Southern Limits

There is much talk in the media about “oil prices” especially when it begins to hurt consumers at the fuel pump. Prices are sometimes referred to as  Brent crude or West Texas Intermediate (WTI) or sometimes just as oil. So what does this all mean and what are the differences?

Brent crude is sweet light oil sourced from fifteen fields in the North Sea. “Sweet” refers to the sulphur content. The lower the sulphur content the easier it is to refine. “Light” refers to the ability of the oil to flow freely which makes it easier to transport and refine. In comparison oil from the Alberta tar sands is considered to be heavy as it is transported as diluted bitumen (dilbit) and is much more difficult to refine.  WTI is lighter and sweeter than Brent with a sulphur content of 0.24% compared to 0.37%. WTI is sourced from around North America and priced from the trading hub of Cushing, Oklahoma.

Figure 1: Monthly ratio of the nominal price of Crude Oil (petroleum); Dated Brent divided by the price of West Texas Intermediate. From Indexmundi.

Historically Brent prices lagged behind WTI until Brent began selling for more than WTI in the early 2000s for the first time. Since then Brent has gradually pulled away from WTI and was trading at a US$17.81 premium at the time of writing.

Goldman Sachs expects WTI to close the gap with Brent in the near future as shipments into Cushing slow, decreasing supply. This does not bode well for global oil prices with Goldman Sachs also predicting that Brent will reach US$120 in the next three months due to field maintenance in the North Sea and European market optimism.

Traditionally WTI has been used as the international benchmark for oil prices but over the last few years Brent has overtaken WTI in importance. This is backed by a 2007 report from the now defunct Lehman Brothers that WTI was no longer a gauge for the international oil market. As Cushing is landlocked it is restricted by pipeline capacity which has led to an supply glut over the past few years. WTI is not traded in any significant quantity outside North America.

Steve Austin at OilPrice.com: “Brent is the real international benchmark.Two-thirds of the oil consumed in the US is Brent, and two-thirds of international crude is priced to it. Still the media and market persist in quoting WTI, rather. This is a US singularity, like the non-adoption of the metric system.”

Figure 2: Oil production from the North Sea, based on EIA data. From Our Finite World.

North Sea oil production peaked in 1999. Even with record high oil prices since 2007 production has not been turned around. Oil companies have been in dispute with the British government over tax rates since 2011, responding by cutting production by 18% which lead to a £2.3bn drop in tax revenues. Since a government u-turn on the tax arrangement, investment in the North Sea is expected to increase from £8.5bn last year to £11.5bn this year.

This decreased output from the North Sea has raised grumblings that Brent is no longer a true indicator of global supply and demand either. But there is currently no viable alternative and so it looks as though Brent is set to stay as the global benchmark for sometime to come.

I have a joke with a friend of mine that airline pilots are nothing but glorified bus drivers. As cynical as this may be, for the majority of us with regular jobs who fly economy air travel is increasingly becoming like its land-based cousin: cramped, overcrowded and at times downright unpleasant.

Most people living in our modern industrial society take air travel for granted. We think very little about hopping on a plane and travelling around the world for little more than a couple of weeks wages. As jet fuel prices bounce along with the price of crude however many airlines are increasingly struggling to break even. Fuel prices now account for 35 percent of operating costs compared to 15 percent a decade ago. Air travel has always been a fickle business, earning an average net profit of one to two percent, compared with an average of over five percent for U.S. industry as a whole. Research from the 1980s found that some carriers would have zero profitability if they had lost just one out of ten business passengers. 

So how does the future look for the airline industry? If recent trends are anything to go by, not good. Not good at all.

Plane Trends

Airlines have increasingly been moving towards smaller aircraft despite the popularity of the “Superjumbo” Airbus A380 since its release in 2007. Airbus has sold 253 A380s while Boeing has orders for 106 747-8s with the large majority of these being used for cargo operations. Richard Aboulafia from Teal Group,  an Aerospace and Defense Market Analysis company believes that smaller, sleeker aircraft are the future of international air travel ““The market for large aircraft in general is disappearing fast. Most of the 747-8 planes are cargo. There’s just a limited market.”

