The oil slick on the road ahead

This past year as crude oil soared from the high $20s to nearly $40 per barrel (/bbl), most commentators, and this columnist was no exception, held the optimistic view that the spike would not last and prices would settle down to the mid-$30s. As and when Iraqi crude returned to the market in any quantity, further softening would result, limited by the extent to which other west Asian producers would restrict their output. Even when in the beginning of August 2004, UK Brent benchmark prices entered the $40/bbl region, it seemed to be more of a response to fear of temporary interruptions and the rapidity with which it fell away from a high of over $45 on August 20 to close below $40/bbl by the end of the month, tended to reinforce the optimistic view.

September has buried that idea, as for the better part of this month, prices have tested new levels. For sure, there has been a stream of bad news from the usual stuff in Iraq to a series of hurricanes that threatened oil rigs in the Gulf of Mexico to the latest threat to Nigeria?s southern oilfields. But this kaleidoscope of events have been played out on the grim reality that short-term demand has risen so much faster than has supply, that the usual supply cushion has more or less vanished.

The oil business has been a cartel for about as long as it has existed. Only the cast of characters has changed, with Opec nations in charge (more-or-less) ever since 1973. A cartel exists through its ability to restrict output. Demand is given from outside, so if I and my cronies who control the supply agree to cutback production, then the price will rise. Those outside of the cartel also gain by not rocking the boat overmuch such that prices begin to slide. On occasion ? as during the Asian crisis ? demand falls so precipitately that the discipline of the cartel fails and prices plummet as they did so memorably to $10/bbl in December 1998. But there is a plus side to this cartel business, which is that, there ought in theory to be a supply cushion which producers can fall back upon if demand rose more strongly than expected.

Why should producers not simply grin with glee and watch prices soar? Because they have an interest in price stability; prices that are too high can spur technological changes that can reduce demand in the long-term ? as it did in the OECD, especially Europe, in the 1980s after the second oil price shock. Prices that are too high can also spur exploration and kick-in marginal high-cost sources. Most crucially, if oil prices rise too fast and too high a level, it impacts economic growth adversely and then future period demand for oil is less than it would otherwise have been. For all these reasons, Opec has always operated with some kind of a price band in mind: if prices were to fall below this they would cut back on production and if prices were to rise above the band, then they would step-up output.

The system never worked well in the best of times. But developments over the past few years have more or less skewered it ? at least for the moment. It used to be believed that with modest investments, Iraq could raise its capacity from 2.5 million barrels per day (mb/d) to over 4 mb/d quite rapidly. Ever since early 2002, as the US-led regime change in that country unfolded, all players began to factor in the strong likelihood of this additional supply. In reality that has not come to be and Iraqi production is still struggling at 1.8 mb/d ? which is a huge expectation gap of over 2 mb/d. On the demand side, consumption has soared in some unexpected locations. Between 2002 and 2004 (estimated) global oil demand has risen from 77.9 to 82.2 mb/d. Of this increase of 4.2 mb/d, as much as 1.4 mb/d comes from China, way ahead of the largest oil market ? namely, the US (up only 0.9 mb/d). India also contributes disproportionately (to the level of her consumption) with an increase of 0.5 mb/d. Furthermore, the collapse of oil prices in 1998 and 1999 had undermined the confidence of oil companies in allocating financial resources to develop new sources and as a result there is not enough new capacity to accommodate the unexpected surge in demand from developing Asia.

Now look at the ?spare? capacity as computed by the International Energy Agency (IEA). Relative to June 2004 production, the excess of sustainable capacity for Opec (excluding Iraq) was 1.1 mb/d, of which 0.35 mb/d was in Saudi Arabia. Relative to August 2004 production however, the ?spare? capacity (again excluding Iraq) had fallen dramatically to 0.31 mb/d. It?s true that Saudi Arabia can come up with another 1 mb/d over a few months, but that is just how tight supply has become. Outside the Opec there is of course no ?spare? capacity and the fastest growing non-Opec source, Russia, is on the one hand seeing a slower growth in output and on the other has problems such as the one with Yukos. With the squeeze being as tight as it is, it?s understandable why every little potential supply disruption causes prices to flare in the way that it does. In the short-term there does not seem to be any source of relief ? and that includes an early normalisation of circumstances in Iraq.

IEA estimates that in 2005, world demand would grow more slowly than it did in 2004 by 1.8 mb/d, with China?s demand increase falling to 0.48 mb/d from 0.84 mb/d in 2004, and a similar moderation in other developing Asian economies, including in India. Clearly, with continuing strong economic growth in Asia, demand might grow more strongly than the IEA estimates for 2005. An additional 1.3 mb/d of supply is expected from non-Opec sources in 2005, but Opec would have to chip in an equivalent amount in excess of that for the comfort of the cushion to reappear. Normalisation of Iraq in 2005 would solve that problem handily, but in its absence tight market conditions are likely to continue into the middle of 2005 and so too high prices and volatility. Price discomfort is here to stay ? for some time at least.

The author is economic advisor to ICRA