Insights On OPEC

The Oil Market Outlook for 2010: A Mid-Year Review and Look at the Medium-Term

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

The Oil Market Outlook for 2010: Wild or Mild?

Ten years ago, we found ourselves entering a new century and a new decade worried about the Y2K computer glitch and predictions of impending chaos in a digital world.  This year, as we enter what some are calling “Y2.1K,” we are also facing a large number of unknowns on both the political and economic fronts that could have dramatic impact as the year unfolds.  It seems to be true that we are emerging from a deep and troubling global financial crisis and one of the worst economic recessions since the 1930s. After the experience of the past two years, people want to be optimistic about the economic recovery, and while there are many good reasons for being so, not everything is well on the economic front.

The Economy.  According to the World Bank and others, global real GDP contracted by approximately 1.5 percent in 2009.  Hopefully the worst is behind us. Expectations now put global real GDP growth at around 3.2 percent in 2010, but the growth is likely to be very uneven, with the BRIC countries (Brazil, Russia, India and China) and emerging markets rapidly establishing their dominant position in the global economy.  High and rising government deficits, high unemployment and growing protectionism increase the possibility of a slower than normal economic recovery in the Organisation for Economic Co-operation and Development (OECD) nations.

The positive initial effects of the G-20’s coordinated response to the financial crisis and the ensuing economic meltdown may not be sustainable in all countries.  Many problems persist, particularly in the developed world, in housing, autos, household expenditures, and public sector balance sheets.  This coincides with a rapid rebound in economic activity in the emerging economies in the past two quarters. This growth has already sparked fears of a new economic bubble in some areas and talk of mounting international imbalances.  Just how these divergent paths will interact to steer global economic prospects is largely unknown and a major source of uncertainty for the year ahead.

Oil Market.  The oil market has weathered another boom-and-bust cycle, and global oil demand, after declining for two years in a row (the first time in 25 years), appears set to grow once again.  Commercial oil inventories are high, and there are comfortable margins of unused production capacity both upstream in crude oil production and downstream in the refining sector.  Peak oil fears about supply constraints have been pushed to the back burner for the time being, and there is enough supply around to fuel even the most wildly optimistic economic growth scenarios for the next two to three years at the very minimum.  How peak oil scarcity plays out in the medium- and long-term is still an open question, but in the absence of some outside shock to the system, it shouldn’t be a factor in 2010.

On the basis of market fundamentals alone then, 2010 should be a fairly calm year for the oil market.  Demand prospects should gradually turn around and are likely to strengthen throughout the year.  Oil prices (average NYMEX closing price for the front-month WTI contract), which were about $62 per barrel on average in 2009, could be expected to gradually strengthen further as the global economy continues to transition from recession to renewed growth.

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While the demand side could be expected to exert some upward pressure on prices, high inventory levels and ample margins of spare production capacity should keep any price increases to moderate levels.  Oil futures prices indicate that investors generally expect oil prices to rise in 2010, but in the absence of any major unexpected shock to the system, which could turn out to be an understated qualification, an oil-price spike seems unlikely.

The market appears set to support an oil price this year that is higher than 2009’s average of $62 per barrel, but not as high as the $99 per barrel average seen in 2008.  Prices at the higher end of this range may not be sustainable.  They could undermine the economic recovery and oil demand.  They are also likely to provoke additional regulatory responses aimed at restricting “speculation” in the oil-futures markets.

Other Views.  As economic growth and oil demand recover, most large investment banks expect oil prices in 2010 to average between $75 and $92.50 per barrel, a 20 percent to 50 percent increase year-on-year.  The latest U.S. Department of Energy Short Term Energy Outlook predicts prices will average about $79 per barrel in 2010, which is close to but higher than the pre-crisis average of $73 per barrel of 2007.  Most analysts expect the first half of the year to be weaker than the second half.

The more bullish members of this group see the market’s preoccupation with weak demand and surplus inventories gradually turning, once more, into supply-side concerns about the oil market’s ability to fuel rising global demand in the years ahead.  They believe that traders and investors will begin positioning themselves to take advantage of tighter markets in the future, and that supply-side concerns will again dominate market expectations and oil price formation.  The most bullish of these analysts say they would not be surprised to see oil prices make a few, brief excursions to $100 per barrel or more in 2010.

