World's Oil Supply-Demand Balance Precarious, Says Greenspan

Oil and Gas Journal
June 12, 2006

WASHINGTON, DC, June 12 -- The worldwide supply and demand balance for oil has become so precarious that even small acts of sabotage and local insurrection can affect prices, former Federal Reserve Chairman Alan Greenspan told a US Senate committee earlier this month.

In testimony before the Senate Foreign Relations committee, Greenspan noted that world oil markets already were strained when Hurricanes Katrina and Rita hit the US Gulf Coast late last summer and that questions remain about how much excess capacity to produce crude oil exists in the world. "No matter what the precise answer is, the buffer between supply and demand is much too small to absorb shutdowns of even a small part of the world's production," he said.

Growing threats of violence to oil fields, pipelines, storage facilities, and refineries, especially in the Middle East, have also increased private demand for oil inventories, according to Greenspan, who formed consulting firm Greenspan Associates LLC in February after serving 18 years as Fed chairman.

For most of oil's history, producers and consumers have determined its price, and only those who could physically store large quantities could trade it.

"But important advances in finance have opened the market to a large number of participants. There has been a major upsurge in over-the-counter trading of oil futures and other commodity derivatives," Greenspan said.

When it became apparent in the last 2 years that not enough money was being invested to expand production capacity relative to demand, hedge funds and other institutional investors began bidding for oil, he said. "They accumulated it in substantial net long positions in crude oil futures, largely in the over-the-counter market. These net long futures contracts, in effect, constituted a bet that oil prices would rise."

Investors' inventories
Producers and consumers still essentially own most of the world's crude oil inventories, according to Greenspan. But prices that have risen despite increases in total inventories the past few years suggest that investors hold some part of the oil in storage tanks and pipelines, he said.

A near tripling of the notional value of commodity derivatives, excluding precious metals, reported by US commercial banks during 2005's four quarters reflects financial institutions' surging participation in claims on oil inventories because most of these contracts are for oil.

"The accumulation of net long positions on the New York Mercantile Exchange by noncommercial traders, which is to say investors, has exhibited a similar pattern," he added.

Demand from investors has made crude oil prices move higher sooner than ever, with producers increasing production dramatically and consumers reducing consumption modestly in response, Greenspan said.

He said it would be unlikely that world oil markets would regain the 10 million b/d of spare capacity that they had 20 years ago because few national oil companies, aside from Saudi Aramco, are investing enough of their cash flow to convert reserves into productive capacity.

The significant proportion of oil revenues held as financial assets suggests that many governments think benefits from investing in additional production are limited, Greenspan said.

"Moreover, much oil revenue has been diverted to meet rising world oil demand. Unless these policies, political institutions, and attitudes change, it is difficult to envision a rate of reinvestment by these economies adequate to meet rising world oil demand."

Downstream concerns
World refining capacity adequacy also has become a matter of concern, according to Greenspan. It has not grown as quickly as upstream production capacity, which soon will make it what he called "the binding constraint on growth in oil use" if the trend continues.

"This may already be happening with certain grades of oil, given the growing mismatch between the heavier and more sour content of world crude oil production and the rising world demand for lighter, sweeter petroleum products," he said.

The increasing dominance of transportation fuels, which must meet increasingly stringent environmental requirements, creates a special need to add coking and desulfurization capacity.

"Yet the expansion and modernization of world refineries are lagging," Greenspan said, adding that the spread between the price of light, sweet crudes and heavier grades has widened.

He said the US economy has been able to absorb higher oil prices because deregulation and globalization the past 3 decades have made it more flexible. Current oil prices over time should reduce US petroleum dependence, and still higher prices will move consumers to hybrid vehicles and, despite their inconvenience, plug-in hybrids.

"Corn ethanol, though valuable, can play only a limited role because its ability to displace gasoline is only modest at best. But cellulosic ethanol, should it fulfill its promise, would help to wean us of our petroleum dependence, as would clean coal and nuclear power," Greenspan said. "With those developments, oil in the years ahead will remain an important element in our energy future, but it need no longer be the dominant player."