The oil price undoubtedly has peaked. With OPEC production above what is required and US inventories...
The oil price undoubtedly has peaked. With OPEC production above what is required and US inventories rising there is good reason to believe prices will drift downwards. There are, however, good reasons to believe that the near and medium-term outlook is still good. The combination of relatively strong demand for crude and, crucially, low spare capacity is likely to continue to keep prices above historical averages.
Oil prices have been driven up primarily by strong global demand. GDP which grew by 1.3% in 2001, 2.1% in 2002, and 3% in 2003 is forecast to grow by about 4% in 2004. This, not surprisingly, has driven up oil demand very strongly. In 2002 global demand for crude grew by 0.74mb/d to 77.4mb/d. In 2003 it grew by 1.74mb/d and in 2004 is expected to grow by about 2.6mb/d. Admittedly oil demand is expected to grow at 2003 levels next year as GDP growth slows down, however, this is still a fairly healthy growth rate.
As with everything in the commodities markets in recent years, Chinese demand growth has been one of the key factors driving up oil prices. This is likely to be the case in the foreseeable future. Between 2001 and 2002 Chinese demand grew by 0.1mb/d to 5mb/d. In 2003 it grew by 10% to 5.5mb/d and in 2004 it is expected to be 6.4mb/d. Effectively 36% of estimated global oil demand growth. This is certainly significant relative to historical levels and demand growth rates in other regions.
On the supply side the key factor is OPEC. OPEC (including Iraq) at 29.5mb/d is currently producing above its 27mb/d quota and above the call on its production, in other words, the amount it needs to produce to keep the market in balance.
Most of its spare capacity has been absorbed by the stronger-than-expected demand. This partly reflects the fact that extra capacity has come on stream at a much slower pace than expected and is expected to do so going forward. OPEC spare capacity is currently around 1-1.5mb/d primarily held within Saudi Arabia. The IEA's estimate of spare capacity2 is even less as the chart shows. The combination of the limited spare capacity and the perceived threats to production is one of the key factors that have held up prices. This is likely to persist and keep prices high and above historical levels going forward. In addition continuing disruptions to supplies in Nigeria and the perceived threats to Saudi Arabian production does help maintain an element of risk in the price. To put it into perspective, Iraq on a good day produces 2.0mb/d. If for any reason a significant amount of this production is disrupted the market will tighten significantly.
World crude markets are by no means short of supply with OECD and US inventories approaching normal levels. What is limited are lighter crudes and complex refining capacity. This is very much reflected in the higher than average premiums WTI has traded above the heavier crudes. The abundance of OPEC oil, in my view, is a key factor dragging prices off their peak. Nonetheless the limited refining capacity at the complex end leading to a tight product market in the US continues to be a positive for the crude price.
What should not be under- estimated is OPEC's desire to maintain high prices. It is a fair assumption that given OPEC's ability to do so in the past, the current environment of limited spare capacity, is likely to all other things being equal make them more effective. OPEC is also seriously considering the idea of increasing their price band from the current $22-28/bl given the market dynamics have shifted upwards and the dollar has weakened significantly.
The key risk is that OPEC, as GDP growth slows down and we enter a seasonally weaker second quarter, will struggle to rein in its production as it has done in recent years.
Overall, the fact that capacity is expanding at a slower rate than previously expected, the limited OPEC spare capacity, slowing but adequate Chinese demand, geopolitical risks, and strains on the refining capacity should lend support to the drifting price. OPEC's ability to cut back will be a key factor. Recent history suggests they should not be under- estimated. A Brent oil price per barrel in the mid-30s is certainly not unrealistic for next year.
1 Source: UBS
2 IEA Definition of Spare Capacity - available in 30 days and sustainable for 90 days
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