By Oxford Analytica - 12/11/07 04:32 PM EST
With oil prices still hovering at record levels, uncertainty in oil markets is high at a time when there is concern over whether higher energy prices could trigger economic recession.
Oil prices this year reached near-historic levels associated with the 1979-80 oil shock. The key question for 2008 is how much of the price rise since the start of 2007 has been driven by tightness in crude oil physical markets versus behavior in financial paper markets.
In 2008 physical markets, oil demand will increase while supply-side projects are delayed and mature fields struggle to maintain capacity.
Ultimately financial paper markets will determine if prices rise further or fall if speculators withdraw quickly.
Geopolitical concerns will support oil prices above $70 in 2008, driven by perceptions of a continuing tight market.
Two broad factors have been at work during the course of the year:
• Physical. Some oil price strength can be attributed to a tighter physical market:
• Demand. The International Energy Agency (IEA) suggested a demand rise in 2007 of around 1 million barrels per day (b/d). This reflects solid global economic growth — a pattern expected to continue in 2008, though at a slower pace. However, there are some signs of slowing oil demand in response to rising prices, reflected in downward revisions to demand estimates. The rise is much less outside the dollar trading zone, reflecting huge devaluation of the dollar in recent years.
• Non-OPEC supply. The IEA estimates growth of non-OPEC supply at 0.6 million b/d in 2007. Signs are that project delays continue, though non-crude liquids have been a key source of growth. For example, biofuels are expected to add 400,000 b/d in 2008. However, OECD output continues to decline more rapidly than expected.
• OPEC supply. OPEC increased production during late 2007 following a period of compliance with cuts agreed to in late 2006. In particular, there are signs — such as rising tanker rates — that Saudi Arabia informally has increased production to ensure no real physical shortages of crude.
• Inventory. The inventory surplus, which threatened the market towards the end of 2006, has now gone. Much of this inventory reduction has been driven by steep backwardation from September in the futures market — where future oil prices are expected to be less than current prices — discouraging holding of physical stocks. However, consensus is that the stock overhang is now back to relatively normal levels. In September, OECD forward cover was 52.8 days, close to the five-year average.
• Speculative. Simultaneously, financial paper markets and political concerns have driven oil’s price strength:
• Mid- to long-term expectations. Backwardation and rising prices have attracted financial investors, whose net long-term position is higher than for some time. “Money managers” continue to see oil (as a commodity) as a better mid- to longer-term option than other elements in financial portfolios. Therefore, the futures curve three to six years out — a reflection of expectations regarding longer-term crude prices — over the past year has been above $70 per barrel, compared to $60 two years ago and $40 three years ago. This reflects a genuine perception of impending shortage, rather than short-term speculative concerns.
• Geopolitics. Geopolitical concerns give speculative support to high prices. Tensions in Iran continue, though recent U.S. intelligence pronouncements have diffused them somewhat. The Nigerian crisis continues to worsen, inhibiting physical supply from the Delta. Also affecting price was the recent threat of Turkish action against Iraq’s Kurdish region, even though it only exports just over 300,000 b/d.
Looking to 2008
In terms of the physical market, 2008 may be a re-run of 2007:
• Demand. IEA forecasts suggest demand will grow at around 1.9 million b/d, above general consensus. The U.S. Department of Energy suggests 1.5 million b/d and OPEC 1.3 million b/d.
• Supply. Supply-side project delays are likely to continue, with OECD production declining further as the mature fields struggle to maintain capacity. Furthermore, new supply projects are more difficult and complex, increasing the possibility of schedule slippages.
Debate is growing over the impact of higher prices:
• Future demand. Recent empirical evidence on U.S. petrol demand suggests that over the past five years, price elasticity of demand is much lower than in the 1970s — demand is not responding to higher prices. Clearly much will depend on what happens in the United States as the sub-prime mortgage crisis plays out. However, the growing view is that global economic growth — especially in East Asia, which accounts for much of oil’s projected demand increase — is less dependent on the U.S. economy than 10 years ago.
• Future supply. OPEC has been under pressure from the United States and IEA to increase production in an effort to stem rising prices. The official OPEC line is that high oil prices result from speculation, and increasing physical supply will not help. Indeed, a supply increase may cause pricing problems in the second quarter of 2008, when crude demand traditionally falls. Along with fears of demand constrictions, forecasts of increased non-OPEC supplies heighten OPEC’s concerns.
OPEC faces serious divisions that will continue into 2008:
• Price. While Saudi Arabia has appeared unhappy with high prices, and informally has been pushing more crude into the market, trying to bring prices closer to $60-70 per barrel, a number of OPEC members favor higher prices.
• Politics. A Venezuelan-Iranian axis has developed within OPEC that seeks essentially political objectives. Venezuelan President Hugo Chavez opened the OPEC summit in Riyadh with a call for OPEC to become “more political”.
In keeping with its November stance, OPEC on Dec. 5 decided not to increase production targets, taking a “wait and see” approach. A $10 fall in oil price the week before the OPEC summit supported this decision, arguably demonstrating that, while tight, markets are not short of crude.
Although Saudi Arabia is proceeding successfully with capacity expansion plans, similar plans in the rest of OPEC face implementation barriers:
• Resource nationalism. Resource nationalism is closing doors to investment, as some producer governments are seeking to renegotiate fiscal terms with international oil companies (IOCs), such as Nigeria’s October 2007 renegotiations with Shell, ExxonMobil and Chevron. This may inhibit further IOC investment.
• Resource curse. Many governments are also concerned that increased oil revenues will create an attack of “resource curse,” and wish to slow production growth.
• Capacity constraints. Expansion also faces problems associated with a service industry that has capacity constraints.
Oxford Analytica is an international consulting firm providing strategic analysis on world events for business and government leaders. See www.oxan.com.