Abraham Energy Report

We’ll take it! As was widely expected, OPEC Ministers meeting in Vienna on May 28 had little trouble reaching an agreement to maintain their current output ceiling of 24.845 million barrels per day (mmbd). The fact that the fundamental outlook for economic growth and oil demand remains bearish, that inventories are still near record levels, and that compliance with the group’s production ceilings has slipped a bit since their last meeting didn’t really matter. The overriding fact that prices were up anyway seems to have allowed OPEC Ministers to look past their differences and come to a swift agreement. Algerian Minister Chekib Khelil reportedly told reporters after the meeting that “we get along better when prices are improving.”

The one-page communiqué issued at the end of the meeting recognized the severe and broad impact the ongoing global economic downturn was having on world oil demand, and that this weakness was likely to persist for some time. It recognized that some positive economic indicators now point towards the possibility of the recession bottoming out before year-end, but that rising unemployment, shrinking world trade and weak industrial production are still major concerns. It also recognized the positive effect that OPEC’s past production decisions have had on restoring some stability to oil prices, but that crude supplies entering the market were still in excess of actual demand and inventories remain near record levels.

For this reason, the Conference of Ministers decided to keep current production levels unchanged at this time. All Members reiterated their firm commitment to abide by their individually agreed production allocations. The communiqué also recognized the impact that volatile oil prices have on the investments required to guarantee adequate energy supplies in the medium and long term, and it reiterated OPEC’s commitment “to providing an economical and regular supply of petroleum to consuming nations while, at the same time, stabilizing the market and realizing the Organization’s objective of maintaining crude oil prices at fair and equitable levels, for the future well-being of the market and the good of producers and consumers alike.”

OPEC’s current target or output ceiling went into effect on January 1, 2009, and is based on a total crude oil production cut of 4.2 mmbd from September 2008 actual production levels for the 11 Members of OPEC currently subject to quotas. OPEC’s production of natural gas liquids (NGLs) is not included in the quota calculation. War-torn Iraq, which currently produces 2.4 mmbd, is exempt from OPEC’s targets but remains a member.  The group’s compliance with these production targets improved steadily in January, February and March, before eroding slightly in April.

The still fragile state of the world economy, declining oil demand, rising margins of spare oil production capacity, and record high inventory levels seemed to set the stage for continued market weakness. But oil prices (NYMEX front month WTI), after reaching a 2009 low of $ 33.98 per barrel on Feb. 12, have recently recovered to more than $60 per barrel for the first time since Nov. 10, 2008. While the recent rise in prices is good for OPEC revenues and investment in future supplies, it has many in OPEC scratching their heads to try and understand why. Many people believe speculation is returning to the oil futures market as investors look ahead with anticipation to rising prices and see oil once again as a hedge against inflation and a declining dollar. Contango in crude futures has helped support this view.

NYMEX WTI closed at a 2009 high of $63.45 on May 27, the day before the OPEC meeting. To some observers, the market seems to be defying gravity and flying in the face of the fundamental components of supply and demand. Many analysts believe that the market is over-bought and that some correction in prices may soon occur.

In the lead up to the meeting, Saudi Arabia’s King Abdullah and Minister of Petroleum Ali al-Naimi both reiterated their belief that $75 per barrel is a fair price for oil, but that the market, by looking forward and anticipating a future recovery, may be getting ahead of itself. They believe that the market will eventually reach $75, but only when the global economy and world oil demand are clearly recovering.

The Saudis, who have been strictly adhering to their production targets, are the only OPEC country that is also a member of the G-20, and they clearly don’t want to see too rapid a rise in oil prices undermine the prospects for global economic recovery. It’s a delicate balance. The move up to $60 per barrel helps OPEC with a lot of issues, but could introduce new strains into the still fragile recovery.

Compliance may be slipping. Estimates of OPEC production in April show that OPEC’s compliance with the 4.2 mmbd production cuts agreed upon by the group late last year fell below 80 percent in April, down slightly from an estimated 83 percent compliance in March. The recent run up in crude oil prices—apparent proof of the success of OPEC’s quota system—also appears to have been a temptation too strong to resist for some cash-strapped OPEC members. OPEC production, after declining for seven months in a row, now appears to have ticked up by about 250,000 bpd in April, to a level of 28.2 mmbd for the OPEC 12 (25.8 mmbd for the OPEC 11 subject to quotas).

