Oil output falls begin to take effect

20 March 2009

Despite declining global demand and difficulties in getting member states to comply, oil prices are starting to rise following a series of production cuts introduced by Opec since September 2008.

Crude oil prices may have fallen preci-pitously since July 2008, but it has taken time for the region’s hydro-carbons industry to come to terms with the new environment.

Both the Iraqi and Algerian governments have, in different ways, had the reality of the current situation forcefully impressed upon them in recent months, with international oil companies (IOCs) showing they are unwilling to submit bids in licensing rounds that do not offer a reasonable chance of making a profit.

Algeria awarded just four of a planned 16 exploration licences in its seventh bid round in December 2008, having received limited interest from IOCs because of the tough terms on offer.

Oil majors have also been negotiating hard with Baghdad in the opening months of 2009 to win further concessions in Iraq’s proposed contract model, in what is Baghdad’s first oil and gas licensing round since the US-led invasion of 2003.

The weak economic outlook for most regions of the world means that demand is likely to remain muted this year, and most oil companies are wary of committing to large investments at a time of relatively low prices.

Sharp falls

The Opec reference basket of 12 crudes currently stands at its lowest level since June 2005, at close to $40 a barrel. The basket tends to closely follow the price of West Texas Intermediate (WTI), a global crude benchmark. WTI peaked on 22 July 2008 at $147.22 a barrel, while the Opec basket had peaked a few weeks earlier, on 3 July, at $140.73 a barrel.

Since then, both have fallen sharply. The Opec basket has been trading in a price range of $35-50 a barrel since mid-November 2008 and, at the time of writing, had not broken through the $45-a-barrel level since the first week of January.

The close link between Opec, WTI and Brent crude prices is likely to continue. UK bank Barclays Capital predicts that WTI crude will average $57 a barrel in 2009, and Brent will average $60 a barrel, offering little chance of a return to 2008’s revenue figures for Opec members.

The Opec basket is made up of crudes from the oil cartel’s member states, including Algeria’s Saharan Blend, Iran Heavy, Basra Light from Iraq, Kuwait Export, Libya’s Es Sider, Saudi Arabia’s Arab Light, the UAE’s Murban and Qatar Marine.

The lower prices are not just having an impact on new exploration and production rounds. After several years of far higher prices, all these countries face having to make a tough decision on whether or not to continue with their current spending plans given the prospect of earning far lower revenues.

“The fall in demand is starting to have an impact on future spending plans,” says Craig McMahon, lead analyst at UK consultant Wood Mackenzie. “You are seeing the economic downturn having an effect across the sector, and the Middle East is not immune from that.”

Major energy schemes across the region are being delayed or scaled back, while clients examine the possibility for making further cost-cutting measures.

With the threat of a long-term global downturn, these problems are unlikely to disappear soon. Opec has been trying to force up prices by agreeing to cut production at a series of meetings held in the second half of 2008 and early 2009.

The cartel aims to have cut production by 4.2 million barrels a day (b/d) between September 2008 and the end of February 2009. Further cuts could follow, but the success of the policy hinges both on the willingness of its member states to adhere to the cuts they have promised, and for an upturn in the global economy.

For now, both these issues are problematic. Abdalla el-Badri, secretary general of Opec, admitted in February that its members are only meeting about 80 per cent of their promised production cuts. Since then, compliance is thought to have reached closer to 85 per cent.

While Saudi Arabia and the UAE have both been relatively good at keeping to the new, lower production levels, others such as Iran have been more lax, say analysts.

El-Badri says he wants to increase the level of compliance to 95 per cent before considering making any further cuts.

Price rises

Despite the gap between what the countries promise and what they actually do, signs emerged in late February that the combination of lower demand levels and the production cuts are starting to have an effect, if only to stabilise the market. The price of contracts for April deliveries of WTI crude increased by $7 a barrel in the week ending 26 February to $43.32 a barrel as import levels to the US fell. At the same time, the April contract for Brent crude was trading at $45.15 a barrel, up from $40.90 a week earlier.

The average price of the Opec basket of 12 crudes was $40.50 on 25 February, up $2.36 from the average of $38.14 on 18 February.

Statistics released by the US’ Energy Information Administration (EIA), part of the US Energy Department, on 25 February highlight how quickly demand is slowing in the US, the world’s largest consumer of oil.

The data shows that the US imported an average of 8.7 million b/d of crude in the week to 20 February, 24,000 barrels less than it did the previous week.

The same report shows an average import level of 9.3 million b/d over the previous four weeks, which itself is down 420,000 b/d from the same period in 2008.

“In my view, the cuts they have already made so far might be sufficient to rebalance the market,” says Costanza Jacazio, energy analyst at Barclays Capital. “There are signs that prices are changing.”

In the longer term, rising oil prices will also depend on a rebound in the global economy to increase demand.

Asian exposure

Most Middle East states are heavily exposed to the Asia-Pacific region. Saudi Arabia for example, sells 12.2 million b/d to the Far East, 58 per cent of its total, according to Opec. Iran and Kuwait are even more heavily exposed, selling 65 and 78 per cent respectively of their production to customers in the Asia Pacific region.

North African countries tend to be more heavily reliant on Europe and the US. But wherever they sell their oil or gas, all producers in the region face the same problem.

With economic growth falling away in virtually every market in the world, demand for oil and gas, as well as downstream products such as petrochemicals, is dropping. But there are reasons for Middle East producers to remain optimistic, particularly when it comes to gas. The Middle East’s share of the world’s proven natural gas reserves has been steadily creeping up in recent years.

According to the EIA, the 1,980 trillion cubic feet of gas in the region in 2003 accounted for 38 per cent of the global total, but the figure had increased to 2,566 trillion cubic feet by 2007, or about 45 per cent of the world total.

The figures for proven crude oil reserves are more steady, but the Middle East is in an even more dominant position here -its 739 billion barrels accounted for 61 per cent of the global total in 2007.

In addition, several years of higher prices mean that the region’s governments are still cash-rich. This means that, on the whole, they can afford to maintain a relatively high level of spending, despite the current drop in oil and gas revenues.

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