Oil supply destruction: the next step for the oil market?

Oil supply destruction is a fact of life. The most immediate problem is refinery capacity, which is limited in the world today, restricting the future availability of extra refined products.

Then there is the crude oil itself. Kuwait is the most recent producer to admit that output will have to be scaled back to 2.5 million barrels per day from 2.7 million next year, due to essential maintenance. Indeed, one thing we know from recent history is that when oil producers pump at maximum capacity for a period, it is followed by technical problems that reduce output.

UK and Russian oil output down

This year we have already seen a peak and decline in oil production from Russia and the UK, both significant producers. Even in the Gulf States, Oman has reported a further slide in production.

It is therefore Saudi Arabia, pumping away at 10 million barrels per day that is the main support to global supply. Any slippage in the Kingdom and supply destruction would suddenly become a major factor in the marketplace.

In the short term, the winter weather in Europe and North America will be the main driver of oil prices, and the colder weather has just arrived and with it higher oil prices - US light crude above $61 a barrel.

However, in the medium and longer term, it is the surge in demand from China and India and emerging Asia that will keep prices high. The recent strength of the US dollar has also kept oil prices down, but can not be relied upon in the near future, and renewed dollar weakness could well be the final factor propelling oil prices to a new high next year.

Higher oil price to come?

It has to be said that November was a month of unusual calm in the oil market with mild weather and oil prices slightly lower. There was also a sense of recovering from the damage caused by hurricanes Rita and Katrina, although the longer-term impact on refinery capacity in the US has probably not yet been felt, another supply destruction issue.

In life there is often calm before the storm, and it may be that supply destruction soon raises its head as a very significant factor. That would drive oil prices to new record highs in 2006, and threaten to cause economic recession.

For the market realities of oil have not changed. Demand from emerging and industrialized economies is still growing strongly, and the supply position is held back by ageing oil wells, under-investment in infrastructure and a shortage of refining capacity.