Packed Like Sardines

In an effort to increase profits from each flight a number of airline companies are trying to fit more passengers onto each plane. The sale of an extra one or two seats can mean the difference between breaking even and a loss. While standing room only flights appear to be nothing other than a cheap marketing ploy companies have reduced the seat width in order to fit an extra seat in each row.

Air New Zealand recently replaced its older 747s with a significantly narrower 777-300ER. To accommodate the same 3-4-3 seat configuration the new seats are one inch narrower and the aisle has decreased in size as well. Air New Zealand was named the most innovative airline in the world last year Airlinetrends.com and so it is likely that other airline companies will follow suit.

In 2010 an Italian company, Avio Interiors,  introduced the world to its “Skyrider” saddle-style seat. Intended for up to four hour long flights the passenger sits at an angle with 23 inches of legroom (compared with 30 inches on a standard configuration) allowing more passengers per flight. Two years later no airlines have yet committed to the Skyrider seating but as fuel prices continue to rise one has to wonder how long it will take before it is seriously considered.  

At the other end of the spectrum some airlines have introduced what has colloquially been termed “chub class.” In an effort to accommodate the expanding waistline of Western flyers  Airbus is increasing the size of aisle seats to 20 inches wide on its A320 jets while decreasing middle and window seats by one inch. The premium wide seat will be sold at for an extra US$10.

Weight Reduction

Scoot Airlines, based out of Singapore has recently removed television monitors from airplane seats replacing them with Apple iPads. The television monitors and associated electronics are reported to weigh two metric tonnes.  According to Bloomberg this has enabled the airline to add 40 percent more seating while decreasing the weight of a fully loaded flight by seven percent. 

Extra Charges Everywhere

Traditionally the most successful airlines traded on glamour and providing a service experience. Recent trends however show that airlines are increasingly moving towards a no-frills approach in an effort to cut expenses. To do this airlines are  imposing costs on everything possible under the thin veil of “increased consumer choice.” Changes seen over the last few years include the removal of a complimentary item of check-in luggage, the removal of complimentary meals and extra charges for window seats and seats towards the front of the plane. The iPads on Scoot flights mentioned above will cost US$17 to hire for the flight.

Recommendations from a 2005 study suggest that a low-cost strategy should no longer be considered an exception but should rather become the norm for the airline industry. We can see this recommendation playing out today with the stripping of services from flights shifting to an almost purely user pays model.

Case Study: The Air New Zealand Situation

A good example of this new user pays model is Air New Zealand. In 2010 they changed to single class short haul flights with radically rebundled fares. Travellers can now choose from one of four options beginning with a seat, one 7kg carry-on bag, tea, coffee and water and access to some entertainment options but no new release entertainment. At the other end they have the ‘Works Deluxe’ which allows two priority bags, a carry-on bag, meal and drinks, a seat request, a guaranteed empty seat next to the passenger, premium check in, lounge access and better entertainment options.

Being the most innovative airline company does not necessarily make you the most profitable. Air New Zealand announced a 71 percent earning slump in February 2012. As part of its recovery plan the company announced it was cutting 441 jobs. The airline blamed a decrease in passenger numbers as well as as fuel costs NZ$173 million more than forecast. This is despite the airline enjoying “a solid performance from the domestic network including benefits from the Rugby World Cup and improved market share on the Tasman” according to Air New Zealand chairman, John Palmer.

The outgoing chief executive Rob Fyfe says the price of jet fuel has doubled over the last three years and due to the weak global economy it has been difficult to pass on the higher costs to passengers.The inflation adjusted average price of jet fuel was US$3.04 per gallon for the six months to December 31st. Going off jet fuel prices alone it is unlikely the airline will see much of a turn around in profitability for 2012. In the first six months of 2012  the average price barely moved, up US$0.04 to $US3.08.

The full year earnings are not released until the end of August but the few media releases coming out of Air New Zealand the last few months are beginning to sound increasingly desperate. On 19th July 2012 Fyfe and Palmer called for an “urgent review” of New Zealand tourism. Palmer told Parliament's finance and expenditure committee that despite operational improvements (newspeak for job cuts), Air New Zealand's financial performance was not healthy and decreased expenditure was yet to be reflected in its currently "disappointing" share price.

