Market distortions favour fossil fuels

Fossil fuel subsidies cost governments 550 billion dollars annually according to the International Energy Agency (IEA), an independent, Paris-­based think tank. The International Monetary Fund (IMF) believes the cost of these subsidies is even higher, comprising 6.5 percent of global GDP.

Oil subsidies for consumers

Subsidies take on many forms. In Saudi Arabia, Nigeria and Venezuela – big oil ­producing countries – citizens pay prices below the cost-of-production at the petrol pump. Oil companies are paying to sell petrol in these markets. Why would they do this? International oil companies can still make a phenomenal profit exporting even just a fraction of their output and selling it at international oil prices. So they’ll agree to production contracts, in countries such as Iraq and Venezuela, where a significant proportion of output is nevertheless destined for the domestic market and sold below-cost.

State-owned oil companies, such as Saudi Aramco, do the same thing, but have a different motive. Saudi Aramco explicitly supports government policy aimed at reducing citizens’ cost-of-living. It can also easily afford to supply domestic markets with below-cost petrol by exporting the remainder.

Be aware that policies aimed at reducing the cost of petrol locally do little to encourage fuel efficiency. Furthermore, the IEA believes that only eight-percent of benefits from such subsidies flow to the poorest fifth of the world’s population.

More sagely, the Saudis also fund public projects, such as schools and infrastructure, with profits reaped from oil exports.

Oil subsidies for producers

Tax-­breaks encouraging the exploration and development of local oil reserves are another means of subsidising the oil sector – to the advantage of producers rather than consumers. In the United States, Exxon, Chevron, BP, Royal Dutch Shell and ConocoPhillips all claim tax breaks for exploration and drilling, known as “intangible drilling costs.” On average, seventy­-percent of these costs are regained within a year. [1]

Also, overseas royalty fees paid to foreign governments by US­-based oil firms can be reclaimed against their corporate income tax. Royalties are essentially the fees set by governments for foreign oil companies who wish to do business with them.

Exxon, Chevron, BP, Royal Dutch Shell and ConocoPhillips are all Fortune 500 companies and remain amongst the most profitable in the world despite the recent decline in international oil prices. Yet they’re not required to pay the full corporate tax rate as other for-­profit US companies do.

What’s more, “small,” independent US oil companies are also permitted tax breaks when the amount of oil extracted from an ageing production site starts to deplete -on top of the tax benefits described above. This is very generous given that tax is already proportionate to profit. Imagine that in 2003 my profit-take is $10 million USD. If the tax rate is 30% then I owe $3 million in taxes. If my profit-take drops to $9 million in 2004 my tax burden declines as well, down to $2.7 million. However, this additional tax-­break promises the bill drops even further. I might only owe $2 million. In this case my after-­tax profit is the same in 2003 and 2004: $7 million. Further, the majority of these “small” independents still have an average market capitalisation of two billion US dollars according to Oil Change International.

Oil companies contest that native exploration and production would not be profitable in the United States without these tax breaks. Yet, if a project is not economically viable why should the government of a market-­based society fund your commercial project? Well, there are circumstances under which this is considered appropriate. Perhaps your project serves the public good. This is why governments pay for fire stations, a police force or infrastructure like roads and electricity lines. Or maybe your project is part of the transition towards a greener and more sustainable economy? Or an attempt to curb greenhouse gas emissions?

Green subsidies for producers

Germany’s generous subsidies for renewable energies aspire to such ends. The country’s ambitious Energiewende policy, meaning energy “turn-around,” is the experiment the whole world is watching.

So far, these subsidies have had questionable success. Coal’s resurgence in Europe, along with the decommissioning of the country’s nuclear fleet, have increased Germany’s greenhouse gas emissions over the past few years.[2] Also, subsidies for renewable wind or solar farms’ installation and operating costs are passed on to the consumer. Average electricity prices in Germany have risen since 2008.

Furthermore, feed­-in tariffs that guarantee renewable energy producers a minimum price for their power, and priority to sell into the grid every day, are threatening the traditional market’s stability. Unprofitable gas and coal power plants’ operating hours are decreasing and many have had to close. This could lead to supply shortages and brown-outs or black-outs in the near future.

Finally, it has been demonstrated that early subsidies for solar panels stunted the innovation that would’ve brought commercially viable solar technologies to Europe’s markets sooner. The same technology lag effect has been observed in offshore wind.

Nevertheless, if energy subsidies exist at all surely they should favour low or zero­-carbon energies? It makes no sense for governments the world over to subsidise – to the tune of billions of dollars – the energies increasing the concentration of greenhouse gases in the atmosphere to the disadvantage of other energy sources. Current subsides for renewables comprise but a fourth of what goes to fossil fuels annually. If renewables were to receive the subsidies that fossil fuels do then the market would favour carbon­-friendly energy production over fossil fuels. It is worth making renewable energy production more profitable than it would be otherwise given the global threat of climate change. The same cannot be said for fossil fuels.


[1] References: The Atlanticthe IEA & the IMF.

[2]  This applies primarily to the electricity sector, but overall emissions did rise between 2009 and 2014. The 2008 drop is attributable to the Global Financial Crisis and economic downturn across Europe. Hopefully 2015 is the year this trend will turn-around. Take a look at this graph.

