INTERNATIONAL: Demand, geopolitics underpin oil price

Analysis

Oil prices in nominal dollar terms are at their highest since October 1990. A continuation at this level will, according to the International Energy Agency (IEA), lead to a "dampening of the current cyclical upturn". Yet the causes of these high prices are in dispute: Washington cites OPEC's recent production cuts; Riyadh cites speculation and US gasoline problems.

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Market fundamentals. Economic growth has certainly strengthened. GDP growth in the OECD will average 3.2% for 2004 and 5.8% in non-OECD. Oil demand is now expected to grow at 410,000 barrels per day (b/d) in the OECD (310,000 b/d in the United States, driven largely by the transport sector) and 1.56 million b/d in non-OECD (840,000 b/d in China alone). China's oil demand grew 20% in the first quarter of 2004, while Asia-wide strategic stockpiling has also fed demand (see CHINA: Beijing builds oil reserve - February 26, 2003).

Non-OPEC supply has also disappointed. While non-OPEC is expected to produce an extra 1.2 million b/d in 2004 over 2003, in February alone, US and UK output fell by 757,000 b/d. OPEC is estimated to be producing over 2 million b/d above the formal quota, and with the exception of Saudi Arabia and United Arab Emirates (UAE), most OPEC members are pumping at or close to capacity. April production was down marginally from March, but the OPEC cuts announced in February and confirmed in March have otherwise been ignored (see INTERNATIONAL: OPEC wrestles with quota adherence - February 11, 2004).

Market sentiment. Sentiment has swung strongly behind high prices -- in some cases, on unsound reasoning:

• Misleading stocks. Many in the paper markets point to the historically low level of crude stocks as a signal of shortage, despite a recent build in US crude stocks. Yet the level of crude stocks is misleading. The futures market is in steep backwardation, which means it is much better to lock-in crude supplies by buying paper than by holding physical stocks. In addition, only primary stocks are measured. Fears of shortage draw primary stocks into secondary (wholesale) and tertiary (consumer) stocks; the overall stock level is unchanged.
• US petrol price. Futures prices have now reached record highs and gasoline prices have been rising at three times the rate of crude prices. This is seen as a further sign of crude shortage, but again is quite misleading. The problem with US gasoline prices relates to the 'boutique fuel' problem. The US Clean Air Act allows different regions in the United States to draw up their own gasoline specifications. Currently, there are 54 varieties compared to only five in 1973. Thus, shortages of one specification arising from a lack of investment in what is an unprofitable business cannot be offset by another specification. The price of gasoline in that region rises with no offsetting supply response.
• Gulf tensions. Concern about stability in the Middle East is encouraging bull sentiment. On April 26, suicide bombers attacked Iraq's Basra Oil Terminal, putting it out of action for a short period. A May 3 attack in Yanbu, one of Saudi Arabia's three main crude export terminals, killed five expatriates, leading the US and UK governments to advise their nationals to leave the Kingdom. These unprecedented attacks, on installations that so far have been spared, come at a time of serious deteriorations in Iraq (see IRAQ: Transition blueprint faces multiple challenges - May 7, 2004). There are also concerns over political developments in Nigeria and Venezuela (see NIGERIA: Democratic roots shown to be shallow - April 13, 2004; and see VENEZUELA: Assertive AD may challenge CD, Chavez - April 29, 2004).
• Hedge funds. Investment funds have been injecting extremely large amounts of money into commodity markets generally, pushing up the next month's futures prices and then rolling over to the next month. They are betting on higher prices, their behaviour causes higher prices, which in turn encourages them to push for even higher prices.

If the Saudi explanation for higher prices is correct, then pushing more crude oil into the market will do nothing to alleviate higher prices, and would only risk a serious price collapse when hedge funds decide the roller coaster is going down rather than up.

Outlook. Forces are in play that could push prices in either direction. Clearly, greater instability in the Middle East will drive prices higher, especially if Saudi oil installations are targeted, since the bulk of global excess crude production capacity is in the Kingdom. Those behind the attacks almost certainly see this as a way to hurt the Bush administration before the November US presidential election.

Political developments elsewhere, especially in Iraq, Nigeria and Venezuela, could cause sudden supply losses, which would seriously upset the markets. There are also uncertainties over Russian output, given recent capital flight, constraints on the export network and concerns about the impact of rouble appreciation on the post-1998 economic recovery in the non-oil and gas sectors (see RUSSIA: Oil exports meet infrastructure bottleneck - May 3, 2004). Hedge funds are also quite likely to continue pushing price higher for the foreseeable future. This is reinforced by the call from some OPEC members for the OPEC price band to be increased from 22-28 dollars per barrel to 24-30 (Venezuela) and 25-32 (Nigeria).

Price pressure. Saudi Arabia is certainly uncomfortable with the current levels of oil prices, which are straining relations with Washington. The next official OPEC meeting is to be held in Beirut on June 3. Saudi Arabia has already tried to talk down the oil price by promises of guaranteed supplies of crude, and yesterday called for an OPEC-wide quota increase of 1.5 million b/d. If prices continue to rise, some form of production increase will be announced at the meeting. In theory, such an announcement should have little impact given that most of OPEC has ignored quotas and is producing near capacity.

That the IEA has five times in the last five months revised up its estimates of demand is a sign of analytical under-appreciation of demand forces -- particularly in East Asia. If Chinese economic growth, despite Beijing's best intentions, remains above 8% this year, as seems likely, East Asian oil demand will provide a secular fillip to prices (see CHINA: Strong underpinnings mitigate overheating fears - April 19, 2004). Even a slowing in demand would be offset by the impetus from East Asian strategic reserve stockpiling -- which itself gains impetus from deterioration in Gulf stability. Although high prices will encourage non-OPEC supply, the speed of this response is uncertain.

On balance, the main probability is for continued strength in oil prices in 2004, above 30 dollars as measured by the OPEC basket of crude. The downside risk for prices is that rising global interest rates appear to choke off the world economic recovery. If the paper markets decide the bull run is over, they can destroy quickly what they have raised up.