Oil prices ease but volatility ahead

Crude oil prices have pulled back from highs reached in October, partly driven by a funds withdrawal. The improvement in physical supplies has become increasingly evident now that the impact of Hurricane Ivan has passed. Potential supply disruptions due to geopolitical events have not occurred, and concerns are mounting over 2005 demand growth. The net non-commercial open interest on the NYMEX has dropped to less than 4,000 contracts, from recent highs above 37,000.

Oil prices are still high. WTI may have fallen 16% from its all-time nominal high in October, but it remains up 44% so far this year. The OPEC basket price, more weighed down by deep discounts for abundant sour crude, is up 20%. Supplies are more than adequate to meet current needs, but the factors that have led to elevated prices remain - limited spare capacity against a background of strong demand growth and the threat of supply disruptions. In the US, heating oil stocks are still low for the time of year and refinery utilisation high. Signs of a colder than average winter have the potential to cause another spike in prices before the end of the year.

Against this background, OPEC will meet on December 10 to discuss its strategy for the first two quarters of 2005. The Iranian oil minister has stated that he believes the oil market is oversupplied, but a formal quota cut seems unlikely at this stage. We expect Saudi Arabia to begin quietly scaling back its production from the current 9.5 mbd level. At an estimated 28.3 mbd in October, OPEC-10 production is substantially above the current 27 mbd quota. In reality, OPEC's ability to micro-manage the market is curtailed by its lack of excess capacity. With underlying geopolitical tensions unlikely to ease significantly, and supply disruption fears more than likely to surface from time to time, volatility is here to stay.

For 2005, we anticipate slower GDP growth in the US, particularly in the second half of the year, and lower but still robust GDP growth of 7.5% in China. When combined with the impact of high prices, this should ease oil demand growth below 2%, compared to 3.4% in 2004, even allowing for strategic stock accumulation in China. OPEC capacity is expanding slowly and will begin to reduce the risk premium. We continue to expect WTI to average USD38pb in 2005.

Crude oil (USDpb, average)
2002 2003 2004f 2005f 2006f
WTI 26.1 31.1 42 38 32

Helen Henton
Senior International Economist
Standard Chartered