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Oil trading 101

For those of us who never studied finance or economics, terms such as hedging, futures and long position are very mysterious.  Let’s look at a basic oil trading strategy: selling the futures spread, to understand some of these terms.[i]

First of all, what is a futures contract?

If I sell a contract, to deliver 1000 barrels of oil in December 2015, I have  sold an oil futures contract.

For example, I promise to supply a customer, let’s call him Harry Potter, with 1000 barrels of oil in December. Harry pays this December price to secure his supply and I lock in a comfortable price. Why would Harry do that? If the December futures price is currently $50 Harry probably believes that, come December, the real oil price will have changed. If it turns out to really be $70 (multiplied by 1000 barrels!) then Harry has won. He paid his supplier – me – much less then he would have paid if he had waited until December.

$70 – the actual price of oil in December – is called the December “spot” price.

On the other hand, if it turns out the December spot price falls to $45 then the supplier made the better deal. I wait until December to buy 1000 barrels of oil at $45 each. I supply these barrels to grumpy Harry who already paid me $5 more per barrel and rather thought he had made a good deal back in March.

Oil future prices emerge because different players have different expectations about how oil prices will evolve.

Current market conditions

The oil futures market  is currently in deep contango. What does this mean? Contango means traders expect the price of a barrel of oil to be higher in the future than it is today. Deep contango means this price will be a lot higher. Yet, as we just saw above, when delivery day arrives the spot market might tell another story.

As a trader I need to make a prediction about what will happen over the next few months

For example:

  • Oil storage facilities are near capacity in Europe and essentially full in the US. Storage is becoming inaccessible.
  • Today’s spot prices are at a historic low. I might think they are likely to drop further, since producers cannot store oil to sell later and will be forced to dump their supplies somewhere.
  • Many producers are becoming unprofitable. Investment in new oil production projects is being put on hold because prices around $40-$50/barrel are not enough to cover production costs.
  • If there are few new projects to replace current production then oil supplies will eventually tighten and prices will increase. But not for at least a year or two. Identifying this lag is crucial.

This means the contango will deepen.

Based on the above predictions, I would expect the futures spread to widen. That is, the difference between the spot and future price of oil will get much bigger.[ii] Why?

To reiterate: spot prices will decrease as we have a situation of oversupply that is likely worsen when oil storage facilities run out. Then the oil futures price will increase, relative to spot, since the market is not expected to tighten for one or two years. This pattern should hold for some months.

My trading strategy, based on these expectations, is to sell the futures spread.[iii]

Selling the futures spread means I sell a futures contract for a near month  and buy a futures contract a far month. This will be profitable if I am right about the contango spread increasing.

For example:

It is March 2015.

SELL TIME SPREAD:

  • Sell April oil futures contract @ $48.13
  • Buy May oil futures contract @ $49.13
  • The spread is -$1 per contract.

It is now April 2015 and I need to offset my position.

BUY TIME SPREAD:

  • Buy April WTI spot contract @ $47.13
  • Sell May WTI futures contract @ $51.13
  • The spread is now -$4 per contract.

Intuitively -4.00 < -1.00

So I sold something at a higher price than I bought it back for. Profit!

My total profit is: (-1) – (-4) = $3 x 1000 contracts = $3000

A helpful guideline:

Which trading strategy to use?   Contango time spread (normal market) Backwardated time spread  (inverted market)
Expect the spread to widen Sell spread Buy spread
Expect the spread to narrow Buy spread Sell spread

Selling the spread:  short the near futures position and long the far futures position.

Buying the spread: long the near futures position and short the far futures position.


[i] Please be aware that this example is pure fiction and the author takes no responsibility for losses or gains made by anyone trading oil futures based on the above-described strategy.

[ii] It does not really matter what the price level is per se. So it’s not helpful to say “prices will go up.” Relative to what?

[iii] Short = sell, long = buy. These terms do not have anything to do with time-frames!

Oil prices not too low for Saudi Arabia

My last post explained why international oil prices have fallen dramatically during the last six months. This has harmed the profitability of many oil producers.

International oil traders and producing companies have called on the Organisation of Petroleum Exporting Countries (OPEC) to react to the fall in oil prices. Saudi Arabia is the biggest producing country within OPEC and often represents the group. But what can the Saudis do?

For a long time Saudi Arabia was the world’s largest oil producer. The shale oil revolution changed this. Last year, we saw the US overtake both Saudi Arabia and Russia – the other big player – to become the world’s largest oil producer. Nevertheless, the US consumes a lot of what it produces. Saudi Arabia is still the world’s biggest exporter. Moreover, its vast reserves and production capacity allow it to “swing” supplies. That is, quickly alter the volume of oil it puts into the international market. In a nutshell, decreasing copious OPEC supplies would alleviate the international supply-glut and boost the international oil price.

