OPTIMISM is the prevailing tone to most of the oil price analysis on offer as a new year gets under way in the commodity markets. Economic recovery is in the air and commodity prices have been rising steadily for months. Tantalisingly, oil has yet to post the gains shown by coffee, aluminium and other traded staples that rose by as much as 40 per cent in 1994. Is it the turn of oil in 1995? Most observers believe crude oil supplies and potential demand are in better balance than they were last year and that the potential exists for some modest price appreciation.

Modesty is much in evidence among the analysts. In the light of some of the more fanciful price predictions for the mid-1990s, the caution is well advised. Nobody is talking today of oil at $25 a barrel from 1995, which was a common prediction in the late 1980s. Instead, the benchmark Brent crude, which started 1995 at around $16 a barrel, is expected to put on $1 a barrel during the coming year. 'We have adopted a very cautious stance over the past 12 months,' says Mehdi Varzi of Kleinwort Benson in London, who is predicting an average of $17 a barrel for Brent in 1995.

The basis for the upbeat expectations is simple. Demand is growing steadily, supply is growing too, albeit at a slower rate, and OPEC is pledged to a 12-month production freeze. Therein lie the essential ingredients for believing that prices must rise. And, according to Paul Stevens, the BP professor of Petroleum Policy and Economics at Dundee university in the UK, 'The equilibrium price is established by the strength of belief.' In this view, market perceptions play a crucial part in actual price movements. Hence, these psychological factors should be considered alongside the fundamentals - supply and demand - and the behaviour of OPEC's dominant producer, Saudi Arabia, in a framework for analysing likely prospects.

All point to a pick-up in 1995:

Demand. The International Energy Agency (IEA) is projecting a 1.2 million barrels a day (b/d) increase in oil consumption. Other projections are slightly more conservative. For example, the US' Energy Information Administration estimates that world oil demand will rise by 890,000 b/d in 1995 to an average of 68.98 million b/d. The reason for all the predictions of stronger oil demand is higher economic growth throughout the OECD and most non- OECD countries, with the notable exception of Russia. Demand growth would have been higher if slower economic expansion were not expected in the US and China.

Supply. Non-OPEC supplies grew by at least 750,000 b/d in 1994 with major gains in the North Sea. In November, the IEA estimated non-OPEC supplies at 41.1 million b/d, an increase of 1 million b/d over the previous year. Most forecasters expect an increase of about 500,000 b/d in 1995 with the North Sea showing the biggest gains. Other small non-OPEC increases will come from Angola, Argentina, Brazil, Colombia, Ecuador, India, Malaysia and Vietnam.

OPEC. At the Bali ministerial meeting in November, OPEC agreed to abide by its existing 24.52 million b/d quota for the whole of 1995. There is an element of self-delusion in the claim because the quotas have been consistently violated throughout 1994. Nigeria, Venezuela and Gabon, which is leaving the organisation, were the most persistent violators. However, there is a market for the average of 24.8 million b/d that OPEC has actually been producing. And, given the supply and demand projections outlined above, there could be room for OPEC output to drift up to 25.5 million b/d during the coming year without undermining prices. Indeed, if the full demand expectation is borne out, OPEC could be in the happy position of taking a relaxed attitude towards quota violations and seeing prices rise at the same time.

'Logic says that markets will tighten, prices will go higher,' says Stevens. Higher prices are the desired outcome for Saudi Arabia which, due to its dominant capacity in OPEC, is the effective market controller. The kingdom needs higher prices to boost revenues and ease its budgetary problems. It is also wedded to its 8 million b/d and will not consider any cutbacks if prices fail to pick up as expected. 'I don't foresee any circumstances in which it will cut.' says Varzi.

Rosy outlooks can always fall victim to the unexpected and there are risks that the calm conditions that the markets are contemplating will be disrupted. Iraq, Russia or Algeria could all spring surprises. Kleinwort Benson is assuming some sort of Iraqi rehabilitation in 1995, perhaps leading to a resumption of strictly controlled oil sales. The UN Security Council coalition is looking frayed with France and Russia making diplomatic amends with Baghdad. Some analysts think this could presage some concessions to Iraq during the year and the resumption of exports. 'What's the next step?' asks Varzi. Other analysts are more reserved. 'It's clearly a possibility but I would expect Iraq to begin to become a feature in 1996 or as late as 1997,' says Nick Antill, oil analyst with Barclays de Zoete Wedd.

Risks

Another risk is that political violence could interrupt Algeria's oil production, currently running at 750,000 b/d. Russian oil exports, which are down to about 2 million b/d from a peak of 3.8 million b/d in the late 1980s, are also vulnerable to a variety of potential technical or political problems that could affect supplies. Should any shortages emerge, there is limited spare capacity. Saudi Arabia has up to 2 million b/d of additional capacity that could be activated, while Kuwait, the UAE and Venezuela could also boost output by much smaller amounts.

However, OPEC is not contemplating such eventualities at the start of 1995. At Bali it showed a strong desire to end speculation about its intentions and put a firm floor under prices in the hope that they will start rising steadily this year. After the poor price performance of the OPEC basket in 1994 they agree with the analysts who are talking of higher prices for this year. There are also some grounds for arguing that the pundits, burnt by bitter experience, are even understating the potential for improved earnings over the coming 12 months.