David Fyfe is the Head of Market Research and Analysis at global commodity trader Gunvor and formerly Editor of the International Energy Agency’s Oil Market Report. Matt Piotrowski, Senior Reporter at The Fuse, spoke with Fyfe at Gunvor’s office in Geneva.
Piotrowski: Broadly speaking, supply and demand are moving into balance, or so the current narrative says. Is that the case? If so, why? Supply outages, lack of investment, demand growth?
Fyfe: For many months, people have been predicting that by the second half of 2016, we would stop building stocks on a net basis. That has been the narrative for some considerable time now. What has been surprising is that we’ve been having this steady stream of bullish news since February. It started with all the talk about Doha, which of course went nowhere. It then moved on to the narrative that we’ve passed the bottom of the market and a lot of speculative money came in. It has been carried on by a large amount of unscheduled stoppages on the supply side. If you look at the May peak, it looks like there were over 4 million barrels per day of global productive capacity offline for one reason or another. About 1.5 mbd of that is fairly recent. We’ve had things like the partitioned Neutral Zone off for over a year, but recently there’s been a worsening situation in Nigeria, the Canadian wildfires, lower Venezuelan output among others. And that really has sustained this fairly bullish momentum.
2016 will be the second straight year of cuts to global upstream spending, and some players are expecting further cuts in 2017 too. So there’s plenty of ammunition there for market bulls, but it’s not necessarily a one-way bet in the immediate short term.
My feeling is that the bullish shift might prove a bit premature. We do still have about 370 million bbl of OECD inventory in excess of the five-year average. That hasn’t truly started depleting yet. It may well, particularly if these outages persist, but it will take a while to clear. There is a certain bullish momentum now. And I’d certainly buy into a fairly bullish outlook medium term, but there may be bridges to cross before we move above $50 on a sustained basis. It’s always possible with this much paper money in the market that there could be a downward adjustment. I don’t think we’re going back to January-February price levels, but nonetheless we shouldn’t write off the chance that we will have a temporary correction to the downside. The basic narrative is that we’ve had 9 straight quarters of stock builds and they’re coming to an end and demand is looking strong—well in excess of 1 mbd, and potentially close to 1.5 mb/d. 2016 will be the second straight year of cuts to global upstream spending, and some players are expecting further cuts in 2017 too. So there’s plenty of ammunition there for market bulls, but it’s not necessarily a one-way bet in the immediate short term.
Gunvor was founded in 2000, right before oil prices took off last decade. How has oil trading, in both the financial and physical worlds, changed in the past 10-15 years?
Gunvor, and our main competitors, are overwhelmingly physical players. We’re in the logistics business. It’s about buying, storing, transforming, and shipping crude and other energy commodities from points of surplus to areas of deficit. That’s simplifying a bit, but a lot of people overlook the predominantly physical nature of what we do. The word trading in the physical and paper spaces can mean very different things. The value we bring to the market is our logistical expertise, our knowledge of key segments of the market, and an ability to manage price risk, both on our own account and for clients. What has happened between 2009 and 2015, the two recent high points for margins, is that traders have invested quite heavily in industrial assets. The key point to bear in mind about commodity trading is that high revenue numbers—in the hundreds of billion dollars for the major players—mask a very competitive and relatively low margin business. Typical margins may be 1 percent or less.
The key point to bear in mind about commodity trading is that high revenue numbers—in the hundreds of billion dollars for the major players—mask a very competitive and relatively low margin business.
What many traders have been doing since 2009 is investing in industrial assets such as storage, pipelines, new fleets of transportation, and in our case, refineries. We’ve bought three refineries since 2012. This is really an effort to boost volume, boost flow, and to become more international. A lot of traders who began in the 1990s or early 2000s started trading in niche markets—an individual product or an individual area of offtake. For us, it was fuel oil, gasoil and crude oil out of Russia into Europe. I think you can do that business for a certain period of time, but if you want to have longevity, you have to spread your footprint. We’ve diversified across energy products, so we’re no longer solely in fuel oil, gasoil or crude oil anymore. Now, it’s a whole slate of refined products. The balance has shifted to more refined products than crude, and we’re doing a lot more work also in natural gas. There’s also a lot of sense in expanding along the supply chain, selectively, into things like storage, terminals and processing.
