What?s happening to oil prices?

After Atlantic benchmark crude prices topped $55per barrel (/bbl) in the third week of October last year, there was a widely shared consensus that prices had clearly overshot and relief would come sooner than later. This did happen, as prices softened over subsequent months and the year ended with Nymex crude falling to the mid-40s in December 2004. However, since then crude prices have been on the upswing. Nymex closed last week at nearly $54/bbl. UK Brent, the other important Atlantic benchmark crude, closed just below $52/bbl. The Opec basket of crudes ended last week at over $48/bbl.

It is important to note that: (a) in the rally of October 2004, when Atlantic benchmark crudes touched $55/bbl, the Opec benchmark price remained way behind at under $47/bbl; (b) last week?s price was above its peak value of October by one dollar. Closer home, the price situation seems more acute. In October 2004, the benchmark Dubai-Oman average price for heavy crude remained below $40/bbl; at the end of last week, it traded at nearly $45/bbl ? $5 above its October peak.

Crude petroleum prices tend to harden in the winter, due to cold conditions in the economic and geographical North (read heating oil demand) and tend to retreat from end-March. However, even if the seasonal pattern were to repeat itself, much relief is unlikely. We need to note two factors.

First, the average price of Opec benchmark crude was $36/bbl for all of 2004 and considerably over $40/bbl in the second half of the year. Our domestic refined product prices are probably set so as to be neutral to a price in the mid/upper-$30s. Thus, even a $5/bbl reduction from prevailing prices may keep us $5-7/bbl short from retail prices that fully compensate our oil companies for their production cost. And we cannot keep passing the buck on to ONGC and GAIL, for (a) their capacity for absorption is not unlimited; and (b) it does little service to our national interest.

Second, the tightness in the supply position for crude petroleum is expected to continue in 2005. The International Energy Agency (IEA) has revised its demand estimate for 2005 upward to 84.0 million barrels per day (mb/d), which is an increase of 1.52 mb/d (1.8%) over the estimated consumption of 82.5 mb/d in 2004. It needs to be mentioned that in 2004, world demand had risen by 2.68 mb/d (3.4%). The IEA apparently expects a moderation in demand growth in all major markets, an expectation rooted in the belief that higher prices will curb growth directly, and indirectly by encouraging substitutes, primarily natural gas.

An examination of the IEA estimates for demand in 2005 suggests actual demand expansion may be significantly larger. There is a distinct likelihood that demand growth will be much greater than allowed for in China, India, other developing Asia, quite possibly in the USA and, to some extent, even in Europe.

On the supply side, the IEA expects non-Opec sources to generate an additional 0.9 mb/d of crude, primarily on account of a 0.53 mb/d (4.5%) increase in output from the former Soviet Union. That given, the relatively modest estimate of increase in demand of 1.52 mb/d and adjusting for stocks, leave a ?call? on Opec to produce 28.3 mb/d ? which is about the same as the counterpart figure in 2004 of 28.2 mb/d, and less than actual Opec output of 28.7 mb/d in 2004.

The IEA places the ?sustainable production? capacity of Opec, including Iraq, between 31.0 and 31.5 mb/d, and estimates a current ?spare? capacity of about 2.2-2.7 mb/d. Opec capacity, particularly in the Persian Gulf region, has been augmented through 2004, and it would appear from the workings that the supply side position is not uncomfortable. Except that is, from ?random events? ? accidents, labour troubles, unrest, unscheduled maintenance and the like. IEA places this downside risk of supply losses at 300-400 kb/d for non-Opec supply each year.

Supply disruptions of 300-400 kb/d may well be bearable in the context of the demand growth adopted by the IEA and the consequential call on Opec of 28.3 mb/d, that leaves a ?spare capacity? of over 2 mb/d. However, demand growth in 2005 is likely to be higher than the IEA estimates. And disruptions are more than probable in Opec, too, as Iraqi supplies continue to be disrupted on a regular basis. If for instance 2005 incremental demand is more in line with that experienced in 2003 and 2004, incremental world demand could be higher by 0.3-1.2 mb/d, which would consume much of the ?spare? Opec capacity.

Opec members clearly have not been persuaded by strong prices to signal a production increase. The weakness of the US dollar in which prices are most commonly quoted is, perhaps, seen by many members as justification to protect the upside to their revenues resulting from surging Asian demand. Average Opec prices had risen by 28% in 2004; it is unlikely that Opec would not wish for further gains in 2005. A 10-20% increase over 2004 would result in average 2005 prices in the range of $40-43/bbl. These levels (if not higher) can well be supported by the thinness of the wedge between demand and supply.

Our domestic price situation is far better than it was last summer. Wholesale price inflation was down to 4.8% for the week ending February 19 and that for manufactured goods at a low of 4.2%. It is an opportune moment to make the price correction and prepare for another long year of strong crude prices, where we will be lucky if we can source crude at under $40/bbl. If the judgement of this columnist turns out wrong and crude prices fall like snowflakes in a dream, then retail prices can always be brought down. But the cost of operating on the basis of that dream will indeed be very steep.

The writer is economic advisor to Icra