Opec changes strategy

Oil prices soar and OPEC changes strategy

WTI oil prices topped USD57 per barrel in March as the markets looked beyond bearish short-term fundamentals to potential stronger demand in Q4. High prices have forced OPEC to change strategy and allow higher inventory levels. Before 2004, OPEC managed the market by adjusting output to control global stock levels.

With a small margin of spare capacity, and the ongoing possibility of supply disruptions, this is no longer feasible. OPEC is consequently raising output now ahead of a period of weaker demand to avert tighter conditions in Q4.

This has not yet led to a price decline, as it has narrowed excess capacity even further, but it should lead to softer prices as inventory build becomes clear.

Speculation is an issue... but its also demand

Speculative activity is having a significant impact. Data from the Commodity Futures Trading Commission (CFTC) in the US shows net open positions on the NYMEX, an indication of speculative activity, more than doubling in the last month to a peak of over 76,000 contracts on 8 March.

Net open positions fell in the following week as short positions increased, supporting the view that the market is due for a correction. Prices will likely correct from this peak but stay high, despite bearish short-term fundamentals, on three concerns.

First, doubts over OPEC's ability to continue raising output to meet stronger future demand. Second, a lack of clarity on OPEC's price aspirations. Third, the quality of the oil, hence widening differentials between crudes.

OPEC does have limited spare capacity

OPEC raised OPEC-10 quotas (which exclude Iraq) by 0.5 million barrels per day (mbd) to 27.5mbd in March, still below OPEC's estimate of current output at 27.7mbd, and is discussing a further increase to 28mbd.

Assessments of OPEC's capacity vary. The International Energy Agency (IEA) puts OPEC-10's sustainable capacity at 28.5-29.0mbd and spare capacity at 0.8-1.3mbd. Bloomberg estimates (see ) put both capacity and output higher, with a gap of 1.7mbd in February, but the message is the same.

OPEC has sufficient capacity to meet current demand but not enough to cover unforeseen supply shocks and/or rising demand. The recent Nigerian strike threat has brought the risk of supply shocks firmly back in focus.

The China factor

Oil demand growth was an exceptional 2.8mbd (3.5%) in 2004, on the back of robust global GDP growth.

China accounted for 0.9mbd of the increase, as demand rose by 15.9%. This was partly strong GDP growth (which averaged 9.3%), but also a result of severe power shortages raising diesel demand for generators. This specific factor should ease this year.

China's net imports of crude oil and refined products, which rose by 41% and 83% respectively in 2004. For 2005 we expect China's oil demand growth to be more commensurate with China's expected GDP growth of 8.5%. China is also building a strategic oil reserve, but the first part of the storage infrastructure will not be complete until later this year.

US demand growth is strong, but easing

The US is still the key driver of the oil market, accounting for 25% of global demand, compared to China's 7%. US GDP growth will still be strong in 2005, but should moderate to around 3.5% from 4.3% in 2004.

Consequently we expect more modest global oil demand growth of around 2mbd in 2005 (above the IEA's current forecast of 1.8mbd and OPEC's 1.9mbd). Estimates for non-OPEC supply growth have fallen recently, but still provide a further 0.9mbd in 2005.

This leaves the call on OPEC for 2005 at 28.8mbd, or 0.1mbd more than average 2004 output. The risks to demand forecasts are on the upside, but there is room to manoeuvre if OPEC output is sustained through the low demand season.

OECD inventories have recovered

Higher inventory reduces the need for spare capacity and inventories have returned to more reasonable levels. 6 shows how crude and product inventories in the OECD, which accounts for 60% of global oil demand, have been restored to more comfortable levels following a couple of years of reduced balances.

As the shows, recent monthly declines are part of a seasonal pattern, engineered by OPEC's previous output strategy. The rapid stock build in 1998 led to a price collapse that is still in the minds of OPEC members, and was behind the decision to cut back output at the beginning of this year. High market prices, on genuine future supply concerns, have forced a change in this strategy.

US inventory levels are also more comfortable

As OECD stock data is only available with a lag, markets tend to focus on more timely US data. Energy Information Administration (EIA) figures show crude inventory at average seasonal levels. Although heating oil stocks are relatively low, the winter season is virtually over.

Meanwhile, gasoline stocks are above the top of their 5-year range, leaving the market vulnerable to correction once attention switches to the summer driving season. Demand is forecast to weaken in Q2 - China's growing influence has reduced, not eliminated, seasonal variations.

The call on OPEC crude in Q2 is forecast at 27.6mbd. With OPEC-10 currently providing 27.7mbd, and a further 1.8-1.9mbd from Iraq, stocks will rise further, unless demand is still seriously underestimated. This should allow prices to ease.

OPEC and non-OPEC production capacity is expanding

Production capacity is expanding to meet demand beyond 2005, but the situation will remain tight for the next 2-3 years. 8 shows IEA estimates for OPEC's net incremental capacity - 2.5mbd of capacity is currently due in place by 2007.

OPEC investment is critical for restoring swing capacity and longer term supply growth. OPEC accounts for 77% of proven oil reserves. Upstream investment by independent oil companies has increased significantly with higher prices.

Investment by the top 30 publicly quoted exploration and production companies rose at an annual rate of 15% between 2000 and 2003, according to BP estimates. With a growing consensus for sustained high prices, investment should improve further. Near-term however, non-OPEC output growth has slowed.

Widening differentials highlight investment problem

Refining capacity is even more critical for future prices. Heavy-light and sweet-sour crude differentials widened in 2004 - a reflection of growing demand for sweet crudes to meet tightening low-sulphur regulations worldwide, the limitations of China's domestic refining capacity to cope with sour crude, and the heavy/sour nature of OPEC's swing capacity.

The WTI-Dubai differential has declined from highs in November 2004 as OPEC cut output (see ), while the benchmark WTI-Maya (sweet-sour) differential for the US has been sustained.

Both should narrow as market tightness eases in Q2, but differentials will remain historically high. A lack of absolute refining capacity in the OECD, and appropriate capacity in India and China are key issues that support sustained higher prices for high quality crudes.

OPEC's price aspirations are opaque

OPEC's USD22-28pb target price band, which was introduced in March 2000, has been largely defunct since early 2004, and was officially suspended in January. There are three key arguments for a higher target. First, OPEC's purchasing power has been eroded by USD weakness.

While the OPEC basket has risen 79% in USD terms since March 2003, it has risen only 31% in EUR terms (see 10). Second, while specific countries are suffering, high oil prices have yet to have a significant detrimental impact on global growth.

Third, with hindsight, industry investment rates have been insufficient in meet future demand. However, to date OPEC has not agreed on another target band, and conflicting and unclear messages from members are adding to price volatility.

Price forecasts

We now believe WTI will move in a USD40-50pb band this year, averaging USD45pb. Rising global stock levels will alleviate concerns and allow prices to ease from current levels.

Prices will stay more volatile than pre-2004 as OPEC has lost the ability to micro-manage the market. We are raising our forecast for WTI in 2006 to USD40pb as capacity growth has not accelerated sufficiently to alleviate the market tightness over this period.

The key risk to this forecast is a sharp decline in global growth. It is inevitable that oil demand growth will ease at some point. The critical issue will then become OPEC's ability to manage itself, given the change in relative production capabilities. On current evidence that crunch is not going to come until beyond 2006.