Abraham Energy Report

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 50^th 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