Stuart Burns

The oil price may be up, but oil companies are desperately shelving projects, slashing capital expenditures and laying off workers, and not just in US shale deposits.

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One area where oil production is set to rise for years to come is, ironically, one of the highest cost: the Canadian tar sands oil. Oil sands companies that have already sunk money into mines and steam injection wells in Alberta have no incentive to stop operating or building out projects that are already well underway.

Tar Sands Investments

Such capital intensive projects are on the opposite end of the price sensitivity scale from shale, where dozens of rigs have been idled over recent months. Oil sands are operated more like a factory, fleet of trucks or a pipeline, run at maximum capacity to reduce the unit cost as much as possible and service startup debt according to the FT.

The paper reports the Canadian Association of Petroleum Producers last week forecast that western Canada’s output will keep increasing by about 156,000 barrels per day each year until 2020. Growth continues after that but slows to 85,000 b/d a year until 2030. Capital spending by Canada’s oil and natural gas industry will total Canadian $45 billion (US $37 billion) in 2015, 40% lower than 2014 and solely focused on building out existing projects that are too expensive to abandon.

New on the drawing board projects, on the other hand, have stayed there. New projects are projected to need an average Brent crude price of more than $100 per barrel to break even and no one, absolutely no one, is taking a bet on that anytime soon.

Compare that to an average break-even price of $29 per barrel for reserves onshore in the Middle East, $57 per barrel in ultra-deep water and $62 per barrel in North American shale, according to Rystad Energy quoted in a Reuters Commodity Note.

Climate Change Legislation Looms

The industry faces more challenges than just the price of oil. This year the leftist New Democratic Party was elected to govern the province of Alberta after pledging to raise corporate taxes and review oil royalties. Maybe even more of a threat is legislation as a result of fears of climate change.

The Oil-Climate Index shows that medium, sweet synthetic crude from Canada’s Athabasca oil sands generates 767 kilograms of CO2 per barrel, compared with 559 kg for Brent crude from the North Sea – itself hardly a low-carbon product due to the challenging deep water nature of UK’s North Sea oil fields.

The industry is trying to reduce costs and to reduce the carbon footprint of oil sands extraction technology, and if the innovative and entrepreneurial drive shown by US shale firms is any indication, it will undoubtedly make strides in both of those objectives. Even so, climate change legislation could be the killer just as oil prices begin to recover. A study by University College London found that 85% of Canada’s bitumen reserves should remain un-burnt if the world is to avoid the 2 degrees Celsius average temperature rise seen by many politicians as the tipping point number.

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Greece seems to be teetering on the edge yet again.
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We wrote last year, and this year, as the Greek crisis waned and the international media assumed the problems had been solved that Greece had the potential to come back and make a re-appearance and it certainly has.

ECB, IMF, World Bank Troika

If the troika of the European Central Bank, the International Monetary Fund and World Bank don’t agree on a way forward to release further funds, Greece will default on it’s €1.5 billion repayment due to the IMF at the end of June and the €3.5 billion due to the ECB on July 20.

These are sizable sums of money for a government with no reserves and struggling to meet monthly wage bills, let alone pay suppliers for goods and services, an obligation it has foregone for some months now.

A last minute reprieve may be on the table with proposals the leftist Syriza government coalition has put forward this week. Finally these include proposals to address at least one of two key sticking points. First is raising the pension age to 67, the sticking point is the time frame, both when to start and when the process should conclude.

What Syriza Wants

Athens wants it to be phased in up to 2025 but the troika want it faster. Still, it is at least being discussed now and shows potential. Greek pensions are probably un-payable in the long run as this graph below underlines. Ultimately, a state pension has to fall somewhere in relation to the country’s ability to pay and Greece can’t afford for workers to retire in their early 60’s or sooner and then receive anymore than a subsistence pension; the reality is the country can’t afford it.

In their defense, it should be said, according to the Greek government, 45% of pensioners receive monthly payments below the poverty line of €665. The pensions aren’t generous in overall terms, only in relation to the country’s ability to fund them and the relatively early age that they start.

Screen Shot 2015-06-23 at 08.36.23

Source: Financial Times

The other sticking point is Greece’s value-added tax and raising taxes, in general. The troika want 23% VAT rates to be applied on pretty much everything except food and medicines which would be taxed at a lower rate, but Athens is proposing a number of other sectors be included in the lower rate including energy. But Syriza is also proposing to squeeze businesses further by increasing corporation tax with a one-off 12% tax on corporate profits above €500 million.