The role that geopolitical concerns and other developments play in these forecasts of potential price spikes in 2010 is unclear at best.  In addition, while it is clear that a transition is underway and that demand is set to resume its overall growth path, the strength of this transition and its exact arrival will depend on a number of factors.  The timing and magnitude of inflows to oil and commodity futures markets in the period ahead will mark the strength of investors’ belief in future supply tightness and higher prices.  These flows of funds will depend not only on the forecast for the recovery itself, but also the outlook for major geopolitical upsets, inflation, the status of the dollar, and equity and bond market performance across a diverse group of investment vehicles.

Expect the Unexpected.  Most forecasts are predicated on the absence of unforeseen developments or unexpected shocks to the global oil market, of which there could be plenty in 2010.  In the first few days of trading in 2010, oil prices broke out of their fairly stable trading range and rose to a 15-month high of more than $83 per barrel.  Prices were being driven by news that Russia had cut off oil shipments to Belarus, that production in China’s industrial and manufacturing sectors was exceeding all growth expectations, and that persistent, colder-than-normal temperatures had overtaken much of the Northern Hemisphere in North America, Europe and Asia.  A declining dollar and expectations of a stock market correction also fueled the flow of funds into oil futures.

These day-to-day fluctuations are to be expected, but they accumulate and affect our view of the long-term outlook. The volatility in the first week of trading could be only a sneak preview of the uncertainties that lie ahead in 2010—uncertainties that could turn what otherwise might be a fairly stable-but-growing market into a wildly schizophrenic, volatile ride.

On the economic side, 2010 is likely to be affected by persistent declines in home prices, tight credit, and high unemployment, which will plague household balance sheets, particularly in the U.S. and the European Union.  Business investment and confidence will continue to be shaken by uncertainties over high and rising government deficits, and unresolved political issues related to future taxation, revenue shortfalls, social entitlements, carbon mitigation policies, financial sector regulatory reform, and growing protectionism in trade policy.  G-20 governments all face issues regarding the future timing and pace of their fiscal and monetary stimulus programs.  On the political side, upcoming elections in Iraq, Brazil, the U.S., U.K. and many other countries are looking more and more contentious, with outcomes that are highly uncertain.

On the geopolitical side, even the unthinkable is quickly becoming possible in 2010.  Most of the uncertainty here stems from escalation of the war in Afghanistan, and the start of new efforts to rein in terror, not only in Yemen, Pakistan, Iraq and other parts of the Middle East and Africa, but across the globe.  Potential developments in Iran are likely foremost on everyone’s mind.  Negotiations over its contentious nuclear program could come to a head in 2010 and possibly lead to responses as diverse as increased sanctions and outright military confrontation, which could have direct and possibly severe consequences on global oil markets.  Growing dissatisfaction with the clerical government could also lead to major internal strife, a leadership crisis, possible regime change, and a temporary crippling of Iran’s already weakened economy.

Depending on how all these things play out, 2010 could go from being an orderly transition from recession to growth to a wild, volatile ride.  That’s the question, and it all depends on a large number of unknowns that more than stretch human ability to see around corners and into the future.  While admitting that anything can happen, and that 2010 will bring its own share of surprises to the market, it is nevertheless useful to review what we think we do know about the things most likely to affect the market in business as usual circumstances.

Economic Outlook.  World real GDP now appears to have contracted by 1.5 percent in 2009, with the industrialized OECD economies contracting at –3.5 percent and accounting for most of the decline.  Global growth is expected to return to positive territory in 2010, and register real GDP growth of around 3.5 percent, which is fairly anemic when compared with past recoveries.  Again, BRIC countries and emerging markets are expected to lead the expansion in both the timing and pace of recovery, with real GDP growth rates of 5 percent to 6 percent for the group.  China is expected to grow by 9 percent or more in 2010.  The Middle East, parts of Africa, and Asia (except Japan) are all expected to experience the most robust growth.

