January’s edition of the Abraham Energy Report (AER) contained our detailed outlook for the oil market. In this article, we’ll look back at how the year has unfolded so far, and update our view of the market for 2010 and beyond.
In January, we forecast that the economic recovery would gradually gather momentum, but we also expected the road to recovery to be rough, particularly in the developed economies of the Organisation for Economic Co-operation and Development (OECD). We expected global oil demand to rise once again in 2010, after declining for two years in a row, but nearly all the demand growth would be concentrated in the BRIC countries (Brazil, Russia, India and China) and emerging economies, which have become the new epicenter of global oil demand.
We noted that commercial inventories at the beginning of the year were still at very high levels relative to historical norms, and that a wide margin of spare capacity in both upstream oil production and downstream refining and distribution had opened up. In fact, there was enough spare capacity to push “peak oil” concerns to the back burner for the time being. We said that there was enough oil around to supply even the most optimistic growth scenarios for the next few years.
We expressed our opinion that the energy policies already in place to promote energy efficiency and the development of new and renewable energy resources would continue to nibble away at the demand for oil and other carbon-based fuels this year and in the foreseeable future. For the medium and long term, we noted that a race was developing between rising oil and other energy demands, and the ability of the global economy to both improve efficiency and develop clean and affordable supplies of conventional and new forms of energy. In this environment, and in spite of the strength of the emerging economies, it seemed to us that global oil demand over the medium-term was likely to grow slower than it has in the past.
We concluded that on the basis of fundamentals alone, and in the absence of unexpected shocks to the system in the form of natural or man-made disasters, 2010 could be a fairly calm year for the oil market and an orderly transition from recession to renewed growth. We also noted that the outlook contains a large number of unknowns on both the political and economic fronts that all have the potential of producing considerable volatility in oil markets.
At the beginning of the year, we thought that the market appeared ready to support a price higher than 2009’s average annual price of $62 per barrel (NYMEX WTI), but not as high as 2008’s average price of $99 per barrel. We thought at the time that average prices for the year could wind up somewhere in the $80 to $90 per barrel range. This was a fairly bullish outlook, given the high inventory levels, the amount of spare capacity that had opened up, and the underlying fundamental weakness of the market.
Our view was colored in part by an expectation that OPEC would continue to act largely in its own self interest, and in part by an expectation that demand prospects would gradually turn around and strengthen with the global economic recovery. We also felt that there was a good chance that investors would turn to commodities and oil futures as a hedge against possible inflation and erosion in the relative value of the dollar.
Mid-year Review: More Strength. Where are we today? As always, the year has unfolded both in ways we expected and in ways that were full of surprises. If anything, the global economic recovery is a bit stronger today than it appeared at the beginning of the year and economic optimism is growing. Fears about the possibility of a double-dip recession have receded into the background. At one point, activity in China threatened to overheat its economy, and China’s government took steps to withdraw some stimulus. The Dow Jones Industrial Average settled above 11,000 in early April for the first time in 19 months. Many people take this as a clear sign of optimism.
Both the real GDP numbers for 2009 and the forecast for 2010 have been revised upward slightly for most regions, with the exception of the Euro region where GDP has been marked down slightly. Growth expectations for India and China have been raised the most, but expectations for the United States and Japan have improved as well. The OECD’s index of composite leading economic indicators for 29 of its 30-member countries rose to 103.6 in February from 102.9 in January, one of the highest levels in years. (Anything over 100 indicates an expansion of economic activity.) It now appears that the economic recovery is clearly underway, but employment gains will be slow and continue to lag during the recovery.
Oil demand, primarily in the emerging markets but also to a lesser extent in the U.S., appears to be a bit stronger. While oil demand for the OECD as a whole is still generally expected to remain flat in 2010, U.S. oil demand so far this year has been running about 1 percent, or 100,000 barrels per day (bpd), above the same period last year. For the last four weeks, U.S. oil demand has picked up a bit and is now about 2 percent above the same four-week period of 2009.