The VAT Question

The FT estimates it would raise an additional €945 million this year and another €405 million next year, but would eventually be phased out. The sticking point on the VAT is energy according to a Market Watch report with Athens adamant the VAT should not be more than 13% as this impacts the poorest in society disproportionately but the irony is no one is paying their energy bills, anyway. Last week, the Greek electric power authority reported that its unpaid bills reached €1.9 billion in 2015, more than enough to meet the IMF’s end of month payment on its own.

A more lasting proposal from the government is to raise overall corporate taxes from 26% to 29%, bringing in an additional €410 million next year – assuming companies pay it, of course. Tax revenue is one of the fundamental problems in Greece, whether corporate or private, tax receipts have collapsed particularly among individual taxpayers as people have simply failed to fill in tax forms while they wait to see what happens.

Meanwhile, defaults on bank loans are widespread, around 70% of restructured mortgages aren’t being paid and the banking system is freezing up. Government tax revenues for May were €1 billion short of the budget target exacerbating the state’s problems in trying to meet even day-to-day payments.

In the medium- to longer-term, Greece will need debt relief. To suggest the country can pay off its debts over the next 10-15 years is to consign Greek society to long-term austerity and, as we have seen with the election of the Syriza government, they won’t accept that.

For now, Europe will, for the sake of the Euro and appearances, muddle through with yet another 11th hour fudge. But Athens’ proposals will not be met in full. Pension payments will be higher, tax receipts will be lower and until Germany faces up to debt relief this problem will not go away.

Not that Greece couldn’t leave the Euro. It could and both Europe and Greece would survive but, politically, Euro block politicians do not want to admit the model is flawed and will continue to seek ways of keeping the shambles together. We don’t see a Grexit at this stage. It could come down the road, although northern European politicians are clearly getting more than exasperated with the situation, they are likely to find a way to make it work. Or at least keep the show on the road and continue to advance good money after bad in the hope something will turn up or it won’t blow up until they are out of office.

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Usually, Iron ore and coking coal move in lock step. The two raw materials for steel production are driven by the same demand factor, – at least for seaborne trade consumption – by the Chinese, Japanese and Korean steel industries.

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Often production comes from the same or similar multinational suppliers – Rio Tinto Group, BHP Billiton, Glencore PLC.

China’s domestic producers, like its iron ore mines and steel producers are state owned. Both raw materials have experienced massive investment surges this decade as high prices encouraged producers to boost production and both have suffered aggressive price falls as supply has hit a weakening demand market.

The Iron Ore Mini-Rally

Recently, though, prices have diverged. Iron ore as we wrote last week, has gone through something of a mini-rally driven in part by dwindling Chinese port stocks prompting the impression supply is more limited than originally thought and by announcements of mine closures among smaller producers in places such as Iran and Mozambique.

As Iron ore falls reversed and the price rose 30% since the start of April, coking coal could only look on from the sidelines, continuing its fall from over $300 per metric ton four years ago to below $90 now. The latest quarterly metallurgical coal prices have been concluded at the lowest level in more than a decade as quarterly contract prices follow spot prices downward.

Coking Coal: What Are We? Chopped Liver?

Unfortunately for coking or metallurgical coal, even the token supplier rationalization we have seen in iron ore has not been mirrored for coal. Chinese producers, many state owned have actually increased production last year and, according to the Financial Times, China has become a net exporter of coking coal and its derivatives. China’s coking coal imports fell 24.2% in the first four months of 2015 over the same period last year, no doubt aiding the statistics as marginal suppliers were squeezed out the market.

North American Supply Displaced

Australia still supplies some 50% of imports but Mongolia is becoming increasingly important at the expense of Canadian and Russian supplies. To the extent that the US can no longer competitively supply China. Canadian material may also be displaced as prices in North America will be correspondingly depressed further in the second half of the year as suppliers chase the local market.

The most recent statistics from China quoted by Reuters suggest domestic coking coal may finally be plateauing. May’s number was down 4.2% compared to a year ago and that suggests even domestic suppliers are struggling. There is little on the horizon to offer coal suppliers much optimism but steel mills and steel consumers will welcome the reduction in raw material costs for the rest of this year.

