Despite October price drops, market tightness still looms

Despite the ostensible tightening of market fundamentals and looming shortness of crude on world markets in the fourth quarter, oil prices have shown a continued surprising softness in October.

Just as the early-October slide in oil prices ran counter to the overall direction of the physical market, the stunning 1-day drop of $1.24 in the next-month Nymex contract yesterday can be explained by nothing other than sheer, unwarranted speculation by traders.

The price softness that appeared earlier this month was laid at the doorstep of reports of rising non-OPEC output and weakening compliance among OPEC members. But the volumes involved were tantamount to statistical margins of error, and the earlier price drop seems as unjustified as the most recent one, if one looks strictly at market factors. Certainly, there were some physical market factors-a couple of major US refinery turnarounds pulling demand numbers down a tiny notch and warmer-than-normal weather in the US Northeast-but these, too were relatively insignificant.

The suspicion here is that profit-taking is still, as it was in early October, more of a factor in the price decline. Even with a possibly severe supply crunch looming this winter, traders may have panicked that the market is still overbought, at least for now. Then the lemming effect kicked in, and the minor rally of mid-October turned into a late-October rout.

Still, the warnings come in that the market is headed for a train wreck this winter, or in the words of London think tank Centre for Global Energy Studies (CGES): "To question at this stage whether OPEC should increase output next April is folly."

The latest price decline comes on the heels of a $3/bbl drop in the first week or so of October. This was attributed largely to a reported increase in Iranian production of about 200,000 b/d and a 400,000 b/d surge in non-OPEC output in the third quarter. Also worrisome was the IEA questioning whether there was a decline in OECD stocks during the third quarter.

CGES remains sanguine about its earlier predictions of a fourth-quarter supply squeeze: "

The think tank notes OPEC's resolve to consider stock levels as playing a key role in determining its policy response, hence the market's obsession with the direction of inventories.

Although preliminary IEA statistics suggest there was a 300,000 b/d stockbuild from the end of June to the end of August-with the parallel, counterintuitive spike in oil prices during that period-more recent information suggests that there was a 700,000 b/d stockdraw in Europe in September and that OECD inventories will have fallen by about 200,000 b/d in the third quarter.

"While hardly setting the market alight, these numbers ought to be seen as an early indication of the physical tightness to come," CGES said. "Moreover, OECD inventories do not tell the whole story. It seems logical for the companies to run down stocks held in third-party storage first and then chip away at their own inventories, aided by a growing backwardation."

Demand surge

What has CGES is worried is the expected worldwide surge in demand in the fourth quarter (vs. the third quarter) of 2.7 million b/d.

Current projections call for a 700,000 b/d rise in non-OPEC output, leaving a net increase in the call on OPEC oil-absent any changes in stocks-at million b/d.

"This means one thing: inventories worldwide will have to drop this winter-and by substantial amounts," CGES said. Crude supplies are already tight in the Atlantic Basin, and North Sea cargoes are no longer being arbitraged into the US. Middle distillate stocks remain high, but as winter bites, they will fall swiftly. When companies ramp up refinery runs to meet distillate demand they will seek more crude-which will be scarce. As ever, much depends on the Northern Hemisphere winter-which could add to or subtract 0.2 million b/d from consumption-and on OPEC's behavior.

CGES sees OPEC playing a dangerous game by refusing to consider hiking production before April. Already there are signs of the price hike's effect: US economic growth is expected to slow by a percentage point next year, and together with the lagging effect of higher retail prices, incremental demand growth next year is expected to be half what it was this year. That story could be replicated in Asia, where a fragile economic recovery continues to look for strength.

"OPEC's suggestion that oil inventories should return to 1996 levels before it even considers expanding output is therefore guaranteed to harm its own future prospects (see Table 1)."

Noting that world stockcover in 2000 is expected to be 2 days' worth lower than in 1996, the analyst contends, that to question at this stage whether OPEC should increase production in April 2000 is "indeed playing with fire."

Assuming that OPEC hikes its production to 28.2 million b/d beginning in April, CGES reckons that dated Brent will average $22/bbl in first quarter 2000, drifting lower through the year as higher prices undermine oil demand growth even further (see Table 2). It pegs dated Brent at $18/bbl in fourth quarter 2000, yielding an annual average of $20/bbl.

But if the winter is as cold as forecasters are predicing, expect dated Brent to average as high as $23.50/bbl in first quarter 2000, yielding an annual average of almost $22/bbl.

A mild winter would produce a dated Brent price of $20.50/bbl during the winter, and the resulting stimulus of lower prices on demand will help keep a prop under prices, resulting in dated Brent averaging $18.20/bbl for the year.

CGES concludes: "Should OPEC succeed in engineering a 'soft landing' for the oil market in 2000, reducing the high oil stocks without overheating the market, its members will reap their rewards through higher oil revenues. OPEC's collective gross oil revenues are expected to rise by 26% year-on-year in 1999 as lower output is offset by much higher prices than last year.

"In 2000, the Organization's members can look forward to a further 20% rise in their oil revenues, based on both higher annual average prices and higher output."

That's all well and good and reasonable, but for now, OPEC seems to be saying to the markets: "Show me the (stockdraw) money!"

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OGJ Hotline Market Pulse
Latest Prices as of October 29, 1999

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