To do this OPEC must accept a decrease in total sales volumes and a smaller market share. The burden of cutting back volumes falls predominantly on Saudi Arabia as OPEC’s biggest producer. Saudi Arabia has had experience in the past with cutting supplies whilst other OPEC members “free ride.” Meaning they benefit from an increase in prices without decreasing their sales volumes as agreed.[1]

International producers are effectively asking Saudi Arabia to do them the same favour. Just why would it do so in a competitive market?

For the moment Saudi Arabia has indeed refused to offer anyone any favours. What’s more getting oil out of the ground is very cheap in Saudi Arabia. Its oil wells have some of the lowest “lifting” or production costs in the world. This is what the graph below shows us:

BEP - IEA graph

The ultra-polluting Canadian tar sands projects are well out-of-the-money at oil prices of $50/barrel, since it costs $85 to produce a barrel of oil.[2]

The graph also shows us that Saudi Arabia can remain profitable close to $20/barrel. It could let current prices keep falling without sacrificing market share. Today’s oil price is less of a problem for Saudi Arabia than other countries where lifting costs are higher.

Yet, it is unlikely Saudi Arabia will let prices fall that far. Profits from oil sales directly support the Saudi government’s budget. Also, higher prices eventually become more important than sales volumes as profit margins tighten. For example, if I sell ten barrels at $100 each this is the same as selling a hundred at $10 each. Except that if it cost me $9 to produce each barrel my total profit is $910 in the first scenario and only $100 in the second scenario.

For now Saudi Arabia appears content to keep the price low and wait for US shale oil producers with thinning profit margins to leave the market. This strategy will cause the US shale oil revolution to lose pace and protect Saudi Arabia’s market share in the long term. However, we might see OPEC revise their policy later in 2015.


[1] It’s hard to measure exact output and countries report their own production volumes.

[2] I’ll write about the economic feasibility of the tar sands projects soon.

Why is oil suddenly so cheap?

Between 1998 and 2008 the price of oil increased ten-fold. Everyone was talking about peak oil – the idea that production would plateau and demand for oil would outstrip supply. Skyrocketing prices would force us to replace what we put in our cars. In 2008 prices broke the $100/barrel ceiling – and then kept climbing.

What does it mean to say oil is $100 per barrel? When we talk about dollars we mean American dollars. Barrels are just a standard measure of volume (159 litres). The price of oil refers to a benchmark – a reference price. In the United States this is West Texas Intermediate (WTI), which is a blend of crude oils from diverse suppliers, which mingle at a physical hub in Cushing, Oklahoma. In Europe the benchmark is called Brent – a blend of North Sea produced crude oils. For a crude to become a benchmark there must be enough suppliers and enough barrels that the supply, and therefore the price, cannot be controlled by one player.

Crude oil needs to be processed and refined to produce the more valuable products, such as gasoline or jet fuel, that industry and consumers can actually use. So it is refineries that buy crude oil from producers. However refiners don’t all buy WTI. There are many different varieties of crude oil. An oil producer will mark up or mark down their crude oil relative to a reference price. This is why we call WTI and Brent benchmarks.

What determines this mark up or mark down? The quality of your oil. Oil can be light or heavy – a lighter, less viscous crude produces more of the more valuable petroleum products such as gasoline during the refining process. Oils are also classified as sweet or sour, which refers to the sulphur content. Sulphur is a pollutant which must be removed during refining. This is expensive to do. So the more sour your oil the more pricey the sulphur-removal process.

Oil producers are in the game to turn a profit.The WTI price affects your profitability as a producer.  For example, let’s say WTI is $100/barrel. If it costs you $70/barrel to extract crude oil from a well and you are selling it at a $20 discount to WTI then your profit per barrel is $10/barrel. (That’s a huge win.)

However, if the international price of oil – the WTI benchmark – falls $10 then you lose your profit margin.

A few years after WTI hit $100/barrel (and then went higher) it suddenly fell to $50. Multiply that by the millions of barrels being bought and sold and you can imagine there were some pretty big winners and losers. That’s the situation we have today. But why?

In less than one hundred and fifty words:

1. Since 2008 Europe underwent a recession which dampened demand for oil as economic growth dwindled and consumer spending dropped.

2. The United States is the world’s biggest oil consumer and used to drive global demand. However, over the past few years an energy revolution no one predicted took place in the US. As shale gas “frackers” began producing natural gas and pumping it into the regional pipeline networks, associated shale oil was also being produced. The best fields are called “wet” since they produce oil as well as gas, oil being more valuable. So within a few years the US went from being a huge importer to near self-sufficiency in crude oil production.

3. This meant that global oil markets were dramatically over-supplied. The supply glut happened because two of the biggest markets – Europe and the US – simply weren’t as hungry for crude oil anymore.

These days we actually talk about peak demand for oil. Technology and extraction processes get better every year, so it’s likely we will be able to produce oil for many years to come. However, production will become more expensive and, as environmental pressures weigh in, oil will become pricey enough that consumers and governments look for replacements. Even if that means buying an electric car or investing heavily in public transport.

Peak demand didn’t happen when prices skyrocketed in 2008. It might yet. Or it’s possible that demand for oil is dropping away. The international price will wane if other energy sources or energy efficiency measures become more competitive and attractive. We will have to wait and see if oil demand recovers in Europe or if Asia’s growth fills the gap.