High oil prices likely to continue

In its latest economic brief on the oil market and budgetary developments, National Bank of Kuwait reports the price of crude oil has been on an upward trend since the middle of June with Kuwait export crude averaging $25.126.6 per barrel in AugustSeptember, $0.751.5 above the July August average.

Increased likelihood of war in the Middle East has been cited as the key factor behind the steady rise in crude prices in the past few months. KEC continued to advance in September, averaging $26.5 by the middle of the month. Crude prices rose firmed further following OPEC's decision to keep its output targets unchanged in its most recent meeting on September 19.

Markets have priced a war risk premium into the price of oil
Increased likelihood of war in the Middle East has been cited as the key factor behind the steady rise in crude prices in the past few months. While Iraq's most recent announcement that it will allow the unconditional return of weapons inspectors could reduce the premium being priced into crude, the issue remains far from resolved.

The Oil market continues to consider a war on Iraq likely and pricinges a war risk premium of $2-$3 per barrel into crude prices. While Iraq's most recent announcement that it will allow the unconditional return of weapons inspectors could reduce the premium being priced into crude, the issue remains far from resolved.

Despite OPEC's recent meeting to keep output targets unchanged, the organization's production has continued to rise. Over-production has worsened with OPEC-10 producing as much as 9% above the 21.7 million barrels a day (mbd) target during August. With elevated prices the incentive to over-produce is high.

Furthermore, producers appear reluctant to call for more strict compliance with official targets given the relatively tight market conditions as consumers undertake precautionary stocking within an increasingly uncertain political environment.

Meanwhile, the demand picture has become increasingly pessimistic for the current year with growth of no more than 0.26% expected for 2002 as a whole by the International Energy Agency (IEA). The Centre for Global Energy Studies (CGES) expects growth to be half that. On the brighter side, analysts see more promise in 2003, with IEA expecting 1.4% growth next year.

Prices are expected to remain firm for the remainder of the year as likelihood for war looms higher. Given the great uncertainty about how events will unfold, there are multitudes of scenarios that can be conceived about oil markets, though not necessarily with equal likelihood.

Starting with a base case scenario of status quo and an average winter, we expect KEC at $25.3-$27.2 per barrel in 4Q02, and at $23.7-$24.2 for the year as a whole. A 0.5 mbd OPEC hike at the beginning of the year could keep prices from spiking in 1Q03, but KEC would remain above $23 per barrel. Any upside surprises in global demand for crude, such as a cold winter, could push prices higher.

If current attempts to defuse Iraq's dispute with the international community over weapons inspectors are successful and a US attack is averted, crude prices are expected to remain strong throughout 2003, with KEC averaging $25.8 for the year. Such a scenario would most likely be accompanied by a hike in OPEC production targets early in the year by 0.5 mbd, not enough to bring prices down to the lower end of OPEC's $22-$28 target price range.

In the event of a US strike on Iraq early in 2003, the impact on prices would vary. If a strike is brief and contained within the borders of Iraq, analysts expect oil prices to soar initially before cooling off to near $22. This would entail a minor disruption in crude oil supplies, as 0.9 mbd of Iraqi crude exports can be easily replaced by other OPEC producers.

A brief war would mean more Iraqi oil later in 2003, which could bring KEC down to $19.2 by 4Q03, with a 2003 average of $22.2. Alternatively, a brief war could equally result in still higher OPEC production if producers are unable to act quickly enough to avoid excess supply. Such a scenario could push prices down possibly as low as $11.9 later in 2003.

A more regional conflagration is possible, though unlikely. In such a case Iraq might target export facilities in the Gulf, possibly stopping 3 mbd of OPEC output from reaching markets. Normal production would resume by 2Q03, not soon enough to avoid a severe shortfall of oil, leading to sustained oil prices above $40.

Kuwaiti crude is expected to average $23.9-$25.6 per barrel during the 2002/03 fiscal year. If the government's projected budget of KD 5.43 billion is spent in full, the budget could result in a deficit of KD 241 million or a surplus of KD 316 million. A deficit would be the first in four years.

However, we expect actual spending to come in 6%-10% below budget, or at KD 4.9-5.1 billion. This would mean a budget surplus of KD 298-619 million instead. Of course, these scenarios are based on continued outflow of oil from the Gulf region, as budget projections under the scenario for crude exceeding $40 indicated above becomes a trivial exercise.

Kuwaiti crude is expected to average $23.9-$25.6 per barrel during the 2002/03 fiscal year. If the government's projected budget of KD 5.43 billion is spent in full, a deficit of KD 121-263 million is likely, making it the first deficit in four years, with a possibility for a small KD 75 million surplus.

However, we expect actual spending to come in 6%-10% below budget, or at KD 4.9-5.1 billion. This could mean a budget surplus of KD 276-378 million instead. Of course, these scenarios are based on continued outflow of oil from the Gulf region, as budget projections under the scenario for crude exceeding $40 indicated above becomes a trivial exercise.