European Affairs

Fall 2000

 

Europe and America Head for Conflicts Over Short Supplies
by Edward L. Morse

The trebling of crude oil prices to $35 a barrel in 18 months has exposed critical inadequacies in government plans for dealing with market turbulence and has bared serious potential conflicts between Europe and the United States.

The national and international mechanisms put in place in the 1970s to cope with supply problems no longer apply directly to today's petroleum markets. Those mechanisms, embodied in the International Energy Agency (IEA) in Paris, were established to prevent Europe, North America and Japan from competing with each other for oil supplies.

The IEA's emergency oil-sharing scheme was meant to ensure a fair allocation of supplies that would be adequate for all members. That would enable them to face off any individual producing nation trying to play one industrial country against another, thus potentially jeopardizing North Atlantic or Pacific Basin security.

Today's oil frictions are more complex. Unlike the more purely international energy crises of the 1970s, today's frictions derive from an interdependent trading system and from the domestic reactions to high prices and shortages.

In addition, three structural factors have become irritants in the Transatlantic arena, pitting the EU and the United States against one another in the scramble for petroleum and petroleum products. These factors have made today's petroleum and petroleum product markets far tighter than they otherwise would have been and have played a significant part in the climb of oil prices.

The three factors are: Rivalry between the world's two key marker crudes, North Sea Brent and US-West Texas Intermediate; the imposition of environmental standards by IEA governments, which have made it far harder for Europe's oil companies to provide adequate gasoline, gas oil and diesel; and the impact of consolidation in the oil industry on commercial inventories held by U.S. companies.

These are technical issues. But they could have profound effects on Transatlantic political relations.

Virtually all crude oil traded in the world is tied to the price of one of two marker crudes; Brent in Europe and West Texas Intermediate in the United States, which are traded both on futures exchanges and through spot physical or "wet" barrel markets. A lot is at stake for world exporters in the price relationship between these two crude streams. Yet significant anomalies have been emerging in the price spreads between them.

Changes in these spreads are one cause of friction between Europe and the United States. A recent lawsuit undertaken by a U.S.-based company in a U.S. court against non-American companies trading in the Brent market threatens to explode into a major economic confrontation and could result in a significant challenge to the role of Dated Brent (one of three different reference prices for Brent) as the world's premier marker crude.

At stake are prices and pricing practices, which work to the disadvantage of U.S. refiners, which at present impede the ability of the United States to import crude oil, and which amplify the escalation of global oil prices.

Since the end of the Gulf War, the average spread between WTI and Dated Brent has been a $1.26 premium for WTI. But in early 1999 the gap widened to about $2.50, pulling oil from Europe to the United States.

At other times, including August 2000, the normal relationship was reversed, with Dated Brent holding a premium over WTI, stemming European exports to the United States, as well as African exports priced on Dated Brent.

The reversal also encouraged a flow of products, including diesel fuel, heating oil and jet fuel from the United States to Europe. These extremes beyond the normal market values for WTI and Brent are causing significant controversy today.

The market is, in short, prone to be distorted by "squeezes," when one or more parties buy the lion's share of Dated Brent cargoes. In such circumstances, Dated Brent's price can become expensive vis-à-vis Brent futures as well as WTI. If simultaneously there are market distortions affecting WTI, the total global impact can be magnified.

Squeezes have become tempting as Brent production falls, and are especially tempting when the number of Brent cargoes is reduced because of field maintenance. That's what happened in August and September of this year, when Dated Brent, which normally trades as a discount to WTI, actually traded at a significant premium for a period of time.

As a result, the price of crude oil increased several dollars at a time when Saudi Arabia and other OPEC countries were adding oil to the market in an effort to damp prices. The price increase camouflaged the underlying fundamentals in the market, adding perhaps as much as three dollars a barrel to the price of oil, according to several oil analysts.

And, since it also made Brent-priced crude more expensive than WTI-linked crude streams, it shifted the normal flow of crude from West Africa and the North Sea away from its traditional market in the United States and toward Europe. It has placed a significant premium on crudes from Africa, linked to Dated Brent, for sales to India and the Far East, creating a significant amount of international friction.

Periodically companies become annoyed at the hands-off attitude of the U.K. government and EU regulators toward Brent "squeezes," believing, apparently, that it is the failure to oversee trade in Dated Brent market that creates trade distortions.

It was these circumstances that led Tosco, the largest refiner on the U.S. East Coast, to file its lawsuit this year against a trading company, Arcadia, a wholly owned subsidiary of Japanese-based Mitsui, alleging that it manipulated the market for Brent crude. Tosco also named another European trading company, Glencore, and several other unidentified parties in its lawsuit against the allegedly "monopolistic scheme."

The court documents claim that Arcadia gained a monopoly position in the Brent market in August and September by knowingly obtaining a larger number of 15-day Brent contracts than could be delivered. The lawsuit states: "By causing September Brent crude prices to spike, Arcadia's squeeze on the market caused injury to every buyer in the September Brent Index market," i.e. most of the crude oil buyers in the world.

