High oil prices set to continue well into 2004

Oil prices have remained high in 2003, averaging close to USD 28 per barrel (pb), despite the easing of international tension and the resumption of Iraqi crude production. To put this in context, this compares with an average price of USD 24 in 2002 and USD 20 over the last ten years. With global growth recovering, commercial oil stocks low and uncertainty remaining over Middle Eastern supplies, oil prices are likely to remain firm in the near term. However, such levels are not sustainable. Not only does the high oil price act as a brake on growth and demand, but it also encourages marginal producers to increase output. A wave of new supply is scheduled to come on line over the next 12-18 months, most of it outside of OPEC's control. It is this that will eventually dampen prices.

Oil demand has certainly picked up in recent months. Demand in the US, the world's largest importer, has been steadily rising alongside the accelerating economic recovery. The release of the Q3 GDP growth estimates prompted the Energy Information Administration (EIA) to revise up its Q4 US oil demand forecast by 130k bpd to 20.16m bpd.

But it is the low level of commercial oil stocks and tight oil supply that has been the main cause of buoyant prices. In its last weekly report, the EIA warned that US oil inventories remain 11.2m barrels below their 5 year average and that overall stocks were 300m barrels below the level considered 'comfortable' ahead of peak winter demand. Indeed, the latest report from the Independent American Petroleum Institute showed US crude inventories falling. Such low level of stocks means there is no cushion to absorb any future oil market disruptions. OPEC's surprise September decision to reduce its output quotas by 3.5%, or 900k bpd, compounded these concerns. The cut came into effect on November 1st.

Until commercial stocks are rebuilt the oil market remains vulnerable to any future shock. With the security situation in Iraq deteriorating, lingering concerns about Venezuelan and Nigerian supply and the elections in Iran next March, there are plenty of risks. Iraq is the biggest concern. Given the increasing attacks on Coalition forces, it is not clear whether the Iraqi authorities will be able to maintain current export levels - currently 1.2m bpd - let alone increase them. Industry sources report that Iraq is re-injecting up to 400k bpd back into the oil fields because they are unable to transport it safely. Oil prices are likely to stay volatile and high short term.

All these factors should ensure that OPEC does not need to tighten supply further at its next December meeting, despite recent warnings by OPEC's President. This, however, could be a temporary reprieve. Looking further ahead, m/t market fundamentals are less favourable and during the latter half of next year, OPEC is likely to have to choose between lower prices or cutting back its own production and losing market share.

On the demand side, even given strong US growth both the EIA and the International Energy Agency believe that global oil demand will only increase by 1m bpd in 2004. The US will account for roughly a third of the increase, the remainder being made up by China and other developing nations. These estimates may be revised slightly higher, but the strength of US growth in H2 2003 is unlikely to be sustained, especially if oil prices remain high. The IMF estimates that every USD 5 increase in oil prices leads to a 0.3% fall in potential US and global growth.

The supply side will be even less supportive. Non OPEC supplies are expected to increase by 1.4m bpd in 2004. Pressures are also building within OPEC for higher output. Nigerian President Obasanjo has referred to the current quota of 2m bpd as "unacceptable" and its state oilcompany set a target of 4.1m bpd by 2006. Iraq too cannot be totally discounted. Its output has risen rapidly and Iraqi authorities hope to increase exports by another 1m bpd by April. Even without Iraq, OPEC faces a potential 2m bpd shortfall in demand for its crude by Q3 2004.

Overall, low stocks and tight supply should ensure oil prices remain high in 2004. But in the absence of future shocks, higher global oil supplies should moderate prices as the year progresses. We expect an average oil price of USD 25 pb, with prices volatile in H1 before trending lower in H2. How far they fall will depend partly on what stance OPEC takes. September's decision was an important statement that the Cartel is willing to put price ahead of market share. But OPEC's determination to defend prices has not yet been properly tested; and as non-OPEC output increases next year, it may be difficult to maintain such a consensus.