At the beginning of the year, the consensus view of the International Energy Agency (IEA), the Energy Information Administration (EIA), and OPEC monthly oil market reports expected global oil demand to rise by an average of 1.0 mmbd in 2010. This view has gradually moved upward in the last few months along with expectations for economic recovery. Today, the latest monthly (April) round of forecasts by these organizations expects global oil demand to rise by an average of 1.5 mmbd this year. OPEC’s forecast gain (+1.0 mmbd) is at the low end, and the IEA’s forecast (+1.7 mmbd) is at the high end, with the EIA in between. The EIA, the only one of the three so far to produce a demand forecast for next year, expects global oil demand to rise by 1.6 mmbd in 2011.
Nevertheless, supplies are still plentiful. OPEC production has continued to run well above its quota. The margin of spare crude oil production capacity, primarily in OPEC, continues to inch upwards, as ongoing capacity additions are completed, towards 6.0 mmbd, its highest level in 10 years. Non-OPEC oil and other liquid supplies (biofuels, OPEC and non-OPEC NGLs, and other non-conventional sources, taken together) have continued to show net annual gains of 0.5 to 1.0 mmbd since 2007. They are expected to register net annual gains close to 1.0 mmbd this year and next.
As a result, inventories have generally remained at or above the upper end of their historical average range. OECD commercial inventories in particular, at nearly 60 days of forward demand cover, remain at very high levels. Surplus inventories on land have not come down as fast as OPEC would have preferred, but there is some evidence to suggest that the large buildup of inventories at sea is beginning to retreat.
Lingering Concerns. In spite of growing optimism about the recovery, major uncertainties persist related to the political situations in Nigeria and Venezuela (to name only a few) and the ongoing war on terror. Recent developments in post-election Iraq and Afghanistan—and a possible looming showdown with Iran over its nuclear weapons program that might lead to tougher sanctions—could all cause problems in the market. U.S. relations with Israel, China and Russia over a broad range of political and economic issues have been on a rollercoaster ride lately, which only adds to the potential for instability.
In addition, as the economic situation with Greece and the ongoing EU financial crisis clearly demonstrate, the issues of rising debt, reduced spending, higher taxes and an eventual withdrawal of economic stimulus continue to cloud the economic recovery prospects of many developed nations. Unemployment continues to be persistently high, and will likely remain so in the period immediately ahead. Even though the economic recovery now is firmly gaining strength, the need to cut spending, raise taxes and deal with rising debt could still have a dampening effect on medium and longer-term growth prospects.
Oil Prices. Front month WTI closing prices recovered briefly to hit $70 per barrel as early as June 2009. Prices then hit $80 briefly in October, and wound up averaging around $76 for the last quarter of last year. After flirting with $80 per barrel prices in the opening week of this year, WTI prices retreated as we expected and gradually settled into a fairly stable trading range of $70 to $80 per barrel for most of the year thus far. WTI wound up averaging $78 per barrel for the first quarter of 2010. Prices in early April then broke out of that range to hit an 18-month high, settling at $86.89 on April 6.
Nevertheless, and considering how the year has unfolded so far, we continue to expect oil prices to average somewhere in the $80 to $90 per barrel range for the year as a whole. If anything, given the current fundamentals in the market, the 2009 recovery in oil prices and their recent strength is somewhat of a mystery. The IEA’s latest Monthly Oil Market Report referred to the oil market as “overheated”, and we would also not be surprised to see some correction in the short term.
The only explanation for these higher prices appears to be a widespread expectation that the coming rebound in economic activity will gradually push oil demand to the point where the market’s ability to meet rising global demand is once more brought into question. Many investment banks (Barclays, Goldman Sachs and Bank of America, to name a few) subscribe to this view, expecting crude oil prices to continue to rise as long the economic recovery persists. Investment inflows into commodity indices, ETFs and oil futures have been gaining strength so far this year. In the opening weeks of April, investors have extended the number of net long positions in the NYMEX oil futures market to record highs.