OPEC produced 955,000 bpd above its target in April, entailing a 77 percent level of compliance with the agreed production cuts. Iran, Venezuela and Angola were responsible for most of the April volume increase, but the degree of compliance by Ecuador also remains low. The recent run up in crude prices is providing a windfall for OPEC’s over-producers and added incentive to produce even more.

Some cracks may be appearing in OPEC’s cohesion as a group. The increase in April output is likely to fuel the differences between those who are strictly adhering to their targets (Saudi Arabia and its neighbors UAE and Kuwait), and the over-producers (Venezuela, Ecuador, Iran and Angola) who generally have unmet revenue needs. It was also reported prior to the meeting that Angola, which joined OPEC at the beginning of 2007, has written a letter to the Secretary General of OPEC asking for a special exemption from the current output targets.

Angola’s production capacity has grown steadily since it first joined OPEC, and it could reach a level of 2.1 mmbd this year, some 600,000 barrels above its current production target.  Angola is seeking an exemption similar to the one given to war-torn Iraq; on the grounds that it is still recovering from its long civil war and desperately needs the money for infrastructure and social programs. The communiqué issued at the conclusion of the meeting on May 28 made no mention of this request, whether or not the issue was discussed at the meeting, or how the issue is likely to be decided.

The other OPEC country that bears watching is Nigeria. The Movement for the Emancipation of the Niger Delta (MEND) has recently been stepping up its attacks on oil infrastructure in the oil-producing Niger Delta region, resulting in large weekly movements in oil production. Nevertheless, on a monthly basis Nigeria has managed to produce above its target for the first four months of the year. The potential volatility in Nigeria’s oil outpuInventories. t is probably defying any rational attempt to adhere to OPEC quotas.

Nevertheless, and in spite of these cracks in compliance, OPEC crude oil production so far this year has been on average some 2.9 mmbd lower than last year’s average output of 31.2 mmbd.  If OPEC is successful in holding it together, maintaining current output levels and a reasonable degree of compliance with production quotas, it should be enough to more than compensate for the expected drop in demand and minor growth of non-OPEC supplies in 2009. For this reason it is easier for OPEC at the moment to avoid confrontation with the over-producers and hope for an early recovery.

While OPEC still has some leeway to cope with further reductions in global oil demand and rising levels of non-compliance on the part of some of its members, the huge overhang of commercial inventories is still a force to be reckoned with. Inventories are estimated to have risen to about 62 days of forward consumption at the end of March, as inventories rose counter-seasonally and forward demand fell. This is about eight days higher than last year.

Preliminary reports indicate that inventories may have come down slightly in April, but that they still remain close to the record highs seen in early 1998, following the Asian financial crisis. This remains troublesome for OPEC. High inventory levels can borrow from future demand.  As spot market prices rise, there is more incentive to liquidate inventories, which depresses demand and pushes prices back down. Continuing weak demand prospects and growing noncompliance with quotas could exaggerate this whole process.

Another challenge. At the same time that OPEC’s compliance appears to be slipping, Russian oil production has been creeping up recently, as have its exports of crude and petroleum products. In addition, the recession-induced drop in local Russian oil demand has freed up more oil for export. The latest figures show that total Russian oil exports are up about 450,000 bpd in recent months, which is directly offsetting 10 percent of OPEC’s announced cuts in production.

Russia appears to be going for market share at the expense of OPEC. When prices were declining last fall and early this year, Russia was flirting with either joining OPEC or some other formal type of cooperation. They sent large, high-powered delegations to the last few OPEC meetings. By all accounts, notions of Russian cooperation with OPEC are over. There was no mention of their attendance at the just-completed meeting.

