Oil price outlook improves

In its latest economic brief on the oil market and budgetary developments, National Bank of Kuwait reports that oil prices firmed up slightly during May following a large drop the previous month as the war premium quickly dissipated once the war in Iraq started, and subsequently came to a successful conclusion within a brief period of time.

The moderate rebound in prices appears to be triggered by concern over low gasoline stocks in the US, which were further exacerbated by OPEC's decision to reduce its output ceilings at the start of June. Still, weaker demand due to the outbreak of the SARS virus in Asia helped keep a damper on prices. The outbreak has already had a noticeable impact on travel in a number of Asian countries.

Additional cuts are expected in airline activity as China imposes strict travel restrictions and people reduce their travel until the SARS threat has been controlled. As a result demand for jet fuel is likely to decline during the summer months.

During May, Kuwait export crude (KEC) averaged $24.4 per barrel, after having dropped by $4 in April to $23.8. Prices had been relatively firm during March despite increased production by a number of OPEC producers, in part due to temporary reductions in Nigeria.

Oil stocks are likely to remain relatively low following OPEC's decision to reduce production at its April 24 meeting when the member states excluding Iraq (OPEC-10) agreed on a 2 million barrels per day (mbd) reduction in production from current levels effective June 1, 2003.

During March and April OPEC-10 had been producing well above the self-imposed quota to make up for the loss of Iraq's crude and disruptions in Nigeria. Even though OPEC's benchmark basket of crudes remained well above $22, the lower end of OPEC's $22-$28 target range, the organization felt that a seasonal decline in crude oil demand during 2Q03 combined with an expected return of Iraqi crude during the coming months requires that OPEC-10 make a substantial reduction from current output levels. While the new ceiling is seen as a cut from current production, it represents a 0.9 mbd increase from the current OPEC-10 quota.

Though OPEC members decided to postpone the official reduction in the output quotas until the beginning of June, indications in late April already pointed towards reduced production levels from the peaks observed during March and early April.

Goldman Sachs estimates that OPEC member states in the Gulf region have already reduced their output levels by about 0.75 million barrels a day (mbd). This was in part due to the unsustainability of the output levels achieved during the weeks of the war.

If OPEC production is at quota from June, KEC is expected to average $23.6 during 2Q03. Prices could weaken slightly in 3Q03 as a result of slower demand and the possible resumption of Iraqi exports before strengthening again during the final quarter. The average for the year would be $24.2.

However, the trick for OPEC-10 in dealing with the resumption of Iraqi production is a matter of timing and compliance. If OPEC-10 fail to agree to output cuts equal to the additional Iraqi crude promptly and implement them strictly, as they have indicated they intend to do, prices could weaken in the second half of 2003. Under such a scenario KEC could fall sharply averaging between $16 and $17 in 3Q03 and 4Q03 and into the first quarter of 2004. The average for the year would be $21.

On the other hand, there is the possibility that the announced OPEC-10 production cuts are excessive and that they do not take into account the present conditions in the market, particularly the low levels of crude and product stocks. In such an event, a high level of compliance by OPEC-10 could push prices higher, though they would remain below recent highs with KEC averaging $26.7 during 2003.

The price of Kuwaiti crude is expected to average $17.8-$26.4 during fiscal year 2003/04. As a result, government revenues are likely to be KD 4.2-6.2 billion, in all cases well above the KD 3.56 billion expected in the draft budget by about 30%-90%.

If the government spends the entire KD 5.83 billion allotted for expenditures in the draft budget, according to the price scenarios presented above we will see a deficit between KD 647 million and KD 1.7 billion, or a KD 368 million surplus.

However, we expect expenditures to come in about 10% below the draft budget, or KD 5.36 billion, which means the budget could still see a surplus of KD 834 million in the best care scenario, but is more likely to be in a small deficit of KD 180 million. In the extreme case of continued over-production with prices falling near $16 by year-end, the deficit could rise to KD 1.2 billion.