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After a flurry of interest in the price of oil as levels bounced back up to $65/barrel from below $50 at the turn of the year, most of us have been quietly content to fill up for less at the gas pumps and patiently wait for the heralded but still unseen benefit to the economy of lower oil and natural gas prices.

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Political events may be about to change that cozy situation as Iran nears its crucial end of June deadline to reach a binding agreement on its nuclear program, the Telegraph reports.

Removal of the US- and EU-led sanctions against Iran could pave the way for an immediate relaxation of sales restrictions and opening of the country’s massive oil and gas reserves to development by International Oil and Gas Companies (IOCs). Iran is reported to be scoping a new contract termed the Iranian Petroleum Contract designed to allow major international oil companies a revenue-sharing deal in return for financial and technological investment in the country’s oil and gas sector. Iran holds the world’s fourth-largest oil reserves and the second-largest natural gas reserves. Production of both has fallen sharply since sanctions as this graph shows.

Source: Telegraph.com

Source: Telegraph.com

But this could be reversed over time with western expertise and technology. According to Energy Information Administration data quoted by the Telegraph, Iran could achieve an additional 1 million barrels per day of production in short order, rising over time as investment re-opened old fields and increased flow rates from existing fields.

According to the Telegraph “Iran’s exports of crude oil and condensate dropped from 2.6 million BPD in 2011 to almost 1.3 million BPD in 2013 as a result of sanctions and only marginally recovered by nearly 150,000 BPD to 1.4 million in 2014 as the political situation thawed.

Source: Telegraph.com

Source: Telegraph.com

At its peak before the Islamic revolution in the 1970s, Iran was producing anywhere between 5 million BPD and 6 million BPD of oil and has the potential to return to this level with sufficient investment. Iran’s oil minister is suggesting they could reach output of 4 million BPD next year if an agreement is achieved next week.

That would have a dramatic effect on an already oversupplied oil market and may provoke Saudi Arabia to yet again open the taps and further flood the market to maintain its market share. Most major OPEC producers are hurting at the current oil price, not because their cost of production is above $65 per barrel but because oil revenues make up the vast majority of their export revenues.

Budgets were set at a price of around $100/B and depressed prices leave them running at a deficit. Those with large reserves, like Saudi Arabia’s $700 billion one, can weather such a storm for some time to come. Others, such as Bahrain, are already going cap in hand to fellow Persian Gulf states asking for support.

Ironically, the worst off is probably Venezuela, although it is sitting on the world’s largest proven reserves, production has collapsed due to mismanagement and, with it, government revenues have fallen. Further falls could put the economy in a perilous state. A substantial increase in Iranian oil output would potentially put the Middle East’s two political heavyweights, Iran and Saudi Arabia, at loggerheads economically as well as politically in the second half of the decade.

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Crude steel output will shrink as much as 2% this year, according to Bloomberg reporting data from the China Iron & Steel Association.

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That’s lower than the group’s March estimate of a 1.1% decline and would be the first contraction since at least 1990 the paper says. Crude steel output will shrink to 807 million metric tons this year from 823 mmt in 2014, according to the steel association as producers shut capacity.

Source Bloomberg

Source: Bloomberg

The reduction is being driven by a number of factors but profitability, or the lack of it, seems to be the greatest. Iron ore prices have risen by 40% in just two months as low port stocks at China’s ports suggested a tighter supply market Reuters reports. The market is speculating that producers and traders are holding back supplies in an effort to push up prices but top producer Rio Tinto Group pours cold water on that theory saying they are not in the business of playing the market month by month and supply is plentiful.

Supply Up, Demand Down

The firm will likely ship 350 mmt this year, up from 300 mmt last year. Lower seaborne iron ore prices in Q1 appear to have finally taken their toll on domestic iron ore producers, though, with production dropping 11% in the first five months of 2015 as higher cost producers have been squeezed out.

Source: Bloomberg

Source: Bloomberg

Few are expecting iron ore prices to remain elevated with steel production falling and supply plentiful, iron ore prices are likely to come down from here. Steel reinforcement bar (rebar), has fallen 14% the current quarter to 2,265 CNY per mt ($365/ton) as of Friday, the lowest since at least 2003, according to data from Beijing Antaike quoted by Bloomberg.