When most people think of Gunvor, they think of Russia.
You need to be global unless you see yourself depending upon a single niche market forever.
We’ve diversified not only along the supply chain, but also geographically. Gunvor has always been very proud of its origins on the Russian side of the business. For a while, we also operated major assets in Russia, but recently much of that has been sold. It was a question of better matching our asset base to our more diversified international trading portfolio. Actually, in 2015, we sourced just 12 percent of our total offtake from Russia. Twelve percent is a solid number, and it may fluctuate in the future, but it used to be 100 percent. We, like the other traders, have diversified. It’s about having a sustainable business model. You need to be global unless you see yourself depending upon a single niche market forever. And you need volume. One way to access volume clearly is when you’re running a refinery, you control more volume to an extent.
What are the advantages of having assets all along the supply chain? Does that reduce risks? Is this the new model for independent traders?
That’s right, but this trend may have leveled off. There is no desire on our part to become a global refining business, and there’s no desire on our part to become a major coal supplier or oil producer. The questions we ask, and there are many deals constantly put before our M&A group, are: Will this asset benefit from our trading operations and how will it fit with the trading. Trading remains our core function. We constantly look at assets, but we’ll be highly selective.
The way a trader-refiner approaches downstream refining assets is hugely different than that of an integrated refiner marketer.
The way a trader-refiner approaches downstream refining assets is hugely different than that of an integrated refiner marketer. One of the key points is that you’re buying these assets at a fraction of replacement cost. So our attitude to the way the plant is operated is much more flexible. There is no equity crude that has to be run at max, nor an absolute necessity to run flat-out to supply a downstream retail or wholesale network. It’s more about responding to margins, and optimizing both crude sourcing and products dispatch.
Do you have term contracts or do you mostly buy in the spot market?
We do have relationships with major producers, but we by definition try to arbitrage into the refinery the most profitable barrel that we can run within the constraints of the configuration. So we’re much more selective and flexible. For example, the Rotterdam refinery that we bought this year, formerly operated by Kuwait Petroleum, used to be substantially run on Kuwaiti crude. We are not committed to that as our feedstock. We will buy what is most profitable and what is suited for the refinery’s configuration. We are not going to tie ourselves to a long-term supply contract in that sense. By the same token, we are not feeding a retail business, so we can arbitrage the refined product to wherever it is most profitable to do so. It is very clearly a merchant operation. With a relatively small portfolio of assets, we can run them in a very lean way, while selectively investing to ensure plant efficiency is maximized.
As we talked about before, the market is seeing a lot of supply disruptions now. How do disruptions affect physical traders? Is there less worry about them now than when prices were over $100? Has the mindset of traders changed in the low-price environment?
You can look at it as an opportunity. There are always arbitrage opportunities. We’ve seen this over the last 5-6 years, and particularly throughout the period of the Arab Spring. There have been opportunities for the trading companies to move in. The market lost Libyan crude, then it lost Iranian barrels. These circumstances in a sense create opportunities for the trading houses to move in and say: ‘We can provide you (the refiner) with an alternative that is suitable and close to the quality of the crude you were running previously.’ It depends on the degree of risk in that market. The market can reward you for being bold and going out there and making a move.
The flat price is immaterial to us. It’s all about spreads and arbitrage. In some ways, we benefit from lower absolute price because capital requirements are lower.
Is this less of a concern for the trading community now that prices are lower? It must be said that the flat price is immaterial to us. It’s all about spreads and arbitrage. In some ways, we benefit from lower absolute price because capital requirements are lower. But frankly, whether the price of oil is $50 or $100 doesn’t really matter to us. It’s about market structure, it’s about volatility, it’s about arbitrage opportunities.
