Abraham Energy Report

OPEC Ministers met in Vienna on March 15 to review trends in the oil market, global economy, and the adequacy of their three previous attempts to reduce oil production in line with declining global demand. They also examined the degree of each OPEC Member’s compliance with the existing production quotas set at their last meeting in December 2008.

Against the background of an extremely weak and fragile global economic outlook and continuing erosion in the demand for oil, they agreed that no further cuts in their production ceilings (quotas) were needed at this time. They also agreed that a continued high level of compliance with the existing production quotas, now estimated to be near 80 percent, is of paramount importance to the success of their attempts to stabilize oil prices in the months ahead. Full compliance would remove an additional 0.8 million barrels per day (mmbd) from the market.

This decision to stand pat and maintain the production ceilings adopted in December was widely expected by the market. Recent news of improving compliance and a slowdown in the rate of demand decline allowed prices to creep back to the mid-to-upper $40 dollars per barrel in the week before the meeting. Prices fell back slightly in early trading on the first day after the OPEC decision, but did not move appreciably.

In the week leading up to the meeting, Saudi Arabia, which is actually producing slightly less than its quota, also signaled its unhappiness with the poor compliance of some OPEC members, and an unwillingness to take further cuts unless compliance improves. Saudi Oil Minister Ali Naimi reportedly said in a letter to the OPEC President that over production undermines the credibility of the organization and makes further action unlikely.

The fragility of the global economy and the desire of many OPEC members to contribute positively to a collective economic solution led by the G-20 also played a strong role in OPEC’s decision. The drop in oil prices is providing the world economy with a powerful stimulus. Saudi Arabia and Indonesia are the only current and former members of OPEC who are members of the G-20, but the state of the global economy was first and foremost on the minds of the participants. Pushing for an extra $10 per barrel at this time at the detriment of the global economy would not be in OPEC’s best interest in the long term.

In his opening address to the Conference of Ministers, the OPEC President and Minister of Petroleum of Angola, Jose Maria Botelho de Vasconsuelos, noted that the relatively high level of compliance with OPEC’s previous decisions to cut output has helped to stabilize prices, at a time of continued weakness. He also noted that the breakdown in the world’s financial sector and the downturn in the real economy are still very fluid and the final outcome unclear.

Vasconsuelos noted with concern the impact the downturn was having on the oil industry and investment in future supplies. He called on everyone, OPEC and non-OPEC producers and consumers alike, to work together to support policies and strategies to promote market stability now and in the future.

The communiqué issued at the close of the meeting (see OPEC’s site) makes it clear that the Ministers are very concerned about the global economic recession, systemic risks to the financial system, and the potential for further deterioration. The Conference voiced its strong support for the G-20 meeting process currently underway and its hopes that the process will lead to a substantial improvement in the world economy.

The communiqué reported that OPEC now expects world oil demand to decline by 1.0 mmbd in 2009, and that high stock levels, currently at 59 days of forward cover, will take some time to readjust. The communiqué also noted that the relatively high degree of compliance with the existing production cuts, estimated by outside sources to be 79 percent in February, has contributed to the stabilization of prices at around $40 per barrel since the beginning of the year, in spite of the critical economic outlook.

OPEC noted that the global demand for crude oil produced by its 12 members is now expected to average 29.1 mmbd in 2009, a reduction of 1.8 mmbd from the level achieved in 2008. Full compliance with the production cuts agreed to in December, if achieved, would imply a level of OPEC production of 27.2 mmbd for the year (with Iraq, who is not subject to production limits, at 2.4 mmbd), or a level of 28.0 mmbd for the year with 80 percent compliance..

Both these levels are well below OPEC’s own estimate of demand for OPEC crude oil of 29.1 mmbd in 2009 (by 1.9 and 1.1 mmbd, respectively). This implies that OPEC has built in a cushion of extra production cuts that will help it compensate for high inventories, additional demand weakness, deterioration in the level of compliance with production cuts, or some combination of all these factors.

This has led both OPEC and the International Energy Agency (IEA) to conclude in their latest monthly oil market reports, issued March 13, that current OPEC production levels will begin to gradually redress the inventory overhang and bring the market into better balance later in the year. The math is clear. OPEC is now producing less than the expected demand for OPEC crude this year, and inventories should begin to decline.

