The Libyan Factor

Now that Muammar Gaddafi is about to be toppled from power in Tripoli, international oil majors are poised to stream back into Libya. Italian leader Eni S.p.A. is already rushing back field specialists this morning to assess damage even before the smoke (or the politics) clears in the capital.

The great unknown is how long it will take to ramp up production to pre-crisis levels. Anecdotal evidence is pointing in all kinds of directions. Some European analysts have already concluded it could take one or two years at some of the primary fields, while others are saying the brunt of production could be back on line within a month.

This is going to be a field-by-field approach. More to the point, the condition of pipelines, gathering and processing facilities, terminals and port facilities will be just as important as the oil fields themselves. We know that some of these were heavily damaged. And that means full export volume is not something we can expect to see resume anytime in the near-term.

The Return of Libyan Oil

As always, it makes sense to put things in perspective. The 1.2 million barrels per day that Libya provided the world market before the civil war was prized light sweet (low sulfur content) crude, the most desired oil because it requires the least amount of processing when refined into retail oil products.

The volume was replaced essentially by Saudi Aramco increasing its daily production. But Saudi oil is sour (high sulfur) crude, thereby adding to the cost of refining. The cutoff of Libyan exports also hit Europe immediately, since the vast majority of it goes directly to Western Europe for refining.

Yet, the loss of Libyan volume for the past six months cost less than 1.4% of global daily demand requirements. Getting Libya's oil production back on line is a concern, to be sure, but hardly a game changer.

This morning, as expected, Brent benchmark crude rates are down and share prices in major European oil and refinery companies are up in anticipation that the Libyan impasse is finally over.

However, it remains unclear whether AGOCO (Arabian Gulf Oil Company), the rebel oil company now poised to take over national production, has the ability to administer both raw material flow and infrastructure repairs. Western governments provided assistance during the conflict, with AGOCO personnel quietly showing up in places like London, Paris, Rome, Washington and Houston. But workshops are one thing, running an oil sector on a daily basis is quite something else.

A post-Gaddafi Libya will rely heavily on Western oil companies, especially from Europe, for guidance. AGOCO leaders this morning have already put Russian, Chinese and Brazilian companies on notice that their contracts may suffer revisions. At the same time, they made it clear that more Western European involvement would be "welcome".

This is certainly in the background as European oil shares improve today.

Brent-WTI Spread Shrinks, for Now

While Brent is moving down this morning, West Texas Intermediate (WTI)—the benchmark crude traded on the NYMEX—is moving in the other direction. As I write this, Brent is down 1.5% while WTI is up 1.9%.

This has narrowed the spread between the two somewhat, but with Brent trading at an over 30% premium to WTI price at close on Friday, the market jitters of the past two weeks had extended the differential well beyond what the underlying dynamics would justify. Despite being a better overall crude grade, WTI will not be tracking higher than Brent for some time to come.

Now the decline in Brent pricing is clearly an overreaction to the Libyan events. Without knowing when that oil flow will resume, there is no substance to a dive in price. Hardly surprising that Europe would move on psychology, however, since that is what has been driving markets on both sides of the Atlantic for some time already.

But why would London and New York move in opposite directions?

Why WTI Is Up (And Brent Is Not)

The initial reason for the U.S and UK to make opposite moves here, in my judgment, has little to do with oil and a great deal to do with how it is traded these days. It is now difficult to short oil futures in Europe, given the current ban on shorts in several major markets.

That means the European-based action that would force the price down artificially moved to New York over the past two weeks, where shorting is not only allowed but has been intensifying. In the U.S., the shorts have been resulting from perceptions of overall economic weakness.

Today's pop in the American market results from factors without much longevity. A bounce to be sure, but it isn't sustainable in the absence of anything genuinely positive.

Still, the rise is enough to require that short engineers cover their shorts and, with that action being heavier of late because of the European restrictions, we should expect the short-term rise in New York to be greater than the decline across the pond.

Indications from the weekly Energy Information Administration (EIA) oil and oil product inventory report, which comes out in two days, could show that storage levels are declining. And that may be enough to continue the U.S. rally, but a genuine rollback of recent declines awaits more positive aggregate economic news.

For now, however, New York and London are marching to the beats of different drummers. The depression of Brent prices will recede once a more complete Libyan picture emerges. And the rise in New York will encounter upward resistance unless assisted by broader positive indicators.

All of this is merely another dimension of the volatility that is the hallmark of today's market climate.

[Editor's Note: Kent just recommended three ways to play oil market volatility in his Energy Advantage portfolio. Click here to learn more about Kent's newsletter. . .and to see what he's recommending right now.]

Sincerely,

Kent