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Will the fall in oil prices last?

August 23, 2008 11:27 IST

Following the shock of seeing crude prices pierce through the skies to touch $147/barrel in July 2008 from $50/barrel in January 2007 and its subsequent fall to $115 level has made optimists hope oil will slide back to near old levels in due course. Unfortunately, this optimism appears misplaced as strong market fundamentals point towards an extended run of the oil super cycle.

The recent fall was mainly led by temporary improvement in the supply response in the last few months. Global oil supply has increased by 890,000 barrels per day (bpd). While Norway, Canada, Argentina and Brazil were the non-OPEC contributors, Saudi Arabia, Nigeria and Iran contributed from the OPEC side.

It was further helped by a drop in the US oil demand by an average of 800,000 bpd during the first half of 2008. Thanks to the financial turmoil and a consequent economic downturn, the US has witnessed its first ever decline in oil demand in 26 years.

The recent recovery of the dollar also contributed to this dip. The plunge was sharp also thanks to speculators' unwinding their futures position in the wake of the improvement witnessed in the market balance.

Oil prices are however, unlikely to slide back from the current $100-plus zone to the older sub-$100 zone in the near-term. Going by foreseeable market dynamics, high prices appear to stay. Lack of adequate supply growth, particularly from non-OPEC sources is the main culprit.

Since 2002, the world supply grew by about 8 million bpd (mbpd) to reach 86.4 mbpd out of which non-OPEC contribution was only 2 mbpd. Project delays have become a common feature, caused by higher exploration costs, equipment shortage etc.

The top 10 western oil giants, who produced over 50 per cent of world's oil 30 years ago are now producing only about 13 per cent. In the latest quarter, the output of five of the biggest US oil companies, including Exxon Mobil, declined by 614,000 bpd, the steepest decline over five consecutive quarters.

As if it was not enough, production from some of the large oil fields, like Russia's Gazprom is also declining rapidly. Therefore, the Energy Information Administration in a recent report has scaled down the output growth from non-OPEC source for the year 2008. Given the recent trends, additional growth expected mainly from Brazil and USA through 2009 may not come on stream as expected.

As a result, the emerging world's reliance on OPEC supplies for meeting its ever-increasing oil requirement is rising rapidly. Since 2002, OPEC has increased oil supply by around 6 mbpd. Like other parts of the world, new projects in the OPEC area, like, Saudi Arabia are behind schedules.

Hence, most of production rise from OPEC has been from reserve capacity, resulting in an erosion of almost all spare capacity available with them to reach just 1.57 mbpd now. In such a situation, any seasonal lift in demand or drop in production due to geo-political or adverse weather conditions can lead to another round of spikes in oil prices. This tight situation is likely to continue for many more years.

Continuation of this over-reliance on OPEC supplies in future too is going to keep supply under constraint. Resource nationalism among OPEC players will keep future growth in supplies under their control which will further strengthen their cartel power.

The influence of cartel behaviour has been already visible in the recent past. In late 2006 and early 2007, when prices fell back to $50 from the highs of $80/barrel, OPEC drastically cut its production, which eventually lead to the current upsurge.

In the current case too they can take similar steps to arrest a further fall. OPEC has already indicated that in its meeting in Vienna next month it will review the supply situation.

So the current situation is favouring an upward flexibility to the oil price and downward rigidity. It is an established trend that whenever prices rise abnormally, subsequent corrections ensure a part of the hike remains so that the overall impact is to ensure prices continue to rise.

Moreover, demand destruction in the US and other advanced countries is not sufficient enough to bring the market balance. Oil demand is expected to grow by 1 mbpd in the second half of 2008 and another 1 mbpd in 2009 on the strength of China, India, Middle East, CIS and Brazil.

Since 2000, China's oil demand almost doubled to reach 8 mbpd in 2008. To have market equilibrium at a much lower price, a heavy fall in demand is required and that hardly looks probable.

If the US is technically out of recession and recovers reasonably and inflation in emerging economies cools down by early 2009, oil demand will probably go up further, making the span of the super cycle much longer and durable.

Inventory outlook also supports the bullish outlook on oil prices. The usual stock-building with OECD and refining companies has not happened during the the first half of 2008 on account of high prices, keeping the OECD commercial inventories below the five-year average.

Seasonal build-up of stocks is expected through the third quarter and until winter which will keep the demand growth steady. And every drop in the oil price is likely to push up the stocking process.

Alternative fuels were expected to play a balancing role in diffusing persistent low supply growth. But these fuels are only viable when oil prices rise to at least $70-100 a barrel. Moreover they can replace only an insignificant portion of the demand for fossil fuel in the near future.

These apart, there are a host of random elements that act as swing factors. Unlike a decade ago, today's oil market is increasingly guided by movement in futures prices. Increased oil prices have attracted a large interest from hedge funds who have taken quite a bullish position on the oil market.

About 50-70 per cent of the futures market comprise of speculators who actively contributed for swings to the tune of as much as $8-10/barrel. Geo-political risk in countries like Nigeria, Iran and Venezuela, and now Georgia, together with the post-US election situation and weather disturbances can prove to be hugely volatile factors.

In a nutshell, lean spare capacities with OPEC, more reliance on vulnerable supply sources, rising demand from emerging economies, low oil inventories, and continued geo-political risks are all pointing towards a continuance of an upbeat price outlook.

Therefore, we expect crude price to remain high and find support around $110-$115/barrel. A technical bounce back and a tight market balance are set to lift prices up to the consolidation zone of $120-$130/barrel in next two-three months. We won't be surprised even if oil touches $150/barrel in the next six months as the world passes though a cold winter.

The author is Chief Economist, Essar Group

Ishwar Hegde