Oil to drop as OPEC turns up the taps

by Levi Folk | March 1, 2008

Crude oil prices at US$100 per barrel are at odds with recent weakness in the U.S. economy, with rises in U.S. petroleum and gasoline stocks, and with expectations for higher OPEC oil supply in 2008. The oil market appears to be trading more off hope than fundamentals, which are more in line with US$70 per barrel oil over the next year.

The U.S. economy is limping along at best, after being knee-capped by a severe contraction in the housing market, and this is translating to lower demand for oil in 2008.

The International Energy Agency (IEA) has belatedly cut predictions for global energy demand in its most recent monthly Oil Market Report. Its forecasts for oil are, unfortunately, only ever as good as IMF economic forecasts for economic growth.

The IEA has cut its estimate for global oil demand for 2008 by 600,000 barrels (6.8%) since the credit crisis began last summer. While it was apparent to some that the economies of the developed world would slow for two reasons—a retreating U.S. consumer and poorly functioning global credit markets—the IMF only recently revised down forecasts for global growth when it presented the World Economic Outlook Update in late January.

The IMF appears still behind the curve in its forecasts for the U.S. economy in 2008. End of January revisions to 2.2% growth for 2008, down from 2.7%, appear overly optimistic. The IMF also noted that the “balance of risks to the global growth outlook is still tilted to the downside.” In other words, more downward revisions are likely. Therefore cuts to oil demand in ‘08 loom large over US$100 per barrel oil prices.

Completing the story, additions to OPEC spare capacity in 2008 means that falling demand will be well covered by rising supply. OPEC appears to be bringing on a significant amount of spare capacity with gross additions of 3.1 mbd translating to over 800,000 bpd in net capacity additions by the end of the year. This figure represents the highest level for OPEC spare capacity in years (excluding the first half of 2007 when oil prices had briefly plummeted to the US$55) range.

After falling steadily through the second half of 2007, oil stocks have recovered significantly in recent weeks judging by data disseminated by the Energy Information Administration (EIA).

While it is possible that OPEC could cut production in the near term in the event of falling prices, one would expect OPEC to tread cautiously in the face of a weak US economy. The risk of a US economic recession spilling over to global economic growth makes this a high stakes move with higher an asymmetric payoff.

OPEC has unofficially been increasing production above targets set in 2007. After taking roughly 1.25 mbd of supply out of the market since August ‘06 when oil prices started sagging (they announced 1.7 mbd in combined cuts), they quietly added them back in recent months and then some. The important point here is that expectations for growth in OPEC spare capacity are after adding back any prior production cuts and accounting for additional gains in production.

It is obviously more dangerous to short a commodity, or any security for that matter, in opposition to its secular up-trend, and this pronouncement is certainly applicable to the oil market. However, the überbullish attitude to oil prices by investors and traders is the reason that this opportunity presents itself. Oil prices appear out of line with near-term fundamentals which suggest that spot prices will recede.