Air New Zealand is looking to focus on its domestic, Australian and Pacific service as these have been the most economically sustainable. According to Fyfe, "An aircraft flying to London and back, a 777-300, it costs $1.25 million to get that aircraft to London and back and over 50% of the cost of fuel, a 737 flying to Auckland - Wellington about 23% of the cost is fuel."

The Global Situation

Globally the situation does not look much better. Some Middle Eastern airlines and Asian carriers are still recording strong growth but they are the exception. The International Air Transport Association (IATA)  revised the Middle Eastern profit forecast in March 2012 from USD300 million to USD500 million assuming jet fuel prices stay stable.  A spike in oil prices could however could turn the forecast profit into a USD200 million loss for the region’s airlines. According to the IATA  average oil prices could reach as high as US$135 per barrel this year in the unlikely event of Iran closing the Strait of Hormuz. Oil prices this high would create a US$5.3billion loss for the global aviation industry.   

U.S. airline profits have historically followed a cyclical profit-loss pattern of three to five years since U.S. deregulation in 1978. Profit margins have always been thin, sitting at 1.6% during the 1980s and only 1.0% for the period between 1990 and 2000. The early 2000s however saw economic downturn accompanied by huge industry-wide losses of $7 billion in 2001, $7.5 billion in 2002, and $5.3 billion in 2003. The impact of 9/11 and the associated changes to the way airlines run as well as the Dot-com crash cannot be denied either. Between 2000 and 2005 the industry plunged into record operating losses of $40 billion in total.

Figure 1: World economic growth and airline profit margins: 1970 to 2011. Source: IATA Financial Monitor for Jan/Feb-2012 released on 01-Mar-2012, sourcing IATA, ICAO & Haver.

Figure 1 clearly illustrates the cyclical nature of the airline industry. Whenever world GDP growth drops below two percent this is reflected by the net post-tax profit margin turning negative.

The director general and CEO of IATA, Tony Tyler, has cautioned that global GDP is not expected to pass two percent in 2012. “The risk of a worsening Eurozone crisis has been replaced by an equally toxic risk – rising oil prices. Already the damage is being felt with a downgrade in industry profits to $3.0 billion… With GDP growth projections now at 2.0%...it will not take much of a shock to push the industry into the red for 2012,” Mr Tyler said.  

Rising fuel costs have taken a massive chunk out of the airline industries profit margins. The cost of jet fuel closely maps that of crude oil prices. This means that when prices are high at the local pump the airline companies are also hurting.

The IATA has forecast the airline 2012 fuel bill is expected to be $US213 billion, equivalent to 34 percent of total operating costs. The IATA fuel price average for 2012 is currently $US128.6 per barrel which is estimated to add an extra $US31billion onto the forecast 2012 jet fuel bill.

These IATA forecasts illustrate the fragility of the airline industry. Profitability is an elusive prospect for the industry with the IATA commenting  that  “the best collective margin of the last decade of 2.9% (2007 and 2010) does not cover the cost of capital”. Cargo traffic around the globe declined 1.9 percent in May 2012 compared to May last year. Cargo traffic generated US$66 billion in 2010 but has declined every month since May 2011. “Business and consumer confidence are falling,” Tyler said. “And we are seeing the first signs of that in slowing demand and softer load factors. This does not bode well for industry profitability.”

Dirty Air

If airlines are struggling this much with the current economic conditions it is almost certain that a globally unified approach to carbon taxing would cripple the industry. A report from 2008 found that airlines were emitting 20 percent more carbon dioxide than previously estimated. This could grow to 1.5 billion tons a year by 2025, far more that the worst cast IPCC predictions. As a comparison the entire European Union currently emits 3.1 billion tons of CO2 annually. This emission prediction does assume that oil prices will stay relatively low and that economic growth gets back on track, two assumptions that are looking increasingly unlikely.

Travel While You Can

Environmental concerns aside if you want to travel anywhere in the next five years now is the time to do it. The global economy is extremely fragile at the moment. Petroleum deliveries are at their lowest point since September 2008, with the weakest July demand since 2005 and yet Brent crude prices are still sitting above $US116 per barrel. This is not to mention the impending US “fiscal cliff” where $600bn in tax increases and spending cuts come into effect on January 1, 2013. Unless the US Congress  comes to some kind of agreement on raising the debt ceiling again by the end of this year GDP growth could be reduced by four percent, plunging the US into recession. Europe is cannot escape its current quaqmire without huge upheaval and there is now talk that France will be the next to crumble leaving Germany on its own. China’s growth has slowed to a three year low of 7.6 per cent with little sign of recovery in the next few months.  

