Just in case producers were starting to get complacent about higher oil prices, the markets have delivered a timely reminderthat this is a volatile industry. Whatever the number crunchers are saying about the fundamentals, markets are moved by sentiment. And in early October, sentiment turned suddenly bearish as the recent bull market in oil futures deflated. In just a couple of days of futures trading, investors liquidated positions and stormed out of the sector, sending prices tumbling by $3.60 a barrel.

After the sudden shock there came reassurance as prices picked up again in the following days. Fortunately for the producers this was a blip rather than the beginning of a trend. 'The fundamentals are tightening and it's already recovered more than half the loss,' says Leo Drollas at the Centre for Global Energy Studies (CGES) in London. 'It had very little to do with fundamentals,' says Irene Himona, an analyst at ABN AMRO. 'This was the unwinding of hedge fund positions.'

According to this explanation for the sudden retreat from oil futures, it was investors who had built long positions in paper barrels that were wrong-footed by the sudden revival in the gold price, forcing them to sell their oil positions to raise cash. 'Certainly, part of the speculative froth has gone,' says Himona.

Speculative froth or not, the futures markets are pointing to continued price strength in 2000. Forward WTI is currently running at $21.98 in the first quarter, slipping to $19.82 by the fourth. The average is about $21 a barrel over the year, which would imply an average for Brent of $20.

'If we look at the drivers, it all looks good,' says Nick Antill at Morgan Stanley Dean Witter. World economic growth forecasts are being regularly upgraded, encouraging a positive view of the prospects for oil demand. Afterthe dislocation caused by the Asian crisis and its aftermath, gross domestic product and energy demand are rising in tandem. Morgan Stanley's latest economic forecast is for gross domestic product (GDP) growth of 3.7 per cent in the industrialised countries next year which could help boost demand for OPEC oil by 2 million barrels a day (b/d).

The expectations on stock levels are equally bullish for prices. OPEC has now decided to focus on stocks as the prime indicator that it will monitor when deciding future production plans and ministers agreed in September that stocks had yet to be sufficiently affected by the OPEC cuts to justify an early revision of quotas. They were in good company; the International Energy Agency recorded a build in OECD company stocks between the end of June and the end of August, rather than the widely assumed decline. It was a similar story in the US where the weekly reports from the two main monitoring agencies showed stocks falling only slightly during the summer months.

Most observers believe that a sharp run down of stocks is now about to begin. Says Antill: 'So long as OPEC holds the line to the end of this year we are heading into the first quarter with oil inventories at relatively low levels.' The CGES is predicting that stock levels could be down to 51 days forward cover by the second quarter of next year, which will be the lowest level since 1996. Such low levels would provide a solid base for an increase in OPEC production after the current agreement expires in March.

Further support for high oil prices is provided by the outlook for non- OPEC additions to capacity. In the absence of new non-OPEC volumes, most of the gains should accrue to OPEC producers. Norway shadowed the OPEC cuts earlier in the year with a nominal reduction of 100,000 b/d but it is expected to raise output substantially next year. Non-OPEC output rose by some 400,000 b/d in the third quarter but at this stage there is no reason to expect large non-OPEC gains next year which should clear the way for a big boost in supply by OPEC.

The biggest threat to the high hopes of an extended period of stable prices is posed by OPEC itself. Having achieved a price rise of $12 a barrel since February, OPEC has exceeded its own expectations. Whether it can manage to maintain the gain as the expiry of the agreement looms is now being put to the test.

'It would be reasonable to presume that they would try to manage any increase in a sensible way,' says Himona. The fear is that the temptation to boost output to take advantage of high prices will prove irresistible, leading to an unravelling of the OPEC accord before the spring. Indeed, there are already clear signs that the deal is feeling the strain. Discipline among the 10 participating members was at its highest in June and has been falling steadily since then, which has been largely unremarked by the markets. Iraqi production, which is excluded from the agreement, is ticking steadily upwards.

'It's the old story that people don't keep their eye on the ball,' says Drollas. At least four OPEC members - Algeria, Indonesia, Libya and Qatar - have barely adjusted their output, while Nigeria's apparent compliance was achieved because facilities were closed down by civil disturbance rather than self-discipline. Only Saudi Arabia, Kuwait, the UAE and Venezuela are delivering more or less in line with their quotas.

Iran's behaviour has provoked the most concern. Iranian output has been rising steadily and leapt by as much as 200,000 b/d in September, according to some industry estimates. The excess has yet to find its way to market and has gone into floating storage instead. By early October Iran accounted for more than 60 per cent of the floating oil storage world-wide, amounting to nearly40 million barrels of crude. The explanations for the excess vary. Some would have it that refineries had to be closed; others that it is impossible to reduce production to the OPEC quota level without damaging reservoirs.

Whatever the cause of the stockpile, the consequence is that Iran is in a unique position to benefit from any winter price spike if markets get too tight. 'They could be positioning themselves for an increase in output,' says Drollas. 'They are good traders. If the market gets tighter they can release a little,' he adds. Another view is that the Iranian oil in storage is helping to keep the OPEC accord on track and prices within bounds. Says Antill: 'It represents a cap on prices, not a threat to them.'

Despite the concerns about an erosion of OPEC discipline, the positive sentiment remains strong. With stocks likely to be down to their lowest in four years by the spring, there will be room for an increase in output in the second quarter as the normal stock building begins. If OPEC can organise an orderly rise in quotas to meet the increased call on its crude, prices could remain around current levels for another year at least.

Says Himona: 'Whether it's $18 or $20 is irrelevant. So long as we remain in the $18-20 region the industry will be enjoying very strong cash flow.' As the OPEC cutbacks were driven by the desperate need to restore state finances as oil revenues evaporated, Gulf oil producers will be hoping for a similar result.