Oil to stay north of US$60

by Levi Folk | July 9, 2007

After a brief period of slack last winter, oil prices are once again reflecting the tightness that prevails in oil markets in light of a weak supply response in the face of strong demand globally. A truer picture of oil markets has emerged in recent months, one that suggests that oil markets are not as well supplied as previously thought OPEC supply cuts notwithstanding. In only a few short months, demand has proved stronger than predicted and oil supply that was expected to materialize has not.

The end of the bull market in oil was hastily pronounced by wishful value managers and a doubting public last winter when oil prices broke through $50 per barrel in the midst of a US economic slowdown. Yet, neither warm winter weather nor a US housing recession provided sufficient or lasting respite to counteract what is shaping up as a weak supply response to higher oil prices.

Despite the intensity of capital expenditure directed toward new supply in recent years, the result is appearing less than promising. A variety of factors are conspiring to limit oil production over the near term and perhaps beyond. Capacity erosion or depletion, cost inflation in equipment and services and lack of access to resources in several countries are the most important factors.

Decline rates are most profound in non OPEC oil producing countries. Net additions so far this year are anemic, a total of 640,000 barrels per day (bpd): the former Soviet Union accounts for roughly 400,000 bpd; Latin America added a mere 7,000 bpd; production from the Middle East (Oman, Yemen and Syria) fell; and production in Africa was roughly flat.

Turning to OPEC, production from Iraq has been falling recently and little changed over last year. Production in Nigeria has been hampered by rebel activity in the Niger Delta to the extent that May output was the lowest since early 2003 according to the IEA (June 07 Oil Market Report) who estimates idle capacity at 800,000 bpd. The IEA nets production from Indonesia, Iraq, Nigeria and Venezuela, not unjustifiably, from its estimates of effective OPEC spare capacity,

With that point in mind, effective OPEC spare capacity stands at 2.85 mbd according to the IEA. This number is remarkably low considering that OPEC-10 (excluding Iraq and Angola) quotas have taken 1.7 million barrels per day (mbd) out of the market since July 2006. In fact, current OPEC production appears to be too low to meet “the call on OPEC” which is the difference between projected demand and projected non-OPEC supply.

OPEC production (including Angola) was 30.2 mbd in the first quarter of 2007. Yet increased demand for 2007 implies a call on OPEC (plus any change in stocks) of 32.3 mbd in the third quarter of this year. An additional 2.3 mbd means the effective spare capacity would be less than 1 million barrels in the coming months assuming no change in stocks.

OECD inventories, that is oil and other fuel stocks, were above the five year average at 9.9 mbd in April, but it is important to consider that demand has been rising steadily over the past five years and that the recent inventory trend is down. At 52 days of forward cover, stocks are at their five year average. The Energy Information Administration (EIA) reported an 800,000 bpd draw in the first quarter of 2007 well in excess of the 5 year average first quarter inventory draw of 300,000 bpd. The result: inventories are down toward the middle of the historical range at the end of the first quarter and look to be headed lower.

It’s not one thing but a variety of factors that are conspiring to potentially send oil prices even higher in the near term. Demand has been revised higher this year by 420,000 bpd and last year’s numbers were also ratcheted up by 250,000 bpd. Revisions are attributed to non-OECD countries where demand has been compounding at nearly 4.5 percent per annum since 2003, far stronger than previously thought.

Production outages in Nigeria and declines in Iraq as mentioned previously are surprises that tip the balance to tightness over the next few months. Conflicts in both these countries suggest that resumption to full capacity is unlikely in the near future and current weakness could prevail.

Even if we leave speculation about depletion to peak oil theorists, the balance for oil markets appears exceptionally tight in the near term only a few short months after oil prices were in a free fall. Perhaps the world should get used to $60 oil.