While most banks continue to see oil prices averaging in the $75 to $95 per barrel range for the year as a whole, many more now see higher demands driving prices to the $90 to $100 per barrel range briefly sometime during the next three to six months. T. Boone Pickens, speaking in Washington on April 14th said he expects to see oil at $95 by the last quarter of the year. Price expectations of $130 to $150 per barrel by 2014–2015 are not uncommon.
The EIA has raised its view of 2010 oil prices from $79 per barrel at the beginning of the year to $82 per barrel now, and to $85 per barrel by the end of 2011. U.S. gasoline prices are now averaging $2.85 per gallon, up $0.80 from this time last year. Prices are already flirting with and have exceeded $3.00 per gallon in some parts of the country, and could go higher as the summer driving season progresses. Given our high unemployment and the fragile nature of the U.S. economic recovery, higher oil prices could produce some retrenchment in economic activity, and a reduction in demand. There is some evidence that this might be happening. Oil inventories in the U.S. have risen for 10 out of the last 11 weeks in a row.
OPEC and the Preferred-Price Target of $70 to $80 per Barrel. OPEC Ministers met in December, and again in March, and reaffirmed their support for their previously agreed production quotas. At both meetings they were willing to overlook a growing amount of non-compliance with their production quota system (that reached nearly 2.0 mmbd in March) as long as the global economy was on the mend. Their task was made easier by the fact that oil prices remained in their preferred range of $70 to $80 per barrel. However, not everything has gone as smoothly as they would have preferred. The inventory overhang has failed to come down as they had planned. OPEC is not scheduled to meet again until October.
OPEC Ministers met again at the International Energy Forum (IEF), the producer-consumer dialogue venue, in Cancun at the beginning of April. In the ongoing dance of the shadow puppets (that has been going on, non-stop for close to 40 years now, with consumers on one side and OPEC on the other side) a great deal was said once more about the fact that oil price volatility is the enemy of both producers and consumers alike. In OPEC’s view, prices much lower than its preferred range of $70 to $80 per barrel are not sustainable. Lower prices choke off investments in future oil and alternative supplies, while encouraging demand growth, setting the stage for insufficient supplies, tight global energy markets and low growth. On the other hand, prices much above the preferred range threaten economic growth, strengthen political resolve to move away from expensive oil, encourage efficiency and the development of alternatives, and threaten to destroy oil demand way before the resource becomes scarce.
In the course of the dialogue over the years, several key conclusions repeatedly emerge:
- Security of supply to consumers is just as important as security of demand to producers.
- Oil price volatility drives both consumers and investors away from oil towards more secure, reliable and dependable resources.
- If you want to manage the market to prevent major price spikes, you have to also prevent major price declines.
- Managing the oil market is not easy.
The issue has always depended on where you draw the line. Consumers want to reduce their dependence on potentially unstable supplies of volatile, expensive, imported and now carbon-based fuels. OPEC has offered to guarantee reliable oil supplies at reasonable prices and a comfortable margin of spare production capacity to meet global requirements in exchange for a secure, long-term market for its major, and sometimes only, export.
In the past, however, OPEC has demonstrated a general ability to move quickly during periods of market weakness to act in its own self interest and shore up prices. When prices begin to rise, however, as they did in 2007 and 2008, and again in the past few weeks, additional OPEC supplies have usually been slow in forthcoming. As in the past, OPEC is once again claiming that the market is adequately supplied, that inventories are at high levels and that financial speculators are responsible for the recent run up in prices. OPEC appears once again to be preparing to distance itself from any responsibility for the current rise in prices.
So the question now becomes how serious is OPEC about defending its preferred price range when oil prices are on the rise? It will be interesting to see how all this plays out. The market could be preparing a real test of OPEC’s willingness and ability to keep oil prices within their preferred range. A test of the underlying value of the producer-consumer dialogue and the IEF could also soon occur.
