Did OECD leadership, under severe pressure from a financial crisis in Europe and a newly weakening economy in the US, release government oil inventories in part to please China? Was the IEA’s release of oil reserves a swap for the loosening of China’s capital reserves? (see: Wen Says China Is a Long-Term Investor in European Debt.) Generally here at Gregor.us I avoid exactly this type of geo-political speculation. But weekend remarks from China’s Wen Jiabao that Euroland bond markets would be well supported by China comes after a dramatic move downward in Brent crude—the global grade from which the developing world makes diesel. The dumping of light sweet oil into the Gulf Coast market had its greatest price effect on Brent crude—not West Texas Intermediate—as WTI remains landlocked in Cushing, Oklahoma. Indeed, it is inescapable that OECD policy markers understood that global diesel and gasoil markets, starved for light sweet oil, would be most affected by the release. A swap, in which OECD oil reserves are offered in exchange for China’s continuing reinvestment of capital reserves, is a big win-win (temporarily) for both Western and Asian economies.
Unless, of course, it isn’t.
Because the IEA’s Nobuo Tanaka has kicked off this week reminding markets his organization can release more oil if needed—thus signalling IEA’s new plan to keep the downward pressure on oil running full tilt—we should quantify how much oil IEA/OEC controls. | From the May 2011 IEA Oil Market Report, see: Total OECD Oil Stocks–the Government Controlled Column–in millions of barrels.
Total government controlled oil stocks as of Q1 2011 amounted to 1558 million barrels. At the current release rate of 60 million barrels a month, western governments could continue this program for just over two years. The calculation also holds true for the US contribution of 30 million barrels a month from its own government reserves (SPR), which currently stands at 972.5 million barrels. But surely even the most casual observer understands such a program is not sustainable. The world cannot run on inventories.
Indeed, among the problems I articulated in last week’s post, The Dark Side of the Oil Inventory Release, is the counterintuitive result that releases of oil inventories which are intended to dampen price contain a bullish, not a bearish, signal for the oil market. Furthermore, were the IEA in conjunction with its OECD participants to continue its oil inventory dumping into Autumn, the oil markets would then have to start pricing in a new reality: lower government stocks of oil. After all, government stocks of oil are intended to mitigate disruptive, geo-political events. If the OECD were to lower its reserves by 10%, then the market would be obligated to price in new risk.
Regardless of whether China has agreed to more quickly marshal its capital reserves, in return for a temporary oil price knockdown, the current trajectory of its oil demand is largely governed by diesel, as domestic consumption roars. China’s extraordinary demand growth for diesel can be seen in various ways. Firstly, as a crunch that takes place at the crossroads of its transport and power sector, as was nicely articulated at FTAlphaville late last year. But principally, as a crunch that’s driven mainly by the heady growth in automobile and truck sales. In a post earlier this year, China Sign Post correctly noted that heavy truck sales more accurately signal China’s demand growth for oil. | From the article at China Sign Post see: Estimated additional diesel fuel demand from new heavy trucks sold in China, in million barrels per day.
So is China smiling after the stock releases, of the past few days? West Texas Intermediate crude oil is currently back at the $95 level, right where it was trading prior to last week’s action. Brent crude oil, which fell as low as $102, is also back above $110. As Dave Cohen points out in a post earlier this week, Brace Yourselves For The Next Oil Price Shock, China’s demand for oil can almost entirely be understood through the lens of diesel. And, that diesel itself is unique.
Never underestimate the role middle distillates play in driving crude oil prices. If diesel is in great demand, and clearly it will be given the Chinese scenarios laid out above, the “best” oil which provides the highest quantities of this product via the refining process is also in great demand. If there isn’t enough of it to go around, prices spike. Ethanol substitutes for gasoline. At large scales—just about anything bigger than the gas tank of Willie Nelson’s bus—nothing substitutes for diesel.
Unfortunately, it does not appear OECD nations have been successful in getting the price of oil down below $100. There remains a justifiable suspicion that Saudi Arabia cannot supply the market either with extra light sweet oil, or with extra oil of any grade, for longer than a month or two. If China and Western countries have indeed made an arrangement to swap these oil price knock-downs for support of Western sovereign debt (at the margin), China would be advised to fill its own inventories quickly when these brief, five-to-seven day discounts on oil arrive, only to disappear.
Further Reading, updated 30 June 2011:
Chinese Largesse Supports Euro, But For How Long?, The Wall Street Journal.
Enter the dragon ‘to save the euro’, The Telegraph.