Oil's up, but where will it go from here?

Oil's up, but where will it go from here
Financial Express, New Delhi, 24 October 2009

Global recovery will push oil prices. Response of producers will be crucial

After the low period of the financial crisis, the benchmark prices of crude oil (Brent, WTI and Dubai) started moving along an upward secular trend from May. And except for a brief jolt between July and August, have remained largely above $60 a barrel. Towards the middle of October the price surged above $75 a barrel boosted by an optimism of a global rebound and eventually reached this year's peak at around $80 on October 21 due to a weakened dollar.

Incidentally, both International Energy Agency (IEA) and the US Department of Energy (DoE), upped their crude demand forecast for 2010 and their prediction of oil prices centered on the IMF's optimistic prognosis of World economic situation. In its monthly oil market report released on October 9, the IEA said it expects global oil demand to average 84.6 million barrels per day (bpd) this year, which implies an increase of 200,000 bpd on earlier estimates. The agency is also expecting the demand next year to climb up to 86.1 million bpd.So, what will the world crude market look like in the coming months? There is no easy answer.

Considering the fundamentals, the dynamics of crude prices can be considered as determined largely by the responsiveness of supply of Opec and non-Opec producers to a rise or fall in demand. However the implication of such responsiveness on crude prices would clearly be contingent upon spare capacity of Opec coupled with crude stockpiles or inventory. Although, Opec in its latest oil market report toed the line of IEA and DoE and expressed optimism about the demand for crude in the coming year, such a positive outlook came with a note of caution. The report underscores: "Given weak oil market fundamentals as reflected in high global inventories and large Opec spare capacity, there is a need for continued close monitoring of both economic conditions and developments in the oil market". Incidentally, Opec's secretary-general also reportedly hinted at raising the group's output in Opec's December meeting if global oil inventories decline and the world economy continues to move along the path of recovery as per the expectation.

While talking about responsiveness of supply, it also needs to be mentioned that the steep decline in oil prices last year did disturb the economics of a significant share of potential future oil supply growth as such decline in oil prices was not matched by an equal decline in the cost of developing new fields or in fiscal terms as reported previously by UK-based Cambridge Energy Research Associates. The increased pace of recovery in economic growth towards the latter half of this year with a concomitant rise in world oil demand, however, appears to have partially arrested the collapse. This becomes all the more evident from a recent statement of the Opec secretary-general who underscored that the current prices have ensured the revival of 7 out of the 35 upstream projects which Opec had kept on hold. The revived projects would collectively account for 1.2 million bpd of additional capacity.

Another interesting development which is unique to this year is Russia's unlikely emergence as the undisputed market leader. Russia's oil production exceeded 10 million bpd in the month of September, which is nearly 25 per cent more than Saudi Arabia, the historical Opec leader and swing producer. Russia emerged as the leader after Opec persisted with output cuts from September last year till the middle of this year. Russia's output spike is being perceived as temporary, and an outcome of the launch of eight new fields this year bolstered by recovery in demand and oil prices. The developments in the coming months are going to spell out whether such predictions are correct or not.

Consider also some geopolitics: Iraq goes to polls this January. In that context, Ali Hussain Balou, the head of Iraq's parliamentary oil and gas committee reportedly warned international oil companies that signing deals with the Iraqi government might turn out to be risky as the new elected government may revise or cancel those contracts. Add to this a random fluctuation in US dollar rate against a basket of other currencies, which only exacerbates the volatility in oil prices. A weakened dollar usually supports oil because it makes commodities priced in the dollar cheaper for those holding other currencies and vice versa for a strengthened dollar rate.

Given the flurry of developments and surprises in this post-recession year, it would be naive to arrive at a ball-park estimate of oil prices in the near or middle term. However, given the concurrence in the positive oil market outlook of IEA, DoE and Opec in terms of economic recovery and expected rise in oil demand, oil prices could be expected to follow an upward secular trajectory till the end of first quarter of 2010.