Where next for the oil price?

Current supply concerns may have helped lift prices off recent four-month lows, but ultimately oil prices are heading lower.

Markets may presently be pre-occupied about potential supply shortages, but attention is likely to turn swiftly to OPEC production levels once war in Iraq ends. Recent estimates put
OPEC production (excluding Iraq) close to 26.5m barrels per day (bpd). That is 2m bpd day above OPEC's temporary quota of 24.5m bpd imposed at the start of February, and around 3.5m bpd above the quota set at the start of the year.

Re-imposing quota discipline will be an enormous challenge for OPEC, particularly given the domestic pressures facing several member states - Venezuela and Nigeria may both be tempted to pump extra oil to make up for earlier revenue losses.

Although a repetition of the price collapse seen after the first Gulf war does not appear on the cards, market fundamentals offer little comfort. Demand is expected to remain subdued reflecting the less than spectacular growth outlook for the US economy over the next couple of years.

Demand in China and Japan, which is switching away from nuclear fuel, is expected to remain strong, but will not compensate for weakness in the US. Adding in increasing non-OPEC supplies, long-term prices are heading down.

Oil markets reacted in predictable fashion to the onset of war in Iraq. As in the first Gulf crisis, crude prices fell sharply - hitting four-month lows - once it became clear that war was both inevitable and imminent, oil traders working on the assumption that conflict would be of short duration with minimum
disruption. The benchmark OPEC basket price, which in February had averaged $31.54 per barrel, retreated back to within the cartel's $22-28pb target range.

Relief proved short-lived however, as markets had to adjust to the possibility of a more prolonged war. News of substantial supply disruptions in Nigeria added to general market concerns about near term supplies in late March. Almost 40% of the West African producer's 2 m bpd output affected by ethnic violence in the restive Niger Delta.

While it is not yet known how long Nigerian oil production is likely to be affected, some analysts see little prospect of a
restoration of calm until after the presidential election, currently scheduled for 19th April. This is not good news for the oil market, until recently Nigeria remained one of the few OPEC producers outside the Gulf with significant spare capacity.

OPEC sought to reassure the market that it could cover the Iraqi shortfall and absorb Nigerian outages. Supply estimates suggest it is a close call. The big headache for OPEC is a lack of spare capacity. Saudi Arabia and the UAE are the only two members with idle capacity of any size.

However, recent comments by UAE Oil Minister Obaid bin Saif al-Nasseri's suggest the federation can provide only limited extra oil. Once again the onus falls on Saudi Arabia.

Here too there are doubts about the Kingdom's ability to provide significant additional supply in the short term. According to a recent report by the International Energy Agency (IEA), Saudi production averaged 9.5m bpd in March, very close to current estimates of the Kingdom's total capacity.

The IEA estimates OPEC surplus capacity was close to 1.5-2m bpd prior to the war. On the assumption that supply increases elsewhere offset some of the lost Iraqi oil, the IEA puts surplus capacity at nearer 890,000 to 1.4m bpd. With Nigerian outage estimated at 800,000 bpd, it is no wonder markets are
nervous.

There are grounds for some optimism. Venezuelan production is recovering faster than initially expected. Government figures (generally on the optimistic side) suggest production is now back at pre-strike levels. Independent data put output at 2.5m bpd, a significant improvement on average daily production
of 1m bpd in the first two months of 2003.

In addition, the end of the Northern hemisphere winter and the scheduled arrival of Saudi oil (ordered in January to help cover increased demand during one of the coldest winter snaps in
recent years in north America) at the beginning of April could also help ease pressure on US inventories.