The OECD recovery is expected to begin a bit later, with real GDP growing somewhat slower than in past recoveries, at less than 2 percent in 2010.  The U.S. is expected to grow the fastest, at nearly 2.5 percent, with EU growth of less than 1 percent and Japan somewhere in between.  If anything, we entered the New Year on a positive note, with fresh reports of inventory rebuilding and industrial output around the globe generally exceeding expectations.  Unemployment in the OECD is likely to remain persistently high in 2010.  Views about the strength of the economic recovery in the OECD nations shift almost daily from optimism to pessimism and back again, depending on the latest economic reports.  Expectations of a double-dip back into recession or a prolonged L-shaped recovery still abound, but they’re not as prevalent as before.

Oil Demand.  World oil demand reached a peak in 2007, and has declined for two years in a row in 2008-09—a first in 25 years.  Most forecasts expect world oil demand to turn around and grow in 2010 by somewhere in the range of 0.5 to 1.5 million barrels per day (mmbd).  If demand grows at the midpoint of this range (1.0 mmbd), global demand in 2010 will rebound to about the same level last seen in 2006, but it will still be about 1.0 mmbd below the previous peak in 2007.

The BRIC countries alone were responsible for almost 60 percent of the entire growth of world oil demand in the last decade.  Together the BRIC countries and emerging market economies are the new epicenter of oil demand, and they are expected to account for virtually all of the growth in global oil demand in the years ahead.  It is interesting to note that more than 13 million new cars were sold in China alone in 2009, compared with about 10 million in the U.S.

Oil demands in the U.S. and in the OECD as a whole have been declining at a rate of just over 1.0- percent per year for the last four years from the peaks reached in 2005.  Some forecasts expect this long-term trend away from oil to continue in 2010, with OECD demand falling by 0.2 mmbd, in spite of the projected economic recovery. Others expect demand to recover and grow by about 0.2 mmbd.  Most forecasters see demand in Europe and Japan continuing to stagnate or decline, so the disparity is largely due to differences in opinion about the strength of U.S. oil demand in 2010.  We are inclined to take the middle road and assume that OECD oil demand (and U.S. oil demand) will remain flat in 2010.

Oil Supply.  Non-OPEC supplies of all conventional and non-conventional liquid fuels rose about 0.5 mmbd in 2009, and are expected to grow by about 0.2 mmbd in 2010.  Biofuels and other non-conventional fuels have managed to slightly offset the trend decline in non-OPEC conventional crude output for the past five years.  Near the end of 2008 and early 2009, biofuels briefly lost some ground during the oil price collapse, but appear set to recover in 2010 and beyond.

Exploration and development expenditures are on the rise again, stimulated in part by the decline in the prices of oil field equipment and services.  Natural decline rates in many oil-producing countries are a force to be reckoned with. Nevertheless, the eventual production of new offshore reserves in West Africa, Brazil and many other places, plus planned expansions of biofuels and unconventional resources, could hold the overall non-OPEC supply curve level for some time to come.  Brazil is set to pass Venezuela as Latin America’s largest producer this year.  They have been invited to join OPEC but declined.

OPEC crude oil production fell by about 2.2 mmbd from 2008 to 2009, while its overall production capacity, as a result of ongoing investment, continued to rise.  As a result, OPEC’s surplus crude oil production capacity rose to near 4.5 mmbd by the end of 2009, a level not seen since the beginning of the last decade.  OPEC’s crude oil production capacity is expected to rise again in 2010 and beyond, due to ongoing expansion projects in Qatar and Angola, and new contracts in Iraq.  Extra production from Nigeria is also possible as a result of the cease-fire in the Niger Delta.   In addition, OPEC production of natural gas liquids (NGLs), which falls outside its production quota system, has been rising by about 0.5 mmbd per year in the past few years.

This trend is expected to continue in 2010 and beyond as OPEC members exploit their gas reserves for both domestic consumption and liquefied natural gas (LNG) exports.  Total liquids production capacity (crude and NGLs) in OPEC, including Iraq, could rise by 1.0 mmbd in each of the next several years.  This would just about meet the expected increases in world demand over that period while allowing OPEC to maintain its current level of spare production capacity.

