Tuesday, July 29, 2008

What is Going On in the Oil Markets? OPEC Appears to be in Control

Oil prices are generally very volatile, but this year has been an exceptional roller coaster. What is going on in the oil markets currently? Note that over the long term, oil prices tend to be determined to a greater degree by fundamental factors (supply and demand) verses technical factors (financial speculation). This article will focus on fundamental factors, making the assumption that supply and demand factors fundamentally determine oil prices.

In the author's view, the effective consensus view on oil prices from approximately 2002 onward prior to July, 2008, was that demand would increase significantly going forward, while supply would stagnate, leading to continued high, and even higher, oil prices. The new "market consensus" since the beginning of July 2008, appears to be, in the author's opinon: slightly higher supply (we are finally seeing a supply response) and only slightly higher demand (developed countries' oil consumption will go down, developing countries oil consumption will go up, but at a lower rate). The new consensus appears to imply a slightly higher supply than demand, going forward, resulting in significant downward pressure on the current and future price of oil.

The reassessment since July 2008, has mainly been driven by two new pieces of information, which are being digested -- world supply in the past few months increased, albeit slightly (by approximately 500,000 bpd from a world average production of 86M bpd, also note that exportable oil has so far not shown increases in supply), and total world consumption slowed significantly, driven mainly by consumption declines in the United States (offset by continued consumption in the developing world, mainly China).

It is argued in this article that this new, as of July 2008, "market consensis" is not exactly accurate -- the supply response in 2008 is not a fundamental change regarding future production, due to the fact that all the increased supply in 2008 has been from OPEC countries, who have an interest in relatively high oil prices. But the demand response in 2008 is likely a fundamental change, meaning that world oil demand will likely slow significantly going forward. The new market consensus is therefore close on demand, but off on supply. If supply is actually being effectively controled by OPEC, but demand is moving at a lower rate, the net result will likely be current pressure on the oil price, but a long term, supported reletively high oil price, in line with OPEC's interests (note OPEC has stated that they are comfortable with long oil prices around $100, if over the short term in the $80's).

The risk to the author's view of the current oil situation -- which is can be summed up by the title "OPEC controling prices" -- is a worldwide economic recession and/or a very large conservation movement in both developing and developed countries, that decreases demand to a higher degree than OPEC effectively can cut supply. In this case, the price of oil would decline significantly.


Oil Prices: Dominated by OPEC Currently


There have been notable developments on both the supply side and the demand side in 2008 in the oil markets -- namely, there is a small overall supply increase in total oil and condensate production in 2008, and on the consumption side, most notabily, oil consumption in the overall world has increased only very slightly (under 500,000 barrels per day) -- with a surprising 5% decline in 2008 in the United States, the world's largest oil consumer, for the past three months (May, June and July).


On the supply side, OPEC is engineering this supply increase, by removing all restrictions by members towards oil production by OPEC members in 2008. The removal of OPEC production quotas, (by a senior OPEC official, reference) has not been reported widely in the media. The king of Saudi Arabia stated in July 2008, that he is "very disappointed" by the increase in the price of oil. This move has been initiated by OPEC in order to support the flagging OECD economies by lowering oil prices, and alleviate pressures on the developing world's economies, according to comments by OPEC officials.


Near term supply increases are determined mainly by Saudi Arabia, currently, as the only country with stated high (over 1 million barrels) of unused oil capacity. Saudi Arabia has promised new oil production in 2008 and so far has delivered between 200-500k of new production (depending on the source, different info from governmental sources the EIA and IEA). The key new oil capacity as most of the new announced projects are very old oil fields, from the 1960's. However note, the political will to increase prices by SA down to below $60 is assessed as "very low" as the King of Saudi Arabia, despite the comment above about being "very disappointed" in another July 2008 interview signalled confidence that reletively high oil prices will continue:


"Prices will continue to soar as the economy flourishes because energy is a vital resource in development. Thanks to the Almighty, our region has a strong oil reserve that can meet future demands."


The apparent paradox of King Abdullah wanting to increase production while supporting a reletively higher price of oil can be solved by Abdullahs observation that (from the July 2008 interview) that: "Our enthusiasm to protect the interests of the international community, in terms of oil, is on par with our eagerness to protect national interests."

