Geopolitics and tight supply to keep oil prices high (page 1 of 2)

As expected OPEC last week agreed a 2m barrel per day increase in quotas with a pledge to increase by output by a further 500 thousand barrels in August. In practice, while OPEC's decision may provide some short term relief, it is unlikely to bring prices substantially lower.

Estimates for OPEC-10 (which excludes Iraq) production for April vary between 25.4 and 25.9 mbpd, well above the 23.5 mbpd quota. Most members are close to capacity. Saudi Arabia claims it is already producing 9.1 mbpd, well above its 7.6 mbpd quota and only 0.4 mbpd below near-term capacity. Yet oil prices have soared in response to heightened security concerns in the Middle East, exacerbated by rising demand forecasts and disappointing non-OPEC production. NYMEX futures prices have reached all-time highs. Dollar weakness also continues to underpin commodity pricing generally.

The key risk, which is adding a premium to the price, is that supplies could be disrupted at a time when demand is booming and OPEC is perceived to have insufficient capacity to fill the gap. Demand forecasts for 2004 may yet prove too low. The International Energy Agency (IEA), Energy Information Administration (EIA), and OPEC have all revised their demand forecasts upward in recent weeks. Asian demand, particularly from China, has been consistently underestimated, but the recent revisions are also driven by a stronger than expected recovery in transport fuel demand in the US. The IEA now expects global demand to rise by 2 mbpd to 80.6 mbpd in 2004, the highest percentage increase since 1996, due to the synchronised global recovery. While the authorities are trying to engineer a slowdown in China, growth is likely to remain strong and the indications are that the US recovery is gathering pace. The risk to the demand forecasts is still firmly on the upside this year.

Meanwhile, with the exception of Russia, non-OPEC supply has not responded as well as expected to high oil prices. It is now forecast to supply 50.1 mbpd in 2004, leaving the call on OPEC (plus stock change) at 26.5 mbpd, 0.5 mbpd higher than previously estimated by the IEA. The rise of Asian demand as a proportion of the total appears to have diminished the impact of US seasonal demand on the markets. OPEC's quota cut to meet seasonal downturn in 2Q now seems to have been premature. The intention was to avoid an excessive seasonal stockbuild. While US crude inventories have improved, they remain below seasonal norms. Gasoline inventories are still low ahead of the summer driving season in the US, although that is partly due to refining constraints. It is essential that inventories be allowed to recover prior to the higher seasonal demand in 4Q.

Consequently, the concentration of global spare capacity in Saudi Arabia is adding to nervousness in the light of the recent terrorist attacks. IEA figures show OPEC-10 spare capacity at around 2.4 mbpd at April production levels, over half of which is in Saudi Arabia, which could also provide another 1 mbpd in 90 days. There is sufficient capacity to meet demand, as long as inventories are allowed to rebuild ahead of the peak demand in 4Q, but there is little room to maneouvre. Iraq supply is volatile, ranging from 1.89 to 2.38 mbpd in the first four months of the year and suffering from sabotage to one of the two main export pipelines to Basrah in May, which reduced output by a third. The scope for Russia to accelerate production is highly uncertain due to pipeline constraints. To date the US has resisted calls to use its strategic oil reserve, owing to its tacit agreement with OPEC, but that could become available if there were a catastrophic event.