This is all bad news for airlines that are already combatting high fuel prices. I expect to see a number of big name airlines fold or amalgamate in the next two years as financiers can no longer afford to prop up an industry that is hemorrhaging with no relief in sight. This could mean a reduced number of flights, less options of places to travel and skyrocketing ticket prices. While mother nature might thank us for the reduction in emissions the airline industry is running on empty. 

It was kindly pointed out to me last week by erich, a commenter on my article at Energy Bulletin that the data set I had used had not been adjusted for inflation. I had originally argued that it shouldn’t make much difference. I thought that as I was dealing with the price changes within a year and as the ANOVA treats each year as a separate group the effect of inflation would be negligible. However after thinking about it for a while I decided it would be worthwhile to run the inflation adjusted numbers to remove any doubt on the conclusions I had drawn from the original data set. Using this consumer price index (CPI) information I adjusted my original data set to 2010 dollars and reran the ANOVA.

Figure 1: Statistically significant Bonferroni-Holm test results looking at the difference between years in the monthly change in price for crude oil (US dollars per barrel), simple average of three spot prices; Dated Brent, West Texas Intermediate, and the Dubai Fateh, August 1982-June 2012. Data from http://www.indexmundi.com/commodities/?commodity=crude-oil

Figure 1 shows there were less results rejecting the null hypothesis, 32 compared to 59 in the unadjusted data which goes to prove erich’s point that at least some of the effect I was seeing was due to inflation. I feel somewhat vindicated at the same time that my original conclusions still stand. As erich said in his comments after I shared the new results “Adjusting prices for inflation makes your analysis and conclusions more robust and defensible” and so I thank erich for first raising the issue in a polite and encouraging manner.

I also tracked down some more oil price data sets that I hadn’t come across before and I was excited to see if my hypothesis, that oil volatility has significantly increased since conventional oil production plateaued in 2005, could be replicated.

This morning I came across an article on the 2012 United States Presidential “Energy Election” at a blog called Con Carlitos, written by Calvin Sloan. He had an interesting footnote which explained something I had not quite grasped and I will quote here in full:

As noted by Steve Austin at OilPrice.com: “Brent is the real international benchmark.Two-thirds of the oil consumed in the US is Brent, and two-thirds of international crude is priced to it. (Brent crude is sourced from fifteen oil fields in the North Sea.) Still the media and market persist in quoting WTI, rather. This is a US singularity, like the non-adoption of the metric system.”

Due to this I decided to look specifically at Brent crude prices as the strongest conclusions can be made from that data. I looked at both monthly and weekly Brent Crude prices between May 1987 and June 2012. Using average annual CPI data from the U.S. Bureau of Labor Statistics I adjusted the monthly and weekly Brent crude prices to 2012 dollars .

The monthly data returned only four results rejecting the null hypothesis. 2008 was significantly different to 1993, 1994 and 1995 and 2011 was significantly different to 1995. I was surprised this result was so low and intrigued to see if the weekly data was any different.

Figure 2: Statistically significant Bonferroni-Holm test results for weekly Brent crude prices May 1987 to June 2012.

It would appear from Figure 2 that the monthly effect was largely masking the difference in Brent price volatility between years. When looked at on a weekly level we see that 76% of the statistically significant results occur after the 2005 production plateau.

It can be concluded  that while oil prices may be highly volatile on a week to week basis the effect is reduced on a monthly basis. We can also conclude that post 2005 we have seen a marked increase in weekly oil price volatility. The first six months of 2012 data is the fourth (equal with 2010) most volatile year for oil prices in the last twenty-five years behind only 2011, 2009 and 2008. The data from July and August  2012 was not included in this data set but it is my guess they would push 2012 further up the ranks. It is even possible by the end of the year that 2012 could be the second most volatile year after 2008. I for one will be watching oil prices over the next few months with great interest to see if the great yo-yoing continues.

