Fingers are crossed for oil prices

19 January 1996

The oil producers of the Middle East had a good year in 1995. Prices for the OPEC basket of crudes rose by about $1.25 to $16.79 a barrel while most Gulf states had based their budgets on lower figures. They will be hoping that such good fortune holds during the year ahead. However, few analysts are forecasting further sustainable advances in oil prices for the coming months.

The outlook is for a world market that could be flooded with surplus oil as the year advances and most of the projections point to lower prices this year. 'The risks must be on the downside,' says Nick Antill, an analyst with Barclays de Zoete Wedd (BZW) in London.

There was much to cheer the market in the final weeks of 1995 and the first trading days of the new year as a combination of cold weather in the northern hemisphere and heavy buying by Asian refiners sent oil prices soaring. The price rally in the fourth quarter took most analysts by surprise and tended to confirm the role of the unpredictable in confounding the best estimates.

Despite the late surge in prices, most of the price forecasts for 1995 turned out to be remarkably accurate. There was a consensus that dated Brent would average from $16 - $17 a barrel during the year; in the event it came in at about $16.90.

There is more caution this year. In its forecast for 1996, Kleinwort Benson expects dated Brent to fall back to $16 a barrel. $1 down on its prediction for 1995. The tone of most other analysis is similar There is no reason to change a flat price projection for this year says BZW's Antill.

Others are less sanguine due to the prospect of rapidly rising supplies. Leo Drollas chief economist at the Centre for Global Energy Studies in London, expects prices to average about $16 50 a barrel during the first half but fears they could fall as low as $12.50 a barrel after that, due to a 'tidal wave' of new oil which is set to reach the market.

There are various estimates of the timing, size and impact of this new oil but the case for the risks being on the downside seems inescapable. This is due to several factors affecting the fundamentals:

Demand. The International Energy Agency (lEA) expects world oil demand to rise by 1.0 million barrels a day (b/d) to a record 71.5 million b/d. OECD demand will account for just over a third of the growth;

the rate of growth in Asia will be much higher. Economic growth is slowing down in many OECD economies while Asian markets are still expanding rapidly.

The projections should be treated with caution, however, although the lEA is the most quoted source for supply and demand data, it nevertheless has a patchy record for accuracy. Some of its forecasts have been revised extensively in the light of actual circumstances.

Last year the lEA was clearly taken aback by the strength of demand and in November boosted its demand estimate for the third quarter by 600,000 b/d. The agency is expecting faster demand growth in 1996 but may still be erring on the side of caution.

The intelligence on Asian demand is sketchy and the completion of several new refineries in the region should help underpin demand for Gulf crude oil. If demand growth runs ahead of expectations this year, as it did in 1995, then the lEA demand forecast may turn out to he conservative.

Supply. The rapid growth in supply, especially from non-OPEC sources, has been the talking point of the last two years. As nonOPEC supplies have surged, so OPEC's market influence has waned. This year will be no different as another 2 million b/d of new crude oil production will lift non-OPEC supply to 44.3 million b/d, according to lEA data. Most of the additions will come from the North Sea and Latin America, with smaller contributions from Africa and the Far East.

The fine balance of supply and demand that was reached in 1995 may buckle under the weight of this new volume, which should start to flow during the second quarter. This is when the trouble could start.

Much more oil will have to) find its way into) storage if prices are not to suffer. According to projections by the CGES, the stockbuilol implied in the second quarter is about 2 million b/d.

This is far too high by comparison with recent years. The stockbuild in the second quarter of 1995 was 1.2 million b/d and in the same period of 1994 it was only 800,000 b/d. The far larger stockbuild foreseen for this year will put intense pressure on market prices for crude. 'We expect the weakening to start in the second quarter,' says Drollas.

OPEC. At its ministerial meeting last November OPEC agreed to stick with the current 24.52 million b/d quota for the first half of the year. This is a change from 1995 when, for the first time in its history, OPEC adopted a quota for the full year. The latest quota pledge has little credibility as it is being widely ignored already. Wellbead production was at least 500,000 b/d over quota during most of last year. The biggest violator, Venezuela, is now exceeding its production share by 400,000 b/d and shows no sign of restraint. According to Bloomberg estimates, OPEC production in December hit 25.72 million b/d, the highest monthly rate of the whole year, and 1.2 million b/d over the quota.

But restraint will be needed as the call on OPEC supplies is expected to fall by about 500,000 b/d in the course of the year. The lEA puts the call in OPEC at an average of 24.6million b/d compared with a call of 25.1million b/d in 1995. There is nothing to suggest that OPEC can or will adapt to this new reality. In a rising market in 1995 much of the OPEC excess found its way into storage and prices remained relatively robust.

OPEC overproduction Such luck is not expected to hold this year.

'OPEC's current production levels, although apparently not causing prices to weaken, will start to) have an effect in the second quarter,' says Drollas. Current production levels imply a daily stockbuild of 2 million barrels extending into the third quarter of the year which is four times the stockbuild figure for the same quarter two years ago.

'They have a very big problem,' says Drollas.

The surge of new non-OPEC supplies has reduced OPEC's ability to influence the oil market to a new low. With a key member like Venezuela violating the quota to such a degree OPEC declarations carry little or no conviction. The forced exclusion from the oil market of Iraq also hangs over the organisation which will one day have to accommodate Iraqi capacity.

There seems little prospect of Iraqi oil finding its way back to market this year unless Baghdad agrees to limited sales under IJN Security Council resolution 986.

This arrangement would allow the sale over six months of as much oil as it takes to earn $2,000 million. This could cause havoc if it triggers a price slide. It would mean minimum sales of about 700,000 b/d, or far more if oil prices were to fall much below current levels. The only consolation is that a resumption of Iraqi oil exports is unlikely to happen just yet.

'Limited oil sales could cause chaos,' says Drollas. 'As it's a dollar-denominated target it could create a vicious circle that would push prices down even further.

That's a nightmare but it's not likely to happen.'

There are several other possible sources of price volatility which could produce the periodic price spikes which have been such a feature of recent years. 'One of the factors keeping prices quite buoyant is what's going on in the downstream,' says Antill.

The US refining and distribution system is particularly prone to bottlenecks in the spring period and oil prices are usually at their firmest during the second quarter. New refining capacity is coming on stream in Asia and the Far East this year which could lead to even tighter conditions.

Refineries are also changing the way they work, cutting their crude inventories and relying more on the spot market. This switch from formal contracts to 'just in time' spot purchases is making markets more volatile. 'If you are cutting down your stocks to very low levels you risk being caught out. The whole system is running on much lower stocks so that any disruption can move prices quite sharply,' says Drollas. 'The premium for prompt supplies is rising.' Prices were pushed sharply upwards in 1995 by events as varied as the oil workers' strikes in Brazil and Nigeria, the threat of sanctions against Nigeria later in the year and the autumn hurricanes in the Caribbean.

This year is certain to produce its own crop of unexpected events which will create some price volatility. A cold winter and a hot summer can make a huge difference to actual energy consumption. The current crop of predictions on supply and demand could also turn out to be wide of the mark. The LEA figures on new supplies may be an overstatement while the projections on non-OECD demand may be understated. If this is borne out by events, the chances of hanging on to the oil price gains of 1995 will be much improved.

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