivings about currency drains, inflation, and a declining effective value of oil exports. The crunch was coming, and there appears no easy way to offset what it will mean if sustained for very long.
Not that we should have a bake sale and take up a collection for these guys. At $110 a barrel, Brent is still bringing in the bucks. The problem developing is not yet one of revenue generation.
What is coming fast is far more disconcerting.
An End to OPEC Dominance?
Aside from Saudi Arabia and Kuwait (at least for the moment), most of the other producing countries in the region are losing control over their own economies. With the rest of the world seemingly dependent upon their oil, these countries are now increasingly dependent on the rest of the world for just about everything else.
From their standpoint, the situation is becoming more acute.
The advent of huge unconventional tight (i.e. shale) oil discoveries in North America have prompted conclusions throughout OPEC that exports to the U.S. will end within two decades.
Similar discoveries combined with the rise of heavy oil deposits in places as diverse as Australia, Morocco, Russia, and Mexico, mean traditional markets for Gulf oil are declining.
Attempts to diversify their economies have been inconclusive or outright failures. As the energy balance begins to swing away from the desert, those on the other side of the table this weekend are for the first time in half a century unprepared to respond.
I came in search of a response to a narrow question on subsidies. I am coming back with a far more endemic concern. There is a change brewing in the Gulf and it is not generating advantage to the region.
We finished our long session and made our way to one of my favorite restaurants. Located beachside in the trendy marina district, the Al Qasr has a world famous Lebanese/Arabic menu but is hardly cheap. Fortunately, it appeared not all traditions were collapsing at the same time.
Our hosts still picked up the tab.
[Editor’s Note: As Kent discussed, unconventional oil sources could have a huge impact on OPEC’s influence in the global energy markets. In fact, he recently discovered one shale oil project that could be the most profitable in the world for early investors. Click here to learn more.]
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