One of the many hypotheses put forward by peak oil theorists is that as the production of conventional oil peaks we will see increasing volatility in oil markets. The basic reason for this is that oil is the fundamental energy resource on which our modern industrial society runs. Economies begin to falter under the pressure of high oil prices as they can no longer sustain growth and so demand for oil falls. As demand falls, so does the price of oil which eventually reaches a level that is conducive to economic growth. Demand increases again followed by the price of oil and the cycle repeats ad infinitum. That is of course until you throw a proverbial spanner in the works in the form of restrictions on the supply side. Historically the most influential spanner has been unrest in the Middle East. However we are increasingly seeing the impact of another much larger and altogether much more catastrophic spanner: the peak production of conventional oil.

Just look at how much more volatile prices have become over the last 30 years:

Figure 1: Monthly change in price for crude oil (US dollars per barrel), simple average of three spot prices; Dated Brent, West Texas Intermediate, and the Dubai Fateh, August 1982-June 2012. Data from http://www.indexmundi.com/commodities/?commodity=crude-oil

Figure 2: Standard deviation of the monthly price change for crude oil (US dollars per barrel), simple average of three spot prices; Dated Brent, West Texas Intermediate, and the Dubai Fateh, August 1982-June 2012. The standard deviation provides a numerical measure of the overall amount of variation from the mean in a data set.

Figure 1 and 2 clearly show that something has been happening to oil prices since perhaps the early 2000s. Visually large changes before that can be attributed to the oil price bubble bursting in 1985 due in part to a massive increase in rig counts, the 1990 Iraq War and the Dot-com bubble beginning in 2000. Some of this variation post 2000 can be attributed to the American invasion of Afghanistan and Iraq (2001 and 2003 respectively), the global financial crisis of 2008, the Arab Spring beginning in December 2010 and the current Syrian crisis. But this doesn’t explain the whole story either. We are in a new era where oil prices are unprecedentedly being affected by production constraints. Figure 2 shows that since 2005 the data values are more spread out from the mean, exhibiting more variation than any other time over the last thirty years except for the 1990 Iraq War. Coincidentally 2005 is also the year when global conventional oil production tailed off: rising only 0.5 per cent between 2005 and 2011.

Up until this point it has been a somewhat subjective analysis. No hard statistics have been carried out. I wanted to see just how different the volatility in prices post 2000 were compared to the rest of the data set. For those of you not interested in the mathematic side of things you can skip this part and go right to the results. But in the spirit of academic openness I would like to explain my methodology. 

Methodology (The Sciencey Stuff)

The data used to create Figure 1 was split into annual groups 1983,1984 etc and converted into their absolute value so that all numbers were positive. Because the monthly oil price change between years was being compared it didn’t matter if the change was positive or negative, just that it changed. A one way ANOVA test was used to determine if there were significant differences between groups of data (i.e. each year). Due to carrying out an ANOVA test  the ratio of the smallest to largest standard deviation could be no more than two (clearly not true from Figure 2), so the figures were transformed to log10. This also ensured that the data followed a normal distribution. The data point from May 2007 was removed as that figure was 0 (i.e no change in oil price from the month before) and could not be calculated to log10.

Using Daniel’s XL Toolbox plugin for Microsoft Excel the ANOVA test was calculated along with a post-hoc Bonferroni-Holm test. Post-hoc tests are carried out in order to find patterns or relationships between subgroups of a data set and the Bonferroni-Holm test is generally known as the most conservative of all post-hoc tests. In this case the relationship being determined was whether or not the change in oil price within one year was significantly different than any other year.

The null hypothesis is that there is no significant difference in monthly oil price change between years. The alternative hypothesis is that there is a significant difference in monthly oil price change between at least two years. 

Results (The Interesting Stuff)

Just a couple of scientific results before we get to what we are really after. The F-value for the above ANOVA is 6.991 and the p-value is 3.02E-21. Because the p-value is less than 0.05 we can reject the null hypothesis and be certain that there is a significant difference in monthly oil price change between at least two years, possibly more. But which years exactly? This is where the Bonferroni-Holm test comes in.

Figure 3: Statistically significant Bonferroni-Holm test results.

