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Wed 2 May 2007 05:01 PM

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Commodities prices in convergence

Global convergence is not a theoretical idea, it is already upon us, and it is rapidly changing the overall economics of the energy industry.

Over the last few years there has been a convergence across the commodity markets, according to Jeffrey Currie, global head of commodities at Goldman Sachs. The underlying economics of the oil industry are changing dramatically, which is shifting the main players within the overall commodity space.

Currie contends that the price of a commodity, be it BTU, bushel or barrel, is now inextricably linked to the other, suggesting they are now pricing as one. The current climate means any one of these markets must be considered in the context of the other two.

"When it comes to British thermal units (BTUs), everyone is talking about Russia," said Currie. "But there has been a global convergence in that market. When we speak of bushels, biofuels are becoming huge. Whether or not we want them, or whether they are economical does not matter. They are here and are being policy driven. The biggest player in this market is Brazil. Now Russia and Brazil are challenging the Middle East within the overall energy complex."


recently published an article refuting the existence of a global gas market. But Currie argues gas is being traded on a global basis, and not as a regional globalised market. Russian gas major Gazprom produces 53 billion cubic metres (bcm) of gas per day - more than the entire US.

"Gas is much further reaching than oil," said Currie. "Gas prices all the oil in the world. Not only are we talking about 45 million barrels of oil equivalent per day, but all the power in the world, particularly in the US and Europe where the dominant driver of power in the future is going to be gas."

The politics associated with gas are also much further reaching. Global gas production largely mirrors the oil market and North America, Asia and Europe are all short on reserves. The economics in Europe and Asia are more dominant than they are in North America. Currie predicts North American reserves will eventually become shorter and more dependent on supplies from the Middle East and Africa.

"With this need to move supplies from the Middle East and Africa to more industrialised parts of Asia, North America and Europe, there has been a convergence in prices, suggesting there is a global gas market," he said. European, Asian, UK and US prices varied widely until more recently. The explosion of US gas prices following Hurricane Katrina reflected this. Three weeks after the hurricane gas prices in the UK exploded. The US drained much of the LNG out of the European market immediately, causing it to spike. Indeed variants across prices over the last ten years have dropped sharply. "There was a 40% variance across global prices in 1996," added Currie. "This has now converged to around 7%. When the arbitrage between the US and Europe opens up, the LNG flows. In this way it acts just like oil."

LNG imports in Europe and the US are now a mirror image of each other. Europe is different from North America in the sense that it doesn't have the storage capacity to provide any kind of buffer, causing more price volatility in this part of the world. In addition, gas in Europe is oil indexed. Gas is being priced on a global basis, based on a commodity that has little to do with it. Oil is now a substantially more expensive commodity than gas and oil indexation is creating prices that are substantially higher than what the underlying economics suggest.

Currently, oil indexation imposed by regulators in Europe is pricing gas. Consumers dictate demand and Russia, Algeria and Norway produce enough to clear the market. If the price in the US is higher than it is in Europe, the LNG flows to the US to drive prices back down. The opposite is also true. The global price is determined by the underlying oil market. In supporting these prices, Gazprom has been cutting back its exports into Europe to accommodate this LNG.

"Lack of storage capacity and oil indexation has a huge impact on pricing around the world," said Currie. "Prices are much more volatile in the UK than the US. What we have is storage blowouts, such as the one in October 2006. We have just brought on around ten bcm of LNG globally. Gazprom has accommodated a large portion of that."

In the 1990s gas prices had a ceiling imposed by fuel oil because if gas prices went above that of oil, generators would switch and start consuming more oil, causing gas prices to drop. But eventually shortages kicked in and gas price began to have a floor imposed by oil. At this point the convergence started. This was beginning to happen by the early 2000s. In the US the BTU market has completely converged with the oil market and is gradually becoming a global phenomenon. The European market has had this scenario imposed on it by oil indexation.

"The NYMEX price simply rotates around the residual fuel price," said Currie. "Ultimately, gas is nothing other than oil. The balance of gas has to impact the balance of oil, which is why Gazprom and Russia is so important to the global energy balance. It will change the overall power position of energy players."

Currie dismissed the ‘peak oil' theory because the cost of supplying the market is what really matters, be it BTU, bushel or barrel. "This is a dynamically changing industry and the risk can change very quickly as we have seen with oil in the sense that it has lost its dominant position and is now sharing it with biofuels and gas," said Currie. "Equally, the situation with gas could change dramatically."

Currie contends the commodity convergence has given creed to biofuels - the largest alternative energy available, and dominated by Brazil. Although being heavily influenced by market policy, ethanol and biodiesel production was 846 000 barrels per day in 2006. Current global production is well over one million barrels per day. If corn prices go up, biofuel supplies will increase and have a knock-on effect for the oil price. According to Currie, biofuel use will increase by 300% over the next ten years.

The most efficient biofuel is sugar-based ethanol, mainly produced in Brazil. The most efficient producer of biofuels are in the southern hemisphere because the tropics can grow sugar and sugarcane-based fuels. Some estimates indicate that global biofuel usage could be met by using small amounts of land in the northern hemisphere, but this has not been implemented because of trade barriers. Here biofuels are still largely considered an agricultural commodity, making production difficult. Biofuels are competing wit 150 years of experience with the European Common Agricultural Policy, as well as the United States Department of Agriculture (USDA), so trade barriers are unlikely to be removed. Ethanol trade barriers in Europe are currently at US $72 per barrel, making imports very expensive. Currie predicts these trade barriers will eventually be removed because of the increasingly favourable cost basis and advantages of sugar-based ethanol.

"The punch line is that gas, sugar and corn all converge on a BTU basis, as well as on a dollar and cents per gallon basis," he said. "There is now BTU convergence to oil, bushel convergence to oil and sugar convergence to oil. It has all become the same commodity.

"It is true that there are vast amounts of low-cost oil in the Middle East, as well as West Africa and other parts of the world. However, these regions do not set the price. It is the high-cost players who dictate prices. Places such as the North Sea, North America and certain parts of Latin America all have a cost basis of well over US $60 per barrel. These high-cost producers are now only just meeting their cost-to-capital, which means costs have had to rise to absorb any of the excess revenue. They are making no more today than what they were in 2000."

And these costs are not going to come down any time in the near future - at least not until the end of the industry's current investment phase, which could last for many years. We are in a period where governments are taxing the oil industry, not subsidising it. This means we will probably see much higher sustainable oil prices for the foreseeable future. This will continue to attract supplies on the biofuel side, again emphasising the importance of Brazil, and will continue to force conversion between gas and oil. This emphasises the importance of Russian gas, as well as the emergence of a global energy market.

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