Distortions have also unsettled trade in petroleum products across the Atlantic, just as they have affected trade in crude oil. Recent distortions in the products market also appear to give Europe more market power, pulling supplies out of North America and into Europe. Here the culprit is not pricing mechanisms but rather increasingly rigid environmental standards, the impact of which is bound to increase in the years to come.

To be sure, the underlying situation has been characterized by low inventories resulting from two years of OPEC production cutbacks beginning in 1998. Those cutbacks were intended to reduce the large stores of crude oil and petroleum products that had led prices to collapse in 1998. In terms of coverage of future consumption in a growing world economy, European and U.S. inventories of gas oil and diesel are at 25-year lows.

Normally, as crude oil supplies increase, so do refinery throughputs, and new supplies of products are manufactured to meet seasonal demand. For many years, Europe and the United States both had surpluses in refining capacity, but the pressure was on the U.S. refiners as increasingly stringent U.S. standards were met through exports from Europe.

Now the pressure is coming from the other side, with Europe unable to meet its own product needs. The result is a sort of neo-mercantilist struggle for the limited supply of products. Thus far the battle this year has been won by Europe, which has been pulling gas oil and diesel exports from the United States.

U.S. Gulf Coast refiners have found it more lucrative to export these products to Europe and Latin America (normally Europe's export market) than to ship them to the U.S. East Coast, setting the stage for a winter shortage in the United States.

Increasingly stringent Euro-pean environmental mandates on the sulfur content of gasoline and distillates are severely constraining the ability of both North American and European refiners to meet demand. One set of European standards came into force this year, with a second to follow in 2005. The timetable for the 2005 standards, however, is being accelerated. The standards, which aim to reduce sulfur content progressively from 50 parts per million to 15 ppm or lower, require massive investments of an estimated $1 billion per refinery.

There are two reactions in Europe. The first is to make the investment, which means shutting down refineries while work is in progress. As a result, a significant amount of refining capacity in Europe will be out for the next two years, limiting the availability of refined products.

The second is to eliminate refineries for which investments of this scale are not economical. Shell and BP have taken the lead in this so far. Merrill Lynch has estimated that between 14 and 17 refineries in Europe will be shut down before 2005, representing 8 to 10 percent of total European capacity. That will further exacerbate shortages, especially of diesel fuel.

Another constraint is the quality of the incremental crude oil slate available to refiners. In general, increases in supply have been "sour" crude oils, laden with sulfur, rather than "sweet" crude oil, with limited or negligible sulfur content. Europe's refineries have virtually reached the limit of their capacity to process sour crude oils according to the new sulfur specifications, meaning that they may not be able to use extra oil if it becomes available.

As a result, Europe can be expected to be short of products that meet the new standards, and, for the time being, one of the principal suppliers will be the U.S. market. The stage is being set for a potentially nasty winter squabble as free market forces draw heating oil, diesel fuel and jet fuel from the United States to Europe at a time of shortage.

This phenomenon is not well understood in the United States, given that products have historically been flowing in the other direction. If a severe heating oil shortage is to develop this winter, caused by a combination of very cold weather and low inventories, the issue of exports of needed products is likely to become highly politicized in the United States.

Over the past five years, there has been a remarkable consolidation in the global oil industry. Mega-mergers are creating a new class of private super-companies among the traditional oil majors, which are challenging the seemingly permanent dominance of state-owned companies.

Among the super-majors, European companies have come to dominate their previously more powerful and numerous U.S.-based rivals. Today three of the four largest companies in the world are European - BP, Royal Dutch/Shell, and TotalFinaElf.

Little noticed in the mega-mergers of the past few years has been the impact on minimum working inventory levels, and the growing discrepancy between corporate inventories in the United States and in Europe. The precise impact has not been measured, and most companies are reluctant to come to grips with the question of what are minimum inventory levels.

There are numerous hints, however, that the mergers are creating a more efficiently run industry, which requires less inventories. It seems clear that the bulk of this inventory reduction is taking place in the United States, while savings in Europe will be very small.

That is because the EU deals with strategic stocks by placing the burden on industry, causing refiners to carry 90 days' supply of product in their own storage tanks. In the United States, on the other hand, the federal government manages the country's strategic reserve and imposes no inventory requirements on companies, many of which have moved to "just-in-time" inventory management or lower inventory levels.

As a result, the U.S. product system is prone to logistical disruption in a way that Europe's is not. This was seen in last spring's price spikes in a number of gasoline distribution areas in the Midwest, where local inventories were very low and where transportation linkages made re-supply difficult. Europe's problems stem less from lack of inventory than from consumer revolts over high prices, which create shortages that should otherwise not have existed.

The irony is that as each side of the Atlantic has moved its separate way, the European countries, with their high consumer taxes, are by and large better protected against supply disruptions than either Canada or the United States. In North America, mergers and efficient operating arrangements have allowed refiners to maintain very low operating stocks as a general rule.

Overall, the European tendency to impose inventory requirements on companies, versus the laissez-faire attitude taken by Washington, has given European consumers significant advantages in the age of mega-mergers.

But if Europe appears to have gained a clear advantage, there will almost certainly be political ramifications this winter. How the coming conflict is to be contained will depend on how local oil product prices affect politics in the individual European countries and in the United States during this presidential election year.