Figure 3 shows the how the only statistically significant differences in monthly oil price changes between years occurred after 2005. In other words between August 1982 and  December 2004 prices rose and fell relatively benignly compared to what happened after 2005. We can see intuitively in Figure 1 what we are told statistically in Figure 3. The mid to late 80s and 90s saw little volatility in oil prices bar the 1990 Iraq War and stayed relatively calm right up until the 2003 Invasion of Iraq. Oil prices haven’t stopped see-sawing since with the first statistically significant difference seen in 2005.

This is only one data point however and we don’t see any grouping of statistically significant volatility until 2007 when the global economy began getting the jitters with concerns surrounding the US housing bubble. The next two years were havoc on the oil markets as prices bounced up and down trying to find some sort of equilibrium. 2010 and 2011 saw a period of calm as the the economy finally readjusted. All was not well though as oil prices this year have so far been the fourth most volatile in the last thirty years.

Conclusion

With the production of oil from conventional sources almost stalling since 2005, concerns about the collapse of the Euro zone still very real and the unknown outcome of the Syrian civil war we are living once again in very uncertain times. This is reflected in the volatility of oil prices so far in 2012. At the time of writing West Texas Intermediate crude was at US$93.25 and Brent crude was at US$112.00. So far this year WTI has fluctuated between $80 and $110 per barrel and Brent between $90 and $123 per barrel. Price fluctuations like this are a double whammy of bad omens. They are neither a sign of healthy economy nor conducive to growing an economy.  

I am not the first person to point this out. Shiu-Sheng Chen and Kai-Wei Hsu from the National Taiwan University published a paper this year in the journal Energy Economics that showed how trade between countries decreases when there is high oil price volatility. Gregor MacDonald over at Chris Martenson’s Peak Prosperity has an article on how oil price volatility kills economic recovery. John Timmer at Arstechnica discusses the implications of the paper by the University of Washington's James Murray and Oxford's David King in Nature, published earlier this year. Murray and King argue that once demand consistently exceeds oil supply the economy enters what they have coined  a "phase transition." They believe we'll be in the volatile phase from here on out.

Chris Nelder at Smart Planet wrote in June that spare capacity will “drop to critically low levels in late 2014/early 2015 as depletion finally overwhelms our efforts to fill the gap with unconventional oil, kicking off a long era of harsh volatility in both oil prices and the global economy as a whole.” “So enjoy the relative stability of the next two years, and take advantage of the narrow ledge concept to trade oil profitably as it bounces between the price floor and ceiling.” Looking at the results I’ve calculated above I don’t think we are looking at a period of relative stability for the next two years. This means the economic situation could be even worse if Nelder’s predictions come true in late 2014/early 2015. We are seeing high oil price volatility right now.      

John Michael Greer of the Archdruid Report published a paper in 2005 titled How Civilizations Fall: A Theory of Catabolic Collapse. His main thesis is that “as societies expand and start to depend on complex infrastructure to support the daily activities of their inhabitants” it becomes increasingly energy intensive to maintain this infrastructure. Eventually “the maintenance needs of the infrastructure and the rest of the society’s stuff gradually build up until they reach a level that can’t be covered by the resources on hand.” What follows next is catabolic collapse, where the society reverts to a level that can be sufficiently maintained, at least for a while. After a time the society becomes anabolic, or begins to build up again until it reaches some new limit and then collapses again. Greer argues this is what Chinese and other societies have done dozens of times throughout history. He believes our current oil based society is in the clutches of catabolic collapse at the moment (it should be noted that collapse refers to a breakdown over a period of years, not some kind of biblical apocalypse).

Whether or not you subscribe to the idea of peak oil it is undeniable that oil markets have been more volatile over the last five to seven years than at any other period. We have entered a new paradigm where oil prices are marked by extreme fluctuations. This volatility is damaging to economic recovery in a time when many countries are already limping along propped up on huge amounts of foreign debt and little to no economic leadership. Oil price volatility is the new norm and there is nothing anyone can do about it bar an unlikely societal shift to a low energy society. The best response is at the personal and local level by reducing your reliance on fossil fuels right now in every aspect of your life. At the very least when things deteriorate over the next few years you will have an extra layer of resilience.