With front-month benchmark US crude touching a record high of