Physical fundamentals reassert themselves in oil markets

Oil markets appear to be edging back towards dominance by mundane physical fundamentals and away from incorporating a geopolitical price premium.

If that trend grows in 2004, will the Organization of Petroleum Exporting Countries continue to succeed with a sustained price-defense strategy? Early indicators are that it will, albeit at a slightly lower price level than in 2003. That slightly lower price level may indicate nothing more than the absence of a premium for possible outages due to war, terrorism, and civil strife.

The reassertion of physical fundamentals in the market outlook could be the main reason OPEC chose to stand pat on production quotas at its Dec. 5 ministerial meeting. Statements from OPEC ministers clearly telegraphed their readiness to trim output at an extraordinary meeting Feb. 10 in Algiers; ostensibly the only question mark at this point is how weather-related oil demand through early winter will change the equation.

Changing market profile

Three of the chief factors in OPEC's success this year in defending an unofficial price target of $25/bbl for an OPEC crude basket were supply disruptions in Iraq, Venezuela, and Nigeria. A fourth was the rest of OPEC's own cohesion at reining in production as a preemptive strike against downward price pressure—after ratcheting it up earlier in the year during outages among their three troubled members.

While the outlook for stability in Iraq remains dicey, it certainly is improving with regard to growing oil production and exports.

Venezuela's output has been substantially restored, although the degree to which that restoration approaches prestrike levels remains in dispute. In any event, President Hugo Chavez continues to consolidate his power vs. an increasingly dispirited opposition, and it now looks likely that he will survive a recall attempt.

Nigeria's attention-getting efforts to curb corruption and improve transparency may be helping to quell the perpetual civil unrest that often targets oil operations in that country.

While the possibility of geopolitically driven oil supply outages probably never will disappear, their prospects have faded somewhat for 2004. And that makes oil prices easier for OPEC to manage—at least if it guesses right on supply and demand.

Supply-demand outlook

Even as physical fundamentals reassert themselves in oil markets, however, there is no clear consensus on them.

The International Energy Agency forecasts that global oil demand will increase by only 1 million b/d in 2004, while non-OPEC oil supply will expand by more than 1.4 million b/d (following growth of 1 million b/d in 2003). Given the state of stock levels today, that spells an eroding chunk of OPEC market share.

But Michael Rothman, a Merrill Lynch Global Securities analyst in New York, offers a contrarian view, contending the IEA "is being misled by overly ambitious growth projections from the global oil companies."

He pointed to IEA having to cut its forecast for non-OPEC supply since March.

Rothman instead pegs non-OPEC oil supply growth at 600,000-900,000 b/d/year. He estimates that the OPEC 10 (minus Iraq) will have to produce 24.8 million b/d next year to keep markets in balance, assuming Iraq produces an average 2.2 million b/d. That compares with the current OPEC 10 quota of 24.5 million b/d.

And while the deficit in inventories held in Organization for Economic Cooperation and Development countries has dwindled, Rothman estimates that OECD stocks will end the year about 60 million bbl below normal levels. So the oil supply-demand balance could remain quite snug in 2004, especially if weather-related demand is strong during the winter.

And Rothman suggests that the Dec. 5 OPEC meeting result supports that view:

"From an oil market perspective, this means some persistence of the current $27-33/bbl price range" for West Texas Intermediate crude. ". . .The tone of the meeting again conveyed the working OPEC notion that it is better to err on the side of undersupplying the market in order to [prevent] a bearish supply overhang from developing that would be capable of producing a bearish price cycle."

Accordingly, the Merrill Lynch analyst offers an average WTI price forecast of $24-30/bbl for 2004.

If anything, the market wild card now may be OPEC itself. The group is wedded to price defense now, especially with a weak US dollar. Yet it also is being pushed into a reassessment of not only individual quotas—namely Nigeria and Algeria—but also into consideration of an overhaul of its basic quota system.

So the recent surge in quotabreaking totaling 1 million b/d offers a disquieting portent of OPEC cohesion in 2004.


Latest Prices as of Dec. 8, 2003

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NOTE: Because of holidays, lack of data availability, or rescheduling of chart publication, prices shown may not always reflect the immediate preceding 5 days.

*Futures price, next month delivery. #Spot price.

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