What price oil?

Crude oil prices are climbing again. $100/bbl is not impossible, if current geo-political concerns continue. And today’s tightly balanced market could persist to 2010. The Energy Institute ran an interesting business breakfast yesterday with Leo Drollas, chief economist of the Centre for Global Energy Studies (CGES). CGES are usually well-informed, being chaired by former Saudi Oil Minister, Sheikh Yamani.

Two main conclusions stood out:

1. Spare oil production capacity has recently increased, but is mostly in the hands of OPEC. Yet CGES believe that OPEC’s attempts to ‘micro-manage’ oil markets ‘often backfire’. This seems to be happening now. In Q3 last year, an abnormally high 1.2 million barrels per day (mbd) stock-build led to OPEC production cutbacks in Q4 06/Q1 07. But this reduction coincided with an unusually cold N American winter. The result? Today’s very tight stock position.

2. OPEC is scheduled to increase its capacity by 3.5 mbd between now and 2010. But there are doubts about whether this can really be achieved. Nigeria should bring on 0.6 mbd, for example – but has already ‘lost’ a similar amount due to the problems in the Niger delta. Iraq is due to add 0.2 mbd, but is losing more than this due to the turmoil in the country. Iran should also add 0.2 mbd – but can they afford the required $2bn?

The key to the oil price story is Saudi Arabia (KSA). Over the past year, CGES estimate that KSA oil production has reduced by 1 mbd to around 8.6 mbd. It is now increasing, but only slowly. CGES also estimate that the KSA needs an OPEC ‘basket price’ of at least $55/bbl to meet their current financial objectives. In addition, they will need to invest $5bn to increase capacity by 2010. KSA concerns about President Bush’s proposed ramp-up of US biofuel production perhaps need to be taken more seriously – will they spend this money, if they feel the capacity is not needed?

So where will the price go over the next 6 months? The official CGES forecast is for it to slip back in Q4, but then average around $75/bbl in H1 2008. This appears reasonable, with one caveat.

Drollas also showed CGES’ research on the effect of speculative activity on oil prices. They have identified a new investor class of commodity investors, hedge funds and financial players, who operate in the futures markets. 13 barrels of ‘paper’ crude are now traded for every barrel of physical crude. The amounts involved have grown from $8 billion in 2000 to $130 billion at the 2006 peak. In terms of trading performance, these investors tend not to drive the price bandwagon, but simply follow the trend up or down.

CGES now see these funds starting to increase their investments again. In the right circumstances, this must mean there is at least a 25% chance that prices will overshoot on the upside, if the trend really gathers momentum early next year. $100/bbl Brent is not impossible in this scenario.

About Paul Hodges

Paul Hodges is Chairman of International eChem, trusted commercial advisers to the global chemical industry. The aim of this blog is to share ideas about the influences that may shape the chemical industry over the next 12 – 18 months. It will try to look behind today’s headlines, to understand what may happen next in important issues such oil prices, economic growth and the environment. We may also have some fun, investigating a few of the more offbeat events that take place from time to time. Please do join me and share your thoughts. Between us, we will hopefully develop useful insights into the key factors that will drive the industry's future performance.

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