The Fundamentals. The economic outlook in the lead up to the OPEC meeting was both dismal and encouraging. It was dismal in that the Q1 GDP numbers and forecasts for the year as a whole continued to come down. First quarter GDP fell at an annual rate of 6.1 percent in the U.S., 15.2 percent in Japan, 14.4 percent in Germany, and 21.5 percent in Mexico. According to the International Monetary Fund (IMF), global economic activity is now expected to decline by 1.4 percent in 2009 before recovering to grow at a relatively sluggish rate (by past recovery standards) of 1.9 percent in 2010.  Unemployment is expected to continue to rise and to show only modest improvement next year.

On the encouraging side, we seem to have weathered the first part of the financial crisis, and the economic stimulus packages enacted around the world are beginning to have an impact. The issue of how we pay for the financial rescue and stimulus plans put into place in the last eight months will continue to weigh heavily on near- and medium-term recovery prospects.

Nevertheless, a recent survey of 45 economists released by the National Association of Business Economists in the days just prior to the OPEC meeting shows that about 74 percent expect the recession to end in the third quarter of 2009.  Another 19 percent expect the economy to reach a turning point in the last quarter, and the final 7 % believe the recession will end in the first quarter of 2010.  Nevertheless, they all expect the recovery to be slower paced than usual.

Oil Supply and Demand. The May round of monthly oil market reports published by OPEC, the International Energy Agency (IEA), and the U.S. Department of Energy’s Energy Information Agency (EIA) in the weeks prior to the OPEC meeting all showed continued weakness and further markdowns in demand expectations. These three forecasts now expect global oil demand to shrink by an average of 2.0 mmbd in 2009, from 85.6 mmbd in 2008 to 83.6 mmbd in 2009.

Only one of these forecasts (the EIA) has thus far produced a demand number for 2010, and they expect global demand to rise slowly, by 0.7 mmbd to a level of 84.3 mmbd.  This is only slightly higher than global oil demand five years earlier, in 2005. The recession wiped out nearly the last four years of oil demand growth. Many analysts also believe that demand growth is unlikely to come roaring back and resume its pre-recession rate of growth. Improvements in efficiency, new technologies and changes in consumer behavior may all be indications of slower demand growth ahead,

The expectations for non-OPEC oil supplies in 2009, according to the three monthly forecasts, now range from a low of – 0.3 mmbd in the IEA report to a + 0.2 mmbd in the OPEC report. The EIA expects non-OPEC oil supplies to grow by 100,000 bpd in 2009 and by 45,000 bpd in 2010. All three expect OPEC natural gas liquids (NGLs) to grow by 0.3 mmbd in 2009.

Putting all these figures into the blender, the three forecasts now expect the demand for OPEC crude oil (from all 12 OPEC Members) to decline on average by 2.5 mmbd in 2009 to an average annual level of 28.7 mmbd for the year.  This is 0.5 mmbd above OPEC’s estimated production in April, and it gives the organization a small margin of comfort to deal with further lapses in compliance, additional markdowns in demand and a gradual return to more normal inventory levels. But it is only a small margin.

Spare Production Capacity. The decline in demand, coupled with production cuts and the completion of some ongoing capacity expansion projects, has raised spare or excess oil production capacity in OPEC from a little more than 1.0 mmbd last summer to near 6.0 mmbd today. Most of this is in Saudi Arabia. Spare capacity is expected to remain at comfortable levels for the next few years, as some additional capacity expansion projects started before the current downturn get completed. In the absence of unexpected developments, the relatively large cushion of spare production capacity should be able to accommodate any turn around in world oil demand we are likely to see in the next few years.

Prices. The daily closing price of the front month NYMEX WTI futures has gradually moved upward from an average level of around $40 per barrel in January and February of this year to a current level of just over $62. The price for the first five months of 2009 now looks like it will come to an average of $47.10. In our earlier forecasts, we expected prices (WTI NYMEX) to average somewhere in the $50 to $60 per barrel range for 2009 as a whole, with the first half being weaker than the second half.  We see no reason to change this expectation.

Even if prices average $60 per barrel for the rest of the year, the annual average price would still come in at or around $54.50 per barrel. Prices would have to average $70 per barrel for the rest of 2009 to pull the annual average price up above $60 per barrel, the upper end of our range.  We don’t believe that the fundamentals in the market can sustain a price at this level for long.

John Brodman
May 28, 2009

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