At the IEF meeting in Cancun, there were rumors about a draft statement circulating among the OPEC Ministers. Rumors suggested that the statement confirmed that investment in new OPEC supplies was ramping up and that OPEC stands ready to meet future oil demands. The draft also noted that the price of oil could be expected to stay in OPEC’s preferred range of $70 to $80 per barrel for years to come. In the end, however, OPEC issued no formal statement along these lines.
OPEC could add more oil to the market and dampen near-term prices, but it probably won’t just yet. With inventories already running at near record levels, OPEC is probably worried that the market could overreact to an increase in supply and push prices below $70 per barrel. From OPEC’s perspective, it’s probably better to err on the side of higher prices and give the market some extra time to correct itself. OPEC knows that to control the oil market, it really has to control oil futures markets, and it may not be ready to overtly play that game.
On the other hand, if OPEC doesn’t act, and if prices continue to rise, the economic recovery could falter, with the blame being placed squarely on OPEC’s shoulders. More importantly, if prices continue to rise they could once again create the crisis conditions that will serve to strengthen consumer countries’ resolve to promote efficiency and the development of alternatives to OPEC oil. The coming months will be interesting. No one ever said that managing the market was easy, and OPEC is beginning to feel the heat.
Peak Oil Is Dead. Long Live Peak Oil. How this plays out in the medium-term is an open question. Supplies appear to be more than plentiful to meet requirements for the years immediately ahead, no matter how you postulate a mix of supply and demand growth scenarios. But as we are seeing in the market today, the actual supply and demand numbers may not matter as much today and in the future as they once did.
The balance of market expectations about a number of key factors is the principal driver of oil prices in both the short and medium-term market today. In the absence of an unexpected shock to the oil market, such as a natural or man-made disaster that suddenly reduces supply, we don’t have to experience actual market tightness to see oil prices rise today, we only have to expect market tightness to get the market to react. If the market works, if it becomes flexible enough, we may never actually get to the point of tightness in a supply and demand sense. This is the “plateau” view of the market. Be that as it may, let’s look at some numbers anyway.
According to the EIA, world oil consumption (of all liquid fuels) reached a peak of just over 86 mmbd in 2007, declining after that for the next two years in a row. Based on current expectations, global oil demand will recover this year and next to surpass the previous peak sometime next year. In this scenario, we assume that annual global oil demand rises by 1.5 mmbd in 2010 and 2011, and by 1.0 mmbd per year beyond that.
Net non-OPEC supplies of all liquid fuels and OPEC NGLs (not subject to production quotas) taken together have been growing at an average rate of about 600,000 barrels per day each year since 2007. They are expected to grow slightly faster this year and next, at a rate of about 1.0 mmbd per year. In this scenario, we assume net non-OPEC supplies and OPEC NGLs together grow at an annual rate of 0.5 mmbd beyond 2011.
When we take account of current OPEC spare production capacity of 6 mmbd, along with net OPEC capacity additions, assumed to be 0.5 mmbd in the coming years, it is possible to construct a scenario about how the future might play out. Assuming inventories are neutral, OPEC spare production capacity in this scenario, based on the assumptions above, never falls below the current level of 6.0 mmbd.
Other scenarios are possible. For example, if global oil demand grows faster, at 1.5 mmbd in 2012 and beyond, and everything else stays the same, OPEC spare production capacity falls to 3.0 mmbd by 2017. If we assume oil demand grows at the faster rate of 1.5 mmbd, and that non-OPEC liquid fuel supplies and OPEC NGLs together stop growing after 2011, OPEC spare production capacity falls to 3.0 mmbd by 2014. While there is nothing magic about an OPEC spare production capacity level of 3.0 mmbd, according to the EIA, the level of OPEC spare production capacity in the past 10 years has averaged 2.8 mmbd. Spare production capacity below this level is but one indicator of market tightness.
By AER Contributing Editor John R. Brodman