Construction Falling

The construction sector has been hit particularly hard, as evidenced by the amount of land purchased for real estate development falling 31% in the first five months of this year and new construction starts slumping 16%, according to the National Bureau of Statistics.

The paper quotes Goldman Sachs saying about 35% of China’s steel demand is related to housing and construction-related activity. Led by construction, China’s apparent steel demand fell 4% to 302 mmt during the first five months of 2015, a reversal from 3% growth in 2014. Meanwhile, exports have surged further underlying the excess domestic inventory position.

China exported a record 10.3 mmt in January and shipments in the first five months of the year were 28% higher than the same period in 2014. At that rate, the country ships out more than any other single country produces, according to data from the World Steel Association; an untenable situation in the long run prompting widespread anti-dumping actions in Europe and the Americas.

No Quick Chinese Turnaround

To what extent profitability will play a role on China’s steel production in H2 remains to be seen. Most expect iron ore prices to fall, reducing supply-side cost pressures for steel producers even if it does little for demand. Reuters quotes Julius Baer estimates of $40 per mt as a possible low point for iron ore and Citi seems to agree saying, “We expect iron ore prices to reverse sharply and decline over the coming months,” averaging $51/mt this year and $40/mt in 2016.

While a few boosters are looking to infrastructure, such as Russian-Chinese pipeline projects and electrification as future drivers of increased steel demand, most are not seeing any increase in demand anytime soon.

Indeed, Li Xinchuang, CISA’s deputy secretary-general, is quoted by Bloomberg as saying in an interview this week: “Low prices will be with us for a long time. So will tepid demand and zero growth, or even contraction, in output.”

That doesn’t bode well for the rest of the world seeing high levels of Chinese steel exports, even when anti-dumping cases are successful in blocking direct Chinese steel exports to a particular market, there is still the effect of diverting that supply to other markets and driving down global steel prices as a result.

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My colleague, Jeff Yoders, referred last week to action taken by Alcoa, Inc. to challenge the Commodity Futures Trading Commission (CFTC) over its involvement in the London Metal Exchange’s (LME) upcoming rule changes.

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The LME is in the process of a long running review of it’s warehouse rules following industry criticism of the length of queues, particularly at it’s Detroit and Vlissingen (Netherlands) warehouses, a situation that was initially viewed as driving up physical delivery premiums. It has since been seen to be only part of a wider problem created by the stock and finance trade’s competition for physical metal.

Pile of aluminium bricks waiting for transport to the factory

Pile of aluminum ingots stuck in Detroit, even though its owners want to take delivery.

Queues have declined in nearly all locations but still remain at upward of a year in Detroit and Vlissingen, although Metro International and Pacorini, the warehouse operators at those locations, have taken steps to further limit intake while the LME’s deliberations are underway.

How Producers Benefit From Premiums

Alcoa, like UC Rusal and other producers, has benefited from the physical delivery premium on top of the LME quoted prices in recent years particularly as, at times, the LME price has been below the cost of production. The addition of the delivery premium has allowed Western smelters to break even and even post profits while achieving no more than the traditional LME price would have given them at a loss.

Currently, with falling LME prices and much-reduced physical delivery premiums even a combined all in price is below cost for many smelters, hence Alcoa’s concern that the LME’s rule changes are not drastic enough to precipitate further falls. The same worries were behind Rusal’s challenge to earlier proposed rule changes last year, a challenge that eventually failed in the English High Courts.

Alcoa’s action is, as you would expect, executed with more decorum and took the step of requesting information and records pertaining to the LME’s application to be a foreign board of trade according to a Metal Bulletin article and is said to have come after a leaked letter from the CFTC to the LME revealed that the regulator had deferred its review of the exchange’s application to register as a foreign board of trade while it evaluated the LME’s warehouse reforms.

What CFTC Wants

The LME needs CFTC approval to act as a foreign board of trade if it is to effectively operate in the US market, so the CFTC could be said to have the exchange over a barrel in terms of forcing them to accept CFTC suggestions or guidelines regarding rule changes. According to the article, the CFTC offered the exchange its “opinion” of the reforms, including that the possibility of capping or banning rents and inducements saying such reforms “show promise.”