Non-OPEC producers represented at the Conference included Russia, Azerbaijan, Egypt, Mexico and Sudan. The First Deputy Prime Minister, Igor Setchin, represented Russia. The Conference agreed to meet again on May 28 in Vienna, and again on Sept. 9.

Recap: The last six months.

In retrospect, since OPEC first took action to cut production in September of 2008, the oil market has been dominated by two main factors:

• the speed and magnitude of the drop in oil demand associated with the free fall in world economic activity, and by

• the degree of OPEC’s compliance with their self-imposed production targets..

It is now clear that OPEC was slow to react to the decline in demand last fall, which pushed more oil into the market than was needed, swelling inventories and pushing prices down. To be fair, OPEC was trying to reduce oil supplies fast enough to keep pace with and even get ahead of declining demand, but the speed and magnitude of the drop in economic activity and oil demand took everyone off guard.

OPEC crude oil output peaked in July of 2008, and declined only slightly in August, September and October. After the emergency meeting in October, OPEC production fell by about 0.5 mmbd in November and again in December. By the beginning of the year, however, OPEC was still producing about 1.5 mmbd above its 24.845 mmbd ceiling adopted in December. Since then, compliance has improved, but they produced about 0.8 mmbd above its quota in February.

As a result, commercial inventories on land and at sea swelled significantly by the end of the year. Inventories in the OECD now stand at slightly less than 59 days of forward demand coverage, compared to the 52 – 53 days of cover preferred by OPEC. As a result, oil prices (WTI, NYMEX) fell freely from their intra-day peak of just over $147.27 per barrel on July 11, to a low of $32.40 per barrel on Dec. 19, just two days after the December OPEC meeting.

The rapid deterioration in the world economy coupled with the collapse of the commodities’ complex and global equity markets, and the massive de-leveraging and flight to cash that accompanied the global financial crisis were also important contributing factors to the weakness in oil. In retrospect, oil prices may have overshot the mark on the way down, just as they did earlier in the year on their way up.

OPEC’s December decision to slash production coupled with an apparent but slow improvement in the degree of compliance with OPEC’s production quotas in December, January and February may be working. Given how far and how fast oil prices have already fallen in the fourth quarter of 2008, OPEC was bound to have some limited success in preventing prices from declining further.

Aside from the anomaly in the WTI/Brent price spread that dominated the market in February, oil prices for the most part have remained above $40 per barrel so far this year. They have gradually moved up in the past few weeks and oil traded in the $46 to $48 per barrel range last week, closing on Friday, March 13 at $46.25.

The price of commodities in general, and oil prices in particular, are what economists refer to as “leading indicators” of economic activity. Just as oil prices fell in advance of the collapse in economic activity, oil prices could be expected to stabilize and begin to rise in advance of an economic recovery. Any signs of good news coming out of the world’s financial markets or early signs of a “bottoming out” or a beginning of economic recovery could be expected to lend support to oil prices from here on out. Conversely, continued bad news on the economic and financial fronts will tend to push prices down.

This may be true in spite of the continuing decline in oil demand that may be far from over. OPEC’s decision at its December meeting to cut production by a record amount, an additional 2.4 mmbd (million barrels per day), brought the sum of the announced cuts by OPEC in September, October and December of last year to a total of 4.2 mmbd. The magnitude of these cuts when coupled with a gradually improving degree of compliance (now estimated at around 80 percent) appears to be enough to give OPEC a cushion to absorb some further cuts in demand and work off the inventory overhang.

Supply and Demand Balances

In the latest (March) round of monthly oil market projections published by DOE/EIA, OPEC, and the IEA, global oil demand is now expected to contract by an average of 1.2 mmbd in 2009, after falling by 0.3 mmbd in 2008.. This is in stark contrast to the 0.2 to 0.4 mmbd decline in demand forecast for 2009 published by these organizations at the time of the last OPEC meeting in December. Can demand go lower?