OPEC. As expected, OPEC Ministers meeting in Angola on Dec. 22, 2009, on the heels of the Copenhagen climate talks, decided once again to roll over their previously agreed production quotas and keep output for the OPEC 11 unchanged at 24.845 mmbd.  In the communiqué issued following the meeting, it was clear that OPEC believed that the world economic recovery and the demand for oil was still weak, saying that its decision was intended to strike a balance between oil price stability and the needs of a growing world economy.

Declining compliance with the quotas was one of the major topics of the meeting, and the Members once again pledged to do their share for the common good.  They also called upon non-OPEC oil producers to become more involved in the process and undertake cooperative action with OPEC.  The non-OPEC countries of Egypt, Bahrain, Indonesia, and Oman attended as observers.

For the most part, OPEC members were happy to see a resumption of gradual and steady growth in oil demand, and most were satisfied with the price recovery that took place in 2009.  Saudi Minister Ali Naimi said after the meeting that the market was good and that “the price was excellent.”  It seems clear that as long as the price stays in a comfortable range above $70 per barrel, most OPEC Members are unwilling to risk the appearance of unity for an internal fight over compliance.  It also appears that rising production in Iraq, Angola, Qatar and Nigeria may eventually push the group to revise its quotas, but with some luck and growing demand, this is unlikely to happen in 2010.  OPEC’s own forecast expects the demand for OPEC oil to rise slightly in 2010.

Copenhagen and Carbon Mitigation.  The failure of the Conference of the Parties (COP) to agree on binding targets for carbon mitigation provided many oil producers with a temporary sigh of relief.  The upcoming elections in the U.S. are also likely to forestall any congressional action on cap and trade or new energy taxes this year.  Nevertheless, the energy policies already in place to promote energy efficiency and the development of new and renewable energy resources will continue to nibble away at the demand for oil and other carbon-based fuels this year and in the foreseeable future.

The automobile companies are slated to introduce plug-in electric and electric hybrid vehicles this year, and government incentives to scrap less efficient vehicles (like “Cash for Clunkers” in the U.S.) are ongoing in many countries.  In the medium- and long-term, a race is 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 energy.  In this environment, global oil demand is likely to grow more slowly than it has in the past.

Admittedly, the outlook contains a large number of unknowns on both the political and economic fronts.  Depending on how these factors play out, 2010 could turn out to be anything from a calm orderly transition from recession to growth to a wild, volatile ride.

Analysis by Abraham Energy Report Contributing Editor John Brodman

Key Concepts:

  • The global economic recovery is underway, but growth is likely to be very uneven between the emerging and developed countries.  The possibility of a slower than normal economic recovery in the OECD is a major concern for the outlook.
  • On a business as usual basis (that is, based on the assumption of no major, unexpected economic or political shocks to the system), global oil demand should recover and grow once again in 2010, with virtually all the gains registered by the emerging markets.
  • Commercial oil inventories are high, and there are comfortable margins of spare production capacity in both crude production and refining. In the absence of some outside shock to the system, peak oil concerns should not be a factor in 2010.
  • The market appears set to support a price higher than 2009’s average annual price of $62 per barrel, but not as high as 2008’s average price of $99 per barrel. Prices could wind up somewhere in the $80 to $90 per barrel range on average for the year.

OPEC Meeting Preview: Partly Cloudy Skies with Sunshine and Rain Possible

OPEC Ministers are set to meet Dec. 22, 2009, in Angola, in what promises to be a much more positive economic atmosphere than the one they faced last year at this time before the Ministers met in Algeria on Dec. 17, 2008.  Prices have recovered from their year-end lows, and have settled into a relatively stable and comfortable (from OPEC’s perspective) range of $75 to $80 per barrel.  Global oil demand is recovering, mostly outside the Organisation for Economic Co-operation and Development (OECD), and production costs for new developments have come down. A comfortable margin of spare oil production capacity has opened up, primarily in OPEC, without giving rise to a price-induced surge in non-compliance with production targets.