Alcoa’s position is the CFTC has no authority to intervene in such a contentious issue and, as such, should refrain from getting involved, preferring an open dialogue with industry members (obviously meaning Alcoa among others) to arrive at solutions.

What Alcoa Wants

Alcoa is quoted as saying “We believe that the CFTC should refrain from any comment or judgment on, or interference with, LME rule changes, and that the CFTC should examine any LME aluminum contract performance issues only through an open, inclusive and transparent process where all affected market participants have the opportunity to present their views.”

You can see where Alcoa is coming from, but, surely, the CFTC also has a responsibility to consumers affected by rule changes and the impact they may have on prices. Consumers have been so damaged by the physical delivery premiums that they have attempted legal action to address the issue but without being able to gain any traction through the courts.

Market Distortion/Disruption

The physical delivery premium is a distortion in the market that serves no party well, it would be better for producers, consumers and the trade if aluminum prices could return to a more historic norm of an LME price plus a small delivery premium reflecting no more than the logistic cost for delivery. If the CFTC’s pressure on the LME helps achieve that it’s all well and good, whether they have the authority to use the LME’s license application as a means to achieve that, we will leave to the courts to decide.

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Having rallied January through May, Copper now looks to be following iron ore downward.

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The metal has fallen more than $400 from its price at the beginning of May to below $6,000 per metric ton on the London Metal Exchange. The spot price is sub-$6,000 with the three-month delivery price marginally higher but also hovering beneath $6,000 per mt.

Chinese Power Non-Demand

According to the FT, analysts expect China’s copper demand to grow by 4% this year, yet that figure is based on considerable use in power grid investment and assumes government spending plans will be met.

Power grid investment actually fell by 8.65% in April, according to the FT, and in the first four months of this year China completed 86.6 billion CNY of grid investment, only 20% of the planned amount for the year, so there is no guarantee that demand growth prediction will materialize.

Last year, only 88.7% of grid investment was completed and this year power consumption has actually fallen as industrial activity has eased. Indeed, Goldman Sachs suggests even planned power grid investment may not provide the boost many hoped for, saying China could switch to aluminum instead of copper for power transmission. Copper is more than three times as expensive as aluminum and China has a surplus of aluminum, yet imports 75% of its copper.

Investors Doubtful, Too

Investors agree with the pessimistic outlook cutting their net long positions in copper, joining Chinese speculators who have been betting against the red metal all year.

A CNBC report says recent weakness is due to weak premiums, high scrap discounts and a failure of the seasonally strongest quarter for copper to translate into solid demand. China’s factories are now approaching a summer slow down and with it lower metal consumption.

Goldman Sachs is predicting Chinese demand will fail to materialize this year and has targeted a price of $5,200 per mt by 2016. Longer term the fundamentals for copper are said to be better than Iron Ore, supply should peak by 2017 and then fall but in the meantime consumers should benefit from weaker prices this year and next.

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The ever-resourceful Renault-Nissan and their ever-creative chief executive, Carlos Ghosn, have just launched their latest offering for the emerging markets, the Renault Kwid.

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Priced at Rs 300,000 ($4,700) is it certainly pitched price-wise at the emerging markets and at first glance should prove popular in its first market, India, but also in other emerging markets in time such as Indonesia, Vietnam and others.

Emerging Auto Markets

The attractions are clear, all have massive populations, low per-capita car ownership markets with huge medium-to-long term potential. A Financial Times article explains that Renault had to start from the ground up in designing the Kwid to achieve such a low price.

They based the whole design team in Chennai, the city known as the Detroit of India – a first for a western car maker – using mostly Indian designers and sourcing Indian parts. The concept they say is frugal, innovation and required a completely new clean sheet approach.

Illustrating the problem, the FT quotes Navi Radjou, a management theorist in saying “companies don’t like to learn new things, to be blunt. They try to exploit their existing knowledge, not to rethink what they do from scratch.”

Why Automakers Miss

Western businesses see developing economies mostly as new markets where they can sell more of what they already produce. Those that try to come up with something new tend only to tweak existing offerings, which rarely works. GM and Volkswagen may well be cases in point, having poured millions into the market with limited success.

Even Indian firms get it wrong. Tata Motors‘ Nano was certainly cheap when it was introduced in 2009, but it flopped. Spurned, the article says, by rudimentary features and a poor safety record.