With the real economy falling rapidly, oil demand in 2009 could eventually drop more than currently expected. In the past 40 years, the most oil demand has ever fallen is by 2.1 mmbd in both 1980 and again in 1981. However, all of the current forecasts mentioned above show significant year on year declines in the first quarter of 2009, followed by a rapid tapering off in the year on year declines in the remaining quarters.

While demand prospects may continue to be cut by additional amounts in successive forecasts over the coming months, the drop in demand may level out later this year. Part of the reason for this is purely technical and mechanical: demand fell very rapidly in the second half of 2008, so the year on year declines in 2009 should moderate.

On the supply side, the global financial crisis and recession are taking a toll on non-OPEC supplies. In December, when OPEC last met, the IEA, EIA and OPEC were expecting non-OPEC supplies to rise by 0.5 to 0.7 mmbd in 2009. In the March round of forecasts, non-OPEC oil supplies (including unconventional oil, ethanol, NGLs and refinery gains) are expected to be flat. However, only OPEC NGLs (which are not included in the production targets) are expected to grow modestly by 0.4 mmbd.

Many analysts believe that the markdowns on the supply side are just beginning. Demand markdowns have stolen the show, but the focus is shifting to supply. Delays, cancellations, a lack of credit, high costs and poor profitability are all taking their toll. Deferred maintenance may also accelerate the rate of production decline in existing fields. Further markdowns in the expectations for non-OPEC supplies in the coming months will help create a tighter market.

All things considered, with some luck, with continued cooperation on compliance, and with the beginnings of some economic and financial market responses to the financial rescue and stimulus packages now being put into place, OPEC may not have to cut production further this year. The second quarter of 2009 is likely to remain extremely weak in terms of market balances, but inventories should begin to gradually decline.

Price Outlook

As we said previously, OPEC may have some limited success in preventing prices from falling much further, but it seems doubtful that they will succeed in raising prices to their preferred level of $70 – $75 per barrel anytime soon. Sustained higher prices may only be possible when the global economy shows definite signs of recovery and renewed growth.

In any discussion of the price outlook for this year and next, it’s instructive and humbling at the same time to remind ourselves that oil prices in 2008 covered a span ranging from $32 to $147 per barrel. Is 2009 likely to witness the same kind of volatility? History has shown us that you should never say never when it comes to the oil market. A lot can happen in a year.

Nevertheless, in the absence of any unexpected disruptions or cataclysmic events, a weak global economy and growing margin of surplus oil production capacity should keep prices much lower and less volatile this year than in 2008. Oil could trade in the broad range of $30 to $60 per barrel this year. It seems logical to expect oil to average $40 to $50 per barrel for the first half of the year, when the economy is the weakest and inventories are flush. Prices could then rise to $50 to $60 per barrel in the second half of the year, when and if economic recovery begins and the OPEC cuts begin to shave inventory levels. An average price of around $50 per barrel for the year as a whole seems like a reasonable expectation.

But the oil market defies reasonable expectations. Will things turn out this way? Probably not! We need to remind ourselves that anything, even the unthinkable, can happen. Much will depend on the impact of declining prices on oil demand, the success of the economic stimulus packages being put into place around the world and the depth of OPEC’s supply cuts.

The market is fickle. If the drop in global demand shows signs of leveling off, if macroeconomic prospects turn positive, and if OPEC shows discipline, prices could recover. In the absence of new regulations on futures trading, there is a lot of money sitting on the sidelines that could come back into oil and commodity markets fairly quickly, especially if the dollar weakens once more. Oil prices are a leading economic indicator.

Geopolitical concerns could also play a huge role in 2009. The Middle East is still volatile, Russia and Venezuela are getting more adventurous, Iran is still pursuing nuclear arms, and militants are limiting Nigeria’s oil output, to mention a few.

The production cuts already announced by OPEC coupled with the completion of major expansion plans in Saudi Arabia will provide the world market with a comfortable margin of spare capacity to offset any unforeseen disruptions in supply for the next few years, and this is generally a good thing. It will also provide us with a cushion of supply for a few years, if and when demand begins to recover. But the impact of low prices on investments in additional capacity for the medium and longer term are likely to be disastrous in the long term.

By Abraham Energy Report Contributing Editor John Brodman

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