The hostile rhetoric directed at OPEC during last year’s surge in prices and the ensuing financial crisis has diminished, and the speculative pressures on oil prices appear to be remaining in check, in spite of long-term inflation fears and renewed capital inflows to commodity markets. The global push to reduce consumption of fossil fuels in the name of climate change has been muted by the economic effects of the recession and the apparent lack of a national and international consensus on the path forward.  OPEC has just moved its headquarters to a new state-of-the-art facility in Vienna, just in time for the 2010 celebration of the 50th anniversary of the founding of OPEC in 1960.

While prospects are clearly better than last year, not everything is rosy.  The strength of the recovery is still in doubt in several parts of the world and, as the Dubai debt crisis demonstrates, the full effects of the credit bubble are still playing themselves out.  The gradual unwinding of government stimulus programs and the global economy’s ability to deal with long-term debt in a sustainable manner remain in question.  Financial sector reforms are being formulated that could dramatically affect how oil and energy trades are conducted in the future.

New technologies are adding to oil, natural gas and other clean and renewable energy supplies while helping to reduce global demand.  A renewed push to deal with global climate change and reduce fossil fuel consumption is probably only a matter of time.  Finally, regional stability in the Middle East remains a problem, and Iran appears to be on a collision course with the rest of the world.

Recap. OPEC met every month from September to December in the fall of 2008 in a concerted effort to understand the rapid deterioration in the economic outlook, and the demand and price for oil.  They pledged to cut output several times in the fall of 2008 in an attempt to keep up with declining demand. The outlook at that time was gloomy, and analysts couldn’t revise their forecasts downward fast enough to keep up with the reality of the marketplace.

In spite of their efforts to trim output last fall, the downward momentum in prices related to the decline in oil demand and economic news, creating a perfect set of circumstances for traders to short the market.  This put additional downward pressure on prices in what became a self-fulfilling prophecy.  The front-month contract for WTI on the NYMEX fell to near $40 per barrel during the week before the December 2008 OPEC meeting, and to a low of $33.87 per barrel at the close of the market on Dec. 19, 2008.  At its meeting last December, OPEC agreed to cut 4.2 million barrels per day (mmbd) from its actual September 2008 production levels. At the time, this was the largest production cut the organization had ever attempted at any one time in its history.

After last December’s OPEC meeting, the Abraham Energy Report concluded (see “December OPEC Meeting: Shock Therapy for Declining Demand,” AER January 2009) that OPEC hoped to deliver a dose of shock therapy to the market in an attempt to stem the decline in prices. We said that the financial crisis was evolving into a synchronized global recession of uncertain magnitude and duration, and that 2009 would be a very difficult year.  We wrote that the inventory overhang would be particularly troublesome, especially in the first half of the year, and that the supply overhang could persist throughout and possibly beyond 2009.

Given how far prices had already fallen, we expected OPEC would have some limited success in preventing oil prices from falling much further. We also thought that it was doubtful that OPEC would have any immediate success in raising prices to anywhere near the $75-per-barrel level that many OPEC Ministers were calling a “fair” price for oil at the time. Sustained higher prices would only be possible when the global economy began to show definite signs of recovery large enough to produce renewed growth in oil demand, we concluded.

In retrospect, 2009 unfolded in some ways as expected, and in other ways that were unexpected, but eventually with great clarity in the rearview mirror called hindsight.  The G-20 process produced unprecedented levels of economic stimulus that began to have an effect on the real economy in much of the world by the beginning of the third quarter.  At the same time, however, the deficits accompanying the stimulus gave rise to inflation fears and a flow of money into gold, equity and commodity markets as a hedge.

This helped to pull oil prices up in spite of continuing weakness in the supply and demand fundamentals.  The front month closing price of WTI on NYMEX rose gradually from about $43 per barrel in the first quarter of 2009 to $60 and $68 per barrel in the second and third quarters, respectively.  If prices remain in the $75 to $80-per-barrel range where they have been trading for the last five to six weeks, the fourth quarter price will average around $77 per barrel, and the average price for the year should come in at about  $62 per barrel.  This is slightly above the $60-per-barrel high-end of the range we expected at the beginning of the year.