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Aluminum has had quite a depressing month.

A flood of Chinese exports, weak demand and robust Western supply in spite of earlier smelter closures have all contrived to leave the market in primary surplus. As such, MetalMiner's monthly Aluminum MMI®, tracking aluminum prices across the globe, registered a value of 86 in June, a decrease of 4.4% from 90 in May.

Compare with last month's trends – download the free May MMI report.

China’s aluminum output rose to a record 2.59 million tons in April, according to the National Bureau of Statistics. The world simply can’t rely on China to restrain output. Prices might need to fall further in order to cause further non-China closures to balance the market. Rusal cited the rising tide of Chinese aluminum exports as a main concern in the producer's first-quarter earnings report, which could increase in light of China removing a 15% export tax on aluminum products.

In the absence of demand from the financial sector, both the LME/CME price and physical delivery premiums have been falling, particularly in Asia.

Aluminum Premiums for Physical Delivery: Takin' a Dive!

As I wrote on the blog recently, Reuters reported this week that premiums have dropped to $100-110 per metric ton for in-warehouse Singapore metal, down from $150 two weeks ago and $400 in December. In South Korea, May tenders were said to be awarded at $135-145 per metric ton and the country is sitting on nearly half a million tons of primary metal inventory. Premiums have dropped in Europe and North America, too, but are said to be stabilizing for the time being, although most are expecting further falls in North America.

Interestingly, the LME has returned to a healthy forward price curve, as it did in times of plenty from 2009-2014 when the stock and finance trade flourished, soaking up excess supply.

With such a strong forward curve and low interest rates, all it needs is a little appetite from the hedge funds and banks, with some encouragement from warehouse companies to store metal, and bingo! Excess inventory rapidly gets sucked up into long-term storage.

According to Reuters, some warehouse companies are starting to offer incentives or discounts on storage costs of around $70 to draw in metal. The foundations are in place for a pick-up in stock and finance activity, and the possibility that “demand” created by that activity could support premiums at least at or around current levels and potentially, at least in Asia, raise them up.

Most are expecting LME prices to fall further; it is entirely possible LME prices could fall while physical delivery premiums could rise. That was exactly the situation we had in 2012-13 and the LME changed its rules to avoid it. The next six months could test the system, let’s see.

What It Means for Semi-Finished Aluminum Markets

The combination of lower LME prices and falling physical delivery premiums have allowed producers of semi-finished products to chase a weak market down, a process hastened by rising supply from China.

Semi-finished product makers' conversion premiums have also been soft in the face of a well-stocked distribution market and slack end-user demand, a situation that, as we enter the summer period, is unlikely to turn around before the fourth quarter.

Exact Aluminum Price Movements Over the Month

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There is a real divergence developing in the oil market which makes predicting future price direction quite challenging. On one side of the Atlantic the market is awash with oil.

According to a Reuters report vessels are sitting off the west coast of Africa and in the North Sea holding millions of barrels of oil for which there are no buyers. Worse, so many vessels are tied up essentially in this floating storage that VLCC (very large crude carrier) freight rates are rising because there aren’t enough vessels available to carry the cargo that is moving under longer-term contracts.

Effects of Floating Storage

This has the effect of making new production more expensive to sell in the Far East and Europe, exacerbating the problem faced particularly by Nigerian producers. According to Reuters, there are around six million barrels of crude from Nigeria’s May program available – some already loaded onto vessels.

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That joins more than 65 million barrels left in June and July for Nigeria alone. Meanwhile in the North Sea, only one VLCC booking has been made to Asia for June, leaving Europe to absorb almost the entire production of the UK Forties field. As mentioned above, the floating storage is putting a stranglehold on new booking rates. May freight rates on the key West Africa to Asia route are up more than 10% Reuters says, roughly 40 cents per barrel higher than April.

Not surprisingly, this has weighed heavily on prices. UK Forties traded at the lowest differential to dated Brent Crude since December 2008 this week, while Norwegian Ekofisk traded at a nine-year low, the paper said.

Prices Actually Going Up in the US

On the other side of the pond, prices are moving in the opposite direction. For the first time in six months, the US oil market is flirting with backwardation, where the spot price is higher than one- or three-month dated delivery – a sign of a tightening market and. potentially. a shortage.

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