Are oil prices going to spike up in the second half?

Are oil markets headed for shortage-and thus a spike in prices-by the end of the year?

With the $20/bbl (Nymex) barrier broken, the bears are now officially in retreat regarding oil price movements for the rest of the year, with no less an august presence than the International Energy Agency suggesting that there may well be a shortfall of oil supplies in the fourth quarter. And some analysts see oil prices staying above $20/bbl in the fourth quarter.

IEA estimates OPEC compliance with the group`s pledged output cuts at 91% in June, up from 88% in May.

Accordingly, global oil production fell last month to 72.3 million b/d in June from about 73 million b/d in the prior month. OPEC members throttled back production by about 200,000 b/d to 25.8 million b/d. Non-OPEC output fell by 500,000 b/d from 44.22 million b/d during the same period, in part due to the 2.1 million b/d cutbacks accord some non-OPEC members agreed to with the key OPEC states, but also in part due to a sharp drop in North Sea flow as a result of the summer maintenance programs.

There are also growing signs of a global oil demand recovery, and IEA now predicts that world demand will average 75.1 million b/d for 1999, an increase from its prior-month projection of 500,000 b/d. The biggest jump will come in the third quarter, when demand is expected to be up 1.3% from a year ago at 74.6 million b/d, which also represents a month-to-month increase for the June forecast of 100,000 b/d. Demand was estimated to have risen by 0.2% in the second quarter.

"The bulk of the demand growth will occur in OECD countries, somewhat more in the United States, where demand remains particularly strong, and less in OECD Europe, but there are also signs that Asia is rebounding from the economic doldrums and that a nascent recovery is getting a firm toehold," IEA said. "Preliminary demand data for Japan and Korea are consistent with a gradual recovery...net imports to the OECD Pacific region increased year-on-year in the first quarter of 1999, for the first time since the fourth quarter of 1997, suggesting the start of an economic turnaround in Japan and Korea."

OPEC`s cohesiveness is also eroding the global stock overhang, as the recent rate of stockbuilding has slowed significantly. OECD stocks held by industry climbed in May by 700,000 b/d, which is less than half the normal rate at this time of year.

Houston analyst Simmons & Co. International thinks that OPEC will be compelled to relax its quotas as inventories get worked off early in the fourth quarter.

"Although it may seem early for a 2000 forecast, it is important to try to understand how much production OPEC will have to return to the market in 2000 to balance supply with demand," Simmons said.

Simmons thinks OPEC will need to increase production in 2000 by 3.6 million b/d to 29.7 million b/d from its output level in second quarter 1999 in order to balance markets early next year.

The analyst reckons that: Non-OPEC supply will fall by 1 million b/d in 1999 and 400,000 b/d in 2000; and world demand will rise by 800,000 b/d in 1999 and 1 million b/d in 2000. If the latter projection proves correct, that would be an increase in global demand of 1.3%; if global demand grows by as much as 2% in 2000, the incremental call on OPEC oil will be 4.1 million b/d.

While the few remaining bears continue to suggest that OPEC cheating will undermine all this market tightening, Simmons thinks that the fact that almost all excess productive capacity within OPEC is concentrated in a few Middle East countries (namely Saudi Arabia) will lead to improved production discipline. Accordingly, it is unlikely that oil prices will remain below $18/bbl.

So, then, OPEC is back in the driver`s seat, oil is at $20/bbl and pointed upward, demand is rising, and happy days are here again, right?

Not so fast.
Simmons also thinks that the prospect of a sustained oil price of $20/bbl or more coupled with projections of sharply higher demand in 2000 will be the catalyst for OPEC to pick up where it left off in late 1997, when it jacked up quotas in anticipation of ever-rising demand-especially in Asia. So higher prices would spur OPEC to increase production from current levels. Simmons predicts there will be a large inventory drawdown in the second half that will tighten markets and spike prices to more than $20/bbl. And that, in turn, will lead to OPEC boosting production again in order to moderate prices.

A few caveats may be in order here, both bear and bull. On the bull side is the prospect of new supply disruptions, notably in strife-torn countries such as Nigeria and Colombia that are major exporters. There is also the lag effect as non-OPEC producers are slow to commit to new E&P spending, fearing the ephemeral nature of higher oil prices-not to mention cleaning up after recently battered bottom lines.

On the bear side is underestimating the resiliency of non-OPEC producers, particularly those in the U.S., Canada, and the North Sea. Even more bearish is the prospect of Iraq making good on its promises to boost production capacity sharply in the next year or so. Baghdad has blithely disregarded its quotas while it remains under sanctions, and there is little reason to believe that will change, especially with higher oil prices. And the U.S. does not have the will to do anything about changing that situation, whether it involves illegal oil exports or legal humanitarian aid-linked oil sales. It would certainly gall the Saudis and Kuwaitis to see Saddam benefiting from the higher oil prices these two countries worked so hard to help bring about. That alone might undermine this vaunted production discipline.

Here`s another (maybe not so wild) scenario that could bring about a really wild price rollercoaster in the next 18 months or so. What if the antidumping petition pressed by a group of U.S. independents against Saudi Arabia, Venezuela, Mexico, and Iraq for allegedly dumping cheap oil on U.S. markets actually goes somewhere? There is speculation that retaliation might be in order, led by the Saudis, in response to the stiff countervailing duties the independents have proposed. Said retaliation could take the form of another embargo of sorts aimed at the U.S., and oil prices could rocket up (pick a number) past $30/bbl. Of course, the new Republican administration and Congress that would ensue after such a debacle would immediately take steps to roll back the duties, the Saudis and others would scramble to bring supplies back on line again, the embryonic economic recovery would be strangled, demand would plunge just as production was ramping up again, and prices would again collapse.

Life on a rollercoaster is exciting, but everybody`s glad when the thing stops to catch their breath.

OGJ Hotline Market Pulse
Latest Prices as of July 14, 1999

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