OPEC’s compliance with the announced production cuts was largely delayed last fall and it improved only marginally in the early months of 2009.  The production cutbacks were finally implemented with a good (70 to 80 percent) degree of compliance from March 2009 onward, but not before inventories grew to levels way above the 5-year average range.  The upward move in oil prices from May to August did little to induce higher levels of OPEC output and greater non-compliance as some had expected, but weak demand kept inventories at record-high levels.

Demand prospects for 2009 continued to be marked down through mid-year, and have just recently been ticking upward in the last few months, with robust growth reappearing especially in Asia.  Oil prices remained volatile through much of the year until late August, but have settled in to a relatively calm trading range of $75 to $80 per barrel since then.  By some measures, the volatility of oil prices has been at its lowest level in years in the past month.

Unlike the fall of last year, OPEC hasn’t met since its September meeting in Vienna, and the relative calmness in the oil market and gradual, if slight, improvements in the underlying fundamentals have encouraged the members to stick with their current production agreement.  In fact, OPEC has been fairly quiet lately.  With the OPEC basket price and WTI trading in a fairly stable and acceptable band of $75 to $80 per barrel, there hasn’t been much reason for OPEC to intervene.

In addition, as OPEC approaches its December meeting, the economic and energy outlooks this year are as different as day from night when compared to last year.  Production costs have come down, demand is starting to grow once again, albeit slowly in the OECD area.  A comfortable margin of spare oil production capacity has opened up, and OPEC seems more than willing to stay out of the spotlight and watch the recovery unfold.

The latest (November) round of short-term oil market forecasts—coming from the International Energy Agency (IEA), OPEC and the U.S. Energy Information Administration (EIA)—now expect world oil demand to decline by an average of 1.5 mmbd in 2009, following a decline of about 0.3 mmbd in 2008.  All three forecasts now expect oil demand to show year-on-year growth in the fourth quarter of this year, and to grow by an average of 1.1 mmbd in 2010.  The next round of monthly short-term forecasts, which will be available in the second week of December before OPEC meets, is expected to confirm these trends.

The return of robust oil demand growth is much more pronounced in China, and Asia in general, than in the OECD area.  OECD oil demand, which has been declining since 2005, could falter once again next year if the economic recovery loses steam, as additional carbon-reduction policies are implemented (with or without agreement in Copenhagen), and as competition from cheap natural gas supplies puts pressure on the middle of the barrel.  Nevertheless, in spite of possible continued declines in the OECD, oil demand for the world as a whole seems set to rebound.

The inventory overhang continues to be a problem, though.  The IEA and the EIA show commercial inventories in the OECD at nearly 61 days of forward consumption coverage.  This is well above the 54 to 56 days of forward cover considered normal for this time of year.  As a result, OPEC will probably once again pledge to “strictly adhere” to its existing production targets at its upcoming meeting.  The demand for OPEC crude oil fell by 2.3 mmbd in 2009, and it is expected to remain relatively flat in 2010.  All three of the monthly outlooks expect inventories to gradually come down during the course of next year.

OPEC oil production is rising in Nigeria as a result of the cease-fire in the Niger Delta, as well as in Angola as a result of new developments. Production appears set to rise somewhat in Iraq over the next few years as the security situation improves.  However, none of these developments are likely to upset the organization’s production agreement.  Production has been higher than expected this year in Russia and in the U.S., but lower in Europe, Mexico and Canada.

There will be plenty of issues for OPEC Ministers to discuss on the margins of the formal meeting, covering the prospects for economic recovery, Copenhagen, the IEA’s latest World Energy Outlook, the emerging surplus of natural gas in some markets, the continuing emergence of China as a powerhouse in the oil demand market, prospects for the dollar, and the declining usefulness of NYMEX WTI as a benchmark for crude oil prices.  Above all, we believe that the Ministers will be thankful to have the past two years behind them, and to be looking forward to better times in 2010, with a comfortable degree of confidence that OPEC as an organization has once again served them well, as it has for much of the past 50 years.  The events of 2009 demonstrated to OPEC once more the veracity of the old adage “united we stand but divided we fall.”

Analysis by Abraham Energy Report Contributing Editor John Brodman