Middle East Oil Troubles Could Lead To Lower Prices

Prices for crude oil fell below $74/b this morning as crude oil continues wobbling downward after hitting a high of around $87/b in early May. Conflicting signals from the Middle East contribute to the uncertainty of which direction oil prices will head.

In May, OPEC rose to a 17-month high as the cartel produced 29.372 million b/d. That amount is 2.197 million b/d above the cartel’s self-imposed quotas on production. The official production quota, adopted in January 2009 is 24.845 million b/d. In May, every OPEC country exceeded its quota.

The largest increase came from Nigeria, which grew by 60,000 b/d, and now exceeds its quota by more than 400,000 b/d. The relative calm in Nigeria has allowed the country to grow its production, but it doesn’t have much effect on the overall crude market because Nigerian production is so volatile all the time.

OPEC production grew to take advantage of the higher prices of early May, and high production is likely to continue as long as prices don’t collapse entirely.

Greed aside, another reason OPEC production could continue to grow is that floating oil storage is declining rapidly. Danish shipping company A.P. Moller-Maersk estimates that there are about 25 VLCC tankers, each of which holds about 2 million barrels of oil, being used for floating storage. That is about half the number of VLCCs being used for a similar purpose a year ago.

The decline in floating storage is a result of an easing of the crude market’s contango, a position where the price of oil for prompt delivery is lower than the price of future delivery. As the prompt and future prices converge, it becomes too expensive to store oil on a tanker.

On of the biggest users of floating storage is Iran, which Maersk estimates is storing oil on 20 of the 25 tankers. That’s not highly unusual because Iran’s lack of refining capability coupled with its limited on-shore storage and its 3.7 million b/d production capacity means the country has to put the black stuff somewhere.

Iran has raised its price for some varieties of crude to keep the dollars flowing in. The country’s oil competes with Russian crude, which is priced lower than Iranian crude. Certain Asian buyers prefer Iranian oil, but the price differential has been too great to ignore.

Iran has cut the differential between its heavy crude benchmark and some other crudes by about half to move product and get it out of floating storage. But in the face of what is expected to be an oversupplied global market for the rest of 2010, Iran is feeling the pressure to drop prices even more to keep the funds rolling in.

Iran’s national budget is based on an oil price of $65/b. Because Iranian crude trades at a discount of $7-$10/b to the Nymex WTI price, when WTI is trading at $74/b, Iranian crude is trading at about $64-$67/b. If crude prices keep falling, Iranian crude could go to $60/b or less. The country was selling its crude for about $80/barrel at the high point of the market in early May.

The weak global economic recovery, particularly in Europe makes the problem worse for Iran. The sanctions against Iran are also having an effect on potential buyers. To gain back those buyers, Iran will have to lower prices, but then it won’t make any money.

The flattening of the contango curve, the decrease in floating storage, and the increasing price pressure on the world’s fourth-largest exporter of crude point to lower crude prices for the rest of this year. The weak recovery just gives crude prices a further nudge downward.

Paul Ausick