On a high

21 January 2000
SPECIAL REPORT OIL & GAS

With all the subtlety of a see-saw, oil prices shot from one extreme to the other during the last 12 months. Having plumbed the depths below $10 a barrel last winter, they ended the year at around $25, in one of the most remarkable turnarounds of recent times. This took some doing and was only achieved after OPEC and its allies pulled together in an exceptional display of unity of purpose, slashing production dramatically from the spring onwards.

To everyone's surprise, the temptation among OPEC members to cheat on quotas as prices rebounded was for the most part resisted. Discipline held up, supplies shrank, markets tightened and prices rose to levels that even OPEC oil ministers might not have imagined possible. 'If a year ago, someone would have told us that prices would be at $23-25 a barrel, we would have been flabbergasted,' admits Irene Himona, an analyst at ABN AMRO. Flushed with success, OPEC must now confront the no less challenging task of returning prices to more manageable levels.

What's in store for the year ahead? The consensus of most market watchers is that OPEC action, whether formally agreed or informally adopted, will lead to an increase in supply and a gradual easing of prices from their current peaks. Most analysts are estimating an average of about $19 or $19.50 for Brent. This would actually be 5-8 per cent higher than the 1999 average of $18.20. 'The oil price risk is primarily on the upside,' says John Toalster at SG Securities. SG is forecasting an easing in 2001, with Brent slipping to $18. Even at this level, prices will still be near the top end of the $15-20 a barrel band. By this time, most long-term forecasters had expected oil to be drifting closer to single digits in a world awash with excess supplies, from OPEC and non-OPEC sources.

Return to growth

On the demand side, the main reason for the new confidence about prices is the robust state of the world economy. It has weathered the Asian economic downturn and soaring stock markets are continuing to defy the doom-mongers. It has taken the decade-long recession in Japan in its stride. Global growth in gross domestic product (GDP) is expected to be in the range of 3-4 per cent this year and energy demand is moving up in tandem. 'Demand is growing normally again,' says Himona.

As far as supply is concerned, the risks are on the upside because of the uncertainty about OPEC's intentions. In the run-up to the March meeting of oil ministers in Caracas, their intentions are still unclear. Some have signalled a determination to keep to the current quotas, in the belief that stocks have still not come down enough to justify a relaxation, while the majority are keeping quiet about what the next move should be. 'The major issue as always is OPEC output,' says Himona.

OPEC may be tempted to try and stick to current quotas in the hope that higher prices can prevail for longer but most observers think this prospect is not tenable and OPEC production must rise. 'A price of $24 a barrel is simply unsustainable,' says Nick Antill at Morgan Stanley Dean Witter. 'If OPEC were to try and defend it at $24, it would be suicidal. We are assuming a gentle return to $18-20 a barrel.'

A gentle descent to more modest price levels may be too much to count on in current conditions. With stocks down and supply and demand more tightly balanced, markets will be much more susceptible to violent swings. Though opinion is divided on the precise extent of the stock draw, there is no doubt that the huge inventory overhang that hammered prices in 1998 has started to come down, creating the tight conditions that are so susceptible to manipulation by speculators and large daily pricefluctuations.

Actual stock levels are notoriously difficult to determine and a little caution may be called for. 'There has been an acceleration in the stock draw but not as fast as everyone was expecting,' says Michael Barry of Energy Market Consultants (EMC). Nevertheless, EMC calculates that OECD company stocks on land had fallen to about 2,390 million barrels by the end of 1999, down from 2,525 million barrels a year earlier. At about 55 days forward cover, compared with at least 60 days at the start of the year, global stocks have not been down at these levels since 1996 which was the last time the markets were so tight and prices were very volatile.

A powerful contributor to the tight supply picture is the dearth of new non-OPEC oil. Shaken by the price collapse of 1998-99, investment by the oil companies is down sharply, with very little sign of an upturn as yet. Calculations vary but non-OPEC additions to output in 2000 are expected to be about 200,000-300,000 barrels a day (b/d). At the very top end ofexpectations, they may conceivably reach 500,000 b/d.

This leaves room for a sharp rise in the call on OPEC. Excluding the contribution from Iraq, which is outside the current production agreement, OPEC production fell to 23.43 million b/d in November. Iraqi production for the month averaged 2.37 million b/d, down by about 500,000 b/d due to the latest dispute with the UN about sanctions. According to SG calculations, the call on OPEC crude should average 29.5 million b/d this year, making room for a substantial relaxation of quotas in the course of the coming months. In a remarkable display of unity, OPEC has achieved compliance rates of up to 90 per cent, according to most industry estimates. Although it may prove almost impossible to agree on a revised quota package by March, a relaxation of quota compliance after the ministerial meeting seems inevitable.

Iraq retains its capacity to upset calculations but is less of a disruptive influence than it was. As the restrictions imposed under UN sanctions have eased, Baghdad has an increased interest in earning as much as it can from oil sales. Production capacity is fast approaching 3 million b/d and there are plans to push this to 3.5 million b/d in the course of this year. Having proved its ability time and again to raise capacity against the odds, there is every chance that this new Iraqi target will be achieved. The only constraint is likely to be the capacity of the pipeline network to Turkey to handle the increased volumes. And, even with this addition to supplies in prospect, the demand for more OPEC oil remainssubstantial.

'It still implies demand for 2 million barrels a day of extra OPEC oil by the end of the first quarter,' says Antill. Any erratic behaviour by Iraq, such as suspending supplies in a dispute with the UN, would only increase the upside price risk, while demand should be ample for any extra oil that Baghdad can bring to market.

With conditions looking so auspicious for OPEC producers, the only danger is that they may find it hard to maintain solidarity and self-discipline around any revision in policy. In mitigation, after making the mistake in Jakarta in 1997 of raising quotas just as the Asian economies collapsed, there will be no rush this time to revise a strategy that is serving them well. However, a decision to leave quotas unchanged in the hope of sustaining prices around recent levels could prove equally mistaken.

As ever, OPEC's predicament is an unenviable one as it tries to anticipate and master the market. Says Antill: 'It assumes perfect management of something that is intrinsically unmanageable.' Having managed the market so successfully last year, it will certainly be a hard act for OPEC to follow.

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