It should be noted that since about 2005 Saudi Arabia and OPEC have signaled a willingness to act to support signifcantly higher oil prices -- higher than the 1990's normalized levels of $10-$30 per barrel. In 2006, when the price of oil briefly dropped below $50, Saudi Arabia cut back production which was a major factor towards oil prices re-starting their trend upward. Quote from March 26, 2006:

"OPEC's unity may keep oil from dropping below $50 a barrel for years to come, energy experts say.``They've learned their lessons,'' said Daniel Yergin, author of the Pulitzer-winning history of the oil industry, ``The Prize: The Epic Quest for Oil, Money & Power.'' ``They like this band from $50 to $60 and they prefer the upper part of the band rather than the lower part,' `We are happy with the level of compliance,'' Mohamed al- Hamli, president of the Organization of Petroleum Exporting Countries, said in an interview in Bangkok on March 22. (2006)"

Further, OPEC has currently removed all restraints on oil production from all countries. OPEC has lifted all quotas as of early 2008 on OPEC production due to the run up in oil prices which threatens the world economy.


"A senior OPEC delegate said Monday that OPEC ceilings and quotas had become largely irrelevant and that OPEC had a "tacit" understanding that those members capable of boosting crude production should supply as much oil as world oil markets needed."

With OPEC producing all out, we get a very small move up in overall oil production. (which actually can be interpreted as a reason for long term concern in terms of oil productive capacity for the world as a whole over the long term -- does OPEC really have potential for significant future output increases if maximum current output increases total output by less than 1 million barrels?)

Which other countries besides SA can increase oil production and oil exports significantly with a moderate probability over the intermeidate term? Almost without exception, they are OPEC member countries. Of non SA production, the two main countries with the most potential are Iraq -- which is quietly increasing production -- and Iran. Lower probability of future significant increases exist from Brazil, Venezuela, Nigeria, Angola and Kazakhstan -- these total the only countries with moderate probability for potential of significantly higher (over 1 million) of future production increases over the intermediate term. But note, these countries, with the exception of Iraq, Kazakhstan and Brazil are in OPEC -- although both Kazakhstan and Brazil have signaled they are interested in joining OPEC.

Note that non-OPEC production is flat, without significant prospects for increases over the intermediate to long term, according to IEA (International Energy Agency) president Faith Birol. The most notable current development is the fact that Mexican oil production declined at over 30% last year without prospects for reversal of that decline this year (that is to say, is continuing to decline at near 30%) and North Sea production is declining at 20% per year. These moves are offsetting any new production -- from for example, Canada or deepwater Gulf of Mexico.

In summary, overall, on the supply side, the current supply increase is likely a deliberate response by OPEC, and it is likely future supply increases are controlled by OPEC. Going forward, without significant world "demand destruction," it is likely OPEC will continue to move to support a long term, relatively high price of oil.

What is Occurring With Demand? Real Demand Destruction in Developed Countries, Developing Countries Still See Demand Increases


The key question on the consumption side: is it possible that overall consumption of oil can decline going forward? This would require, in the developed world, continued declines year to year. Further, this would require, in the developing world, oil consumption to increase little or not at all. The most obvious solution to lower world oil demand is that recession will lower oil demand in both developed and developing countries. The probability of a collapse in China is beyond the scope of this analysis, as is a "Second Great Depression" in the United States. If the US continues to experience a slight recession while China continues to grow, OPEC would still appear to have the upper hand in determining long term oil prices.

One more "risk" to the above theory, that OPEC controls the intermediate price of oil. Can the world move away from oil use in the intermediate term, without economic impacts? It is noted that demand in the United States dropped by approximately 5% so far in 2008, Denmark's oil demand peaked back in 1998, and Japan's oil demand hasn't moved significantly since the 1980's, despite economic growth there (more specifically, in Japan, economic growth in the 80's, followed by stagnation in the 90's).

Proposed:

- lower oil consumption is related to either 1) lower rate transport of goods and persons and/or 2) more efficient transport of goods and persons. 1) is more correlated with lower economic activity (recession), while 2), efficiency, is more correlated by mass transport -- both Denmark and Japan have very good public transportation. Will both the developing and developed world move massively into public transport? The rate of this increase is also beyond the scope of this analysis, but will be addressed in a future analysis.


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