Good fortune shines on oil producers

19 July 1996

Oil producers have enjoyed higher than expected earnings in the year to date and their good luck seems to be holding. Prices are down from their peak in April, but have not fallen as far, or as fast as most analysts had expected. The additional oil revenues have boosted government receipts in the Middle East and eased the pressure on OPEC to plug the holes in its increasingly leaky quota system.

Even the prospect of Iraqi oil exports - due to resume later this year - has been absorbed without undermining prices. As global stocks are lower than for some years, the best explanation for the stronger prices and the bullish tone to the oil markets is that the growth in demand, particularly outside the OECD, has been underestimated once again.

The pattern of price movements through the first six months of the year was true to form, with a steady rise starting in late January and continuing to a peak in April. The big surprise was the angle of the curve as the market moved towards a peak on 11 April.

Arabian light rose from a low of $15.38 a barrel on 29 January to a high of $22.56 a barrel on 11 April before tumbling back down to about $18 a barrel. Its average for the year to 9 July was $17.73 a barrel, compared with $16.26 over the same period in 1995.

Similarly, OPEC could take heart from the fact that the price of the OPEC basket rose to $21.09 a barrel on 11 April, its highest since December 1990 at the peak of the panic over the Iraqi occupation of Kuwait. The bullish prices have been a gift to those governments that have been strapped for cash. OPEC's largest producer, Saudi Arabia, saw its revenues rise to an estimated $12,000 million in the first three months of the year, from about $10,800 million in the same period of 1995.

The main explanation offered for the bull market was the long cold winter in the northern hemisphere which boosted demand for heating oil at short notice and had refiners scrambling for prompt cargoes of crude oil. Another factor is structural and a result of changing practices among refiners who are managing their stocks more keenly, minimising their long-term holdings of crude and attempting to better exploit short term movements in prices.

This has had the unexpected result of making spot markets much more volatile when there is a sudden surge in demand, as occurred last winter. During the winter months, the scramble for immediate deliveries pushed spot prices to $5 a barrel above futures, a degree of backwardation that was almost unprecedented (MEED 31:5:96, Feature).

Such has been the strength of oil prices this year that the news of Iraq's imminent return to the oil market caused barely a ripple. When Baghdad finally accepted on 20 May an agreement with the UN for a limited oil sale for humanitarian purposes, oil prices duly dipped in response. Within hours they had rebounded. In the US, perversely, WTI actually closed $2 a barrel higher a day after the deal was confirmed.

Iraq absorbed

The prospect that 800,000 barrels a day (b/d) of additional OPEC crude will start flowing into the market sometime in the third quarter has not had the menacing effect that was expected. Futures prices have tumbled to within a few cents of the spot market, but such is the continued strength of demand that analysts think there is room in the market for the fresh Iraq supplies.

However, there could still be a delayed response. The Iraqi deal with the UN is wrapped in conditions that might delay implementation and there are technical and physical problems to be overcome before Iraqi oil actually makes it to market.

The sober response to Iraq's return has also deflected attention from OPEC's reaction to the news. At its ministerial meeting in Vienna on 5-7 June OPEC took the easy way out and simply expanded Iraq's quota by 800,000 b/d. This solution was made more palatable by the removal of Gabon's 287,000 b/d from the total quota as the African state is deemed to have finally followed Ecuador and left the organisation for good. The net result was to boost the total OPEC quota by only 513,000 b/d to 25.033 million b/d.

In fact, OPEC produced an average of 26.1 million b/d in May, according to the Parisbased International Energy Agency (IEA), which was close to 1.5 million b/d above its quota for the first half of the year. When, and if, Iraqi production is boosted under the UN deal, total OPEC output could be nudging 27 million b/d.

OPEC simply ducked the issue of quota compliance altogether. Violations by Venezuela, in particular, are now so egregious that a major conflict over quotas seems inevitable. Saudi Arabia is sticking stolidly to its quota of 8 million b/d, but Venezuela was producing more than 610,00 b/d above its quota in May, and making a mockery of the whole system. Algeria, Qatar and Nigeria also consistently produce above quota. A new monitoring committee, led by Iran, but also including Nigeria, has promised to take stern measures against violators when it meets in September, without specifying what these might be.

Trouble could be in store for oil prices later in the year if OPEC output does continue to climb towards 27 million b/d. The IEA projects the actual call on OPEC crude supplies at only 24.5 million b/d to the end of the year, while current production is running 6.5 per cent above this figure. The excess will be even greater once Iraqi supplies start flowing.

In a bearish bulletin released just before the OPEC meeting the Centre for Global Energy Studies (CGES) in London forecast that the OPEC basket price would tumble to $13.00 a barrel in the fourth quarter of the year if the OPEC quota was not adjusted to accommodate Iraq and compliance not was improved.

OPEC was able to fudge its adjustment for Iraq with the help of Gabon's withdrawal and, for all the tough talk from the new monitoring committee, no action to improve quota compliance is planned before September. As it monitors members' output during the summer months, the committee will be watching prices closely to see if OPEC can continue to get away with ignoring its quota with impunity.

Salvation may be provided by the buoyant oil demand from outside the OECD, which some analysts believe the IEA has consistently understated, and the rebuilding of global stocks, which have been falling steadily for the past five years. Data on non-OECD demand in Asia is sketchy at best and in the case of China is even more problematic.

An understatement of Asian demand may explain why OPEC can produce 1.5 million b/d above its quota - which corresponds almost exactly to the IEA estimate of the call on OPEC supplies - without causing prices to collapse. The coming weeks may well determine whether this argument is valid or whether excess OPEC production will start to send prices into a sharper decline.

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