There’s been an explosion of refined products trade around the world, with US refineries exporting more and traditional crude producers such as Saudi Arabia building export refineries. Is this an area that will continue to grow and become more competitive? How are independent traders taking advantage of this growth?
Crude is still the baseload with bigger volumes, but refined product trade is now seeing more growth. I think transportation has become more efficient, a bit more cost-competitive. There are bigger vessels that are capable of taking relatively large cargoes of refined product over longer distances. We’ve had the emergence of the Asian demand boom, even though it is easing at the moment. If you look at the last 5-6 years, supply has been growing Western Hemisphere and demand has been growing in the Eastern Hemisphere. So that has opened up opportunities. The U.S. is now exporting 4 mbd of refined products. It’s a refined product export hub, and that will likely persist. For us, last year, one of the major opportunities was moving gasoline into Asia. There’s strong demand there and a bit of an overhang in Europe. That sort of thing is relatively commonplace now that transportation economics have evolved.
The picture is constantly shifting—which is where the traders come in, to help rebalance the market.
This year the situation has changed as the Chinese independent refiners are running more crude, and exporting refined product to ease their surplus. But Indian refiners have imported more products because of power cuts. So the picture is constantly shifting—which is where the traders come in, to help rebalance the market. New Middle Eastern refineries, they are now running flat out, with extra products volumes looking for a home, arbitraging East and West.
What is OPEC’s role in today’s market? There’s a lot of talk that the group is irrelevant since it can’t put a floor under prices. But it holds 40% of the world’s global supply. How does the trading community view OPEC now?
I’d be wary of writing off OPEC entirely as an organization.
In the broader analyst community, there’s a lot of head-scratching regarding the future of OPEC. I’d be wary of writing off OPEC entirely as an organization. But what I think has been made pretty clear, both in conversations with producers and our peers in the market, there is a belief that for the foreseeable future Saudi Arabia has decided that the upside for them of removing a half million barrels per day from the market at any given time to support prices is quite limited. And without a proactive Saudi Arabia in the organization, I think it means OPEC is in limbo right now. For the time being, we have to assume that OPEC is essentially maximizing supply to the extent that it can. This does bring up interesting questions for the future not just for the organization, but also the whole dynamic of the market.
And that’s why we see articles and reports on a regular basis saying that OPEC is finished.
For now though, price is going to determine how much non-OPEC supply is viable, and that’s what we need to watch more closely – non-OPEC at least temporarily as the source of the marginal barrel.
I’m not going to say OPEC is completely finished, because we can never know what will happen in five years time. For now though, price is going to determine how much non-OPEC supply is viable, and that’s what we need to watch more closely—non-OPEC at least temporarily as the source of the marginal barrel. Even $50 is too low for sustainable upstream investment and capacity growth for many non-OPEC suppliers. Capex cuts in 2015-17 preclude major non-OPEC supply growth from the market calculus through 2020. This sows the seeds for a resurgence in prices, so the question becomes to what extent have the major producers and the service companies really managed to rationalize costs. In other words, we can have a tightening market, but does that tightening stop at $75 or $80 because long-run marginal costs are lower or not? And I think the jury is still out on that.
Will we see $100 oil again?
We are unlikely to see trend prices of $100 in the short term, but prices can always spike because of specific geopolitical events. However, I think it more likely we will oscillate medium term around something closer to $75 per barrel. I’m assuming that the IOCs and service companies have managed to implement some structural cost cutting, as opposed to purely cyclical reductions. But that’s not a universal view. There are analysts out there who say this is all cyclical, and prices have simply come down because there’s no demand for drilling rigs. When there’s demand for more services and crews, we could go higher very, very quickly. I don’t discount that possibility, but my working assumption is that there’s been some structural cost reduction worked through the system, which means we don’t revert to $100 trend levels anytime soon.