Monday, June 28, 2010

Oil Swings May Widen as Spare Capacity Shrinks: Energy Markets

By Alexander Kwiatkowski

(Bloomberg) -- Swings in oil prices may widen over the next five years as OPEC’s shrinking spare production capacity increases traders’ concern about supply shortages.

Oil’s 50-day historical volatility, a measure of how much crude fluctuates around its average price, was at 34 percent on June 25. The measure rose to a record 108 percent in January 2009 after OPEC’s spare production capacity fell to its lowest in almost four years. The group’s idled capacity may drop to 3.9 percent of world demand by 2015 from 6.8 percent this year, according to International Energy Agency estimates.

“That is a fairly significant tightening in the spare capacity cushion,” Mike Wittner, London-based head of oil market research at Societe Generale SA, said by phone. “Over and above increasing volatility, directionally it is going to push up prices.”

The Organization of Petroleum Exporting Countries has said its 6 million barrels-a-day of idled capacity is enough to meet demand and avoid a repeat of the price swings of the past two years, when oil slumped from a record $147 a barrel in July 2008 to $32 in December of that year. Crude traded this year at $64 to $88 a barrel in New York. Oil for August delivery was at $78.40 in electronic trading on the New York Mercantile Exchange, down 46 cents, at 12:18 p.m. London time.

“Concerns about a potential return to greater market volatility remain,” the Paris-based IEA, an adviser to oil- consuming nations, wrote in a report last week. “The declining trend itself, to levels below 5 percent of global demand, suggests more jittery markets ahead.”

Investors can profit from bigger price swings by trading options contracts.

Long Straddle

When volatility is expected to rise, investors may use a strategy known as a long straddle, in which they buy both a call option and a put option on the same commodity, at the same strike price. The gain is generated by how far the price of the underlying commodity moves, regardless of the direction, while their potential losses are limited to the cost of the options.

“If you have swings in the market then it is probably beneficial to the hedge-fund space,” said Pierre Montezin, a fund manager at Zurich-based Plenum Investments Ltd., part of Plenum Holdings AG which managed 761 million Swiss Francs ($693 million) in 2009. “They can be long, they can be short, they can play the curve.”

Price swings may deter pension funds and exchange-traded funds, which typically bet only on prices rising, he said.

“If there is a lot of volatility it is unsustainable to be a long-only investor, your profit and loss swing will just be too big,” Montezin said by phone.

Idle Capacity

OPEC, supplier of 40 percent of the world’s oil, pumped 29.4 million barrels a day in May, with capacity of another 5.5 million barrels idled, according to data compiled by Bloomberg. The group’s spare capacity was as low as about 2 million barrels a day in July 2008, when oil prices peaked, before tumbling as the global recession crimped energy consumption.

Spare production capacity will drop as supplies from outside the group fail to keep up with demand, according to the IEA. The agency estimates world oil usage will rise 6.4 percent by 2015 to 91.93 million barrels a day, while output, excluding OPEC crude, will increase 3.7 percent. That means the world will need more of the group’s oil to meet demand.

“There is good OPEC spare capacity today that should get whittled down as demand increases over the next few years,” Ian Taylor, chief executive officer of Vitol Group, the world’s biggest independent oil trader, said at a conference in London June 24. “The big issue is what the demand increase is going to be. Most people would feel that the market is unlikely to fall but could rise.”

New Capacity

OPEC has said new production will keep spare capacity near 6 million barrels a day through at least 2013. Group members are planning 140 oil projects over the next five years, Secretary- General Abdalla El-Badri said Feb. 1.

Saudi Arabia accounts for almost 60 percent of OPEC’s spare capacity, according to Bloomberg estimates. The country is investing as much as $30 billion on new supplies over the next five years to keep a minimum 1.5 million to 2 million barrels-a- day of spare capacity, Oil Minister Ali al-Naimi said in a May 18 interview with consultant Petroleum Policy Intelligence.

“Markets are sensitive to when OPEC spare capacity starts getting down toward 3 million barrels a day,” according to Wittner of Societe Generale. Should supplies be disrupted from a producer such as Iran or Nigeria “there would not be much left after that,” he said.

--With assistance from Grant Smith in London. Editors: Raj Rajendran, Rob Verdonck.

To contact the reporter on this story: Alexander Kwiatkowski in London at

To contact the editor responsible for this story: Stephen Voss at

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