World Risk - Oil's New Range in the Economy

COUNTRY BRIEFING - FROM THE ECONOMIST INTELLIGENCE UNIT

The price of benchmark US sweet crude oil has averaged US$63/barrel so far this year, reaching peaks of US$68/b in late January and early April, and with mid-February marking the lowest point, at US$57/b. The build-up of stocks over this period, with supply comfortably exceeding demand, would provide good cause to expect the price to fall, were it not for a host of other factors working in the opposite direction. They include the resilience of world oil demand and economic growth, despite the high price of oil, the limited spare production capacity available, both upstream and downstream, and geopolitical concerns in the Middle East, West Africa and Latin America, regions where almost 80% of the world's oil reserves are located.

Most industry forecasts, including that of the Economist Intelligence Unit, point to an oil price of US$60/b plus in 2006. The main risks are considered to be on the upside, with the possibility of price spikes occurring in response to increased tensions over Iran, further losses of production in Nigeria and a repeat of last year's destructive hurricane season in the Gulf of Mexico. The prospect of a big downward correction in the oil price seems unlikely, at least until the current crop of capacity expansions in the main OPEC producers comes on stream towards the end of the decade. In the meantime the main risk on the downside is that further increases in the oil price could have a more marked effect on world growth and oil demand than has happened so far--the IMF has also pointed to the risk of high energy prices triggering an "abrupt and disorderly" unwinding of global financial imbalances.

In store

The oil price has climbed steadily over the past few weeks largely in response to trends in the US, where a rise in crude stocks has been overshadowed by falling stocks of gasoline. Tightness in the US gasoline market is expected to continue, as refineries cope with the disruption resulting from using ethanol as an additive rather than MTBE, to comply with new environmental specifications. Crude oil stocks in the US are at their highest level in seven years, but this has not had a material effect on the oil price because of the expectation of higher refinery throughputs in the coming weeks and owing to the fact that much of the surplus is located on the west coast, and therefore has limited relevance for the main consuming regions in the east.

With forward crude price contracts remaining well above the price for prompt delivery--resulting in contango in the oil market--there is an added incentive for building up storage, as this allow refiners and other traders to realise an attractive margin on future sales in respect of stored crude. This has the effect of limiting the impact of the current global stockbuild on the oil price.

Demand

And yet, there are starting to be signs of a marginal effect on oil demand with the price set at above US$60/b. The International Energy Agency (IEA) has trimmed its forecast for extra demand in 2006 to 1.5m barrels/day (b/d; 1.8%) from an earlier projection of 1.8m b/d, owing to soft demand in south-east Asia and "persistently high product prices". However, the agency notes that this still represents a recovery from 2005, when demand rose by just 1m b/d. The Economist Intelligence Unit forecasts a slightly higher increase in oil demand in 2006 at just over 2%, based on our expectation of a strong recovery in Chinese demand following a relatively subdued 2005 (owing to internal pricing factors) and of a rise in US consumption as damaged refineries come back on stream.

The extra demand can be adequately met from increases in non-OPEC supply and from stable OPEC output of just below 30m b/d. However, this leaves little more than 2m b/d of spare capacity (more than half of which is concentrated in Saudi Arabia), which is still clearly inadequate to offset concerns about the impact of a major interruption in supply, even with the contingency plans drawn up to deal with such an eventuality. The release of strategic stocks by the US and the IEA last August succeeded in mitigated the effects of the Gulf of Mexico hurricanes, and the IEA has provided the assurance that it has sufficient stocks to cope with a cut-off of Iranian crude for 18 months.

Over the next few years, we expect some relief from countries such as Sudan, Brazil, Angola and the former Soviet Union. However, most of the increase in global supply will come from OPEC members (where most of the spare capacity lies), rising by 3-4% per year in 2006-08. New crude oil production capacity will come on stream in Algeria, Libya, Nigeria and Saudi Arabia, with Saudi Arabia claiming that by 2009 it will have the capacity to produce over 12m b/d. A significant portion of the new OPEC crude will be of the lighter varieties, which is what the global market ever more desires.

IOCs-vs-NOCs

Higher crude prices have yielded huge financial benefits to oil-rich governments and national oil companies (NOCs), as well as to international oil companies (IOCs). It has also stimulated a drive to increase production and to invest in new and more sophisticated refining capacity. The surge in oil export revenue has strengthened the bargaining position of governments and NOCs in their dealings with the likes of ExxonMobil, Shell, BP and Total, with most dramatic effects in Latin America, and Venezuela in particular. However, the IOCs have by no means been frozen out. In the Middle East, the extra technological edge of foreign oil majors is being sought to help to optimise recovery from complex reservoirs, and the marketing muscle of the IOCs is considered to be an essential element in making new refinery projects viable.

Thus, at the same time that ExxonMobil is at loggerheads with PDVSA in Venezuela, the US major has secured a 28% stake in the venture that operates one of the largest oilfields in the UAE. ExxonMobil and others are patiently pursuing an opportunity to gain long-term operating rights in four Kuwaiti oilfields, and foreign oil companies are working on oilfield developments worth in excess of US$7bn in Qatar and Oman. Even in Saudi Arabia, whose upstream oil industry is off limits to outside operators, IOCs are being brought in as partners in two major refinery projects. Similarly, Algeria and Libya offer opportunities that are being eagerly pursued by IOCs.

All this activity in the heartland of the global oil industry should eventually restore a more comfortable safety margin between demand and production capacity. Whether this has the effect of bringing the oil price back significantly below US$50/b will depend to a large extent on perceptions of political stability in the Middle East.