MIDDLE EAST oil producers are enjoying some of the most auspicious conditions they have seen for years. All the forecasts that pointed to a fairly flat outlook for prices in 1996 have been upstaged by events. Instead, crude oil has been selling at an average of $3 a barrel more than in 1995, and has touched levels not seen since the Gulf war five years ago. Iraq is exerting a powerful influence on market sentiment just as it did in 1990. Since it became clear in September that Iraq would not start exporting oil again any time soon, prices have surged ahead strongly once more.

The background to this year's price spiral is defined by the brisk demand and sluggish supply growth that have combined to push oil prices much higher. Events in the Middle East have also played a notable role, from the bomb attacks against American targets in Saudi Arabia to the erratic course of the UN oil-for-food deal with Iraq. However, it was stronger economic growth and a cold winter that produced the unexpected boost to demand which has persisted throughout the year as refiners have raised throughput in response. In the US, distillate demand grew by almost 400,000 barrels a day (b/d) in the second quarter; there was also an estimated 260,000 b/d increase in demand in Europe due to the colder than normal weather.

Average world economic growth of 2.7 per cent this year has been led by growth of 7 per cent in the developing countries of Asia which are leading the growth in demand for oil. New oil refining capacity has been coming on stream in Asia at a rapid rate which has provided further support for oil prices. Most of this new Asian demand is being met from Middle East sources, and to a lesser extent from West Africa. This is having the perverse effect of tightening supplies in the Atlantic basin as cargoes flow east, pushing up prices for Brent and WTI.

North Sea surprise

The other big surprise has been the extent to which oil supplies have fallen below expectations, notably from the North Sea. New North Sea fields alone were forecast to bring on more than 800,000 b/d during the course of the year. Unexpected delays have led to a halving of this projection and only about 400,000 b/d is likely to materialise. This shortfall led to a major downward revision of the key forecast by the International Energy Agency (IEA) for 1996 but the delayed fields will mean an even larger boost to North Sea supplies in 1997 (see table). The final figure for the increase in non-OPEC supplies this year may reach 1.2 million b/d; another 1.4 million is expected from non-OPEC sources next year.

This has been good news for OPEC. Not only has the price of the basket of OPEC crudes averaged $19.43 a barrel in the year to date, compared with an average of $16.82 a barrel over the same period last year, but the call on OPEC supplies has risen steadily. This has had the timely result of soaking up all the extra oil produced by those OPEC states that are violating their quotas. It has also brought the 'call' on OPEC crude into near harmony with actual OPEC supply at about 25.8 million b/d.

Analysts explain the 1 million b/d rise in the call on OPEC by the need to rebuild depleted inventories, notably in the US, and to help build new ones in the Far East where the new refining capacity is coming on stream. The IEA has adjusted its own forecasts to show a 1.2 million b/d rise in the call on OPEC this year.

Continuing uncertainty about the Iraq oil-for-food deal has also played havoc with prices. When the deal was agreed in May, exports of Iraqi oil were expected to resume by the start of the fourth quarter and rise to an eventual rate of about 800,000 b/d. Reaction to the agreement was muted, as it was assumed that the markets had already made allowances for Iraq's return. But prices continued their steady slide from a spring peak in April.

Iraqi anxiety

All the calculations based on the imminent return of Iraqi crude are now irrelevant. The deal has been suspended due to the fighting in northern Iraq and there is little prospect of any Iraqi oil flows before next year. If prices stay anywhere near current levels, the eventual volume of Iraqi exports will be much lower too, because the deal is defined in dollar terms. The terms allow Iraq to sell $1,000 million of oil every 90 days; at current prices this means about 475,000 b/d, rather than the 800,000 b/d that was assumed initially.

Just as acceptance of the deal eased anxieties about a tight market, its suspension has rekindled worries about the adequacy of supplies in the fourth quarter of this year and beyond. Conditions are not expected to be as tight as they were in late 1995 but inventories will be lower, leaving plenty of room for unexpected events to put prices under pressure again.

The temptation is there for OPEC to boost its quota when ministers meet in November, especially if there is still no Iraqi oil in sight. High demand has helped to find a home for all of OPEC's production over quota so far this year and the elevated predictions of the call on OPEC supplies may increase the attraction of revising quotas upwards. There are dangers in this as OPEC output is rising steadily without any formal encouragement to produce more. Venezuela alone is heading for production of 3.2 million b/d, which is 900,000 b/d above its quota, while several other members are recording much smaller increments.

There are other grounds for caution. Many analysts consider that events such as the US attack on Iraq in September and the recent fighting in the north have had a distorting effect, pushing prices much higher than is justified by the fundamentals. Prices of close to $25 a barrel for Brent may be excessive when so much of the delayed North Sea oil is about to start flowing. A milder winter and fewer disruptions to oil supplies from offshore oil platforms could also dampen demand dramatically. Bearing in mind such considerations, oil prices look finely poised as the markets move into the peak demand period for the year. There is no accounting for market psychology but oil is no different from any other traded commodity. Once the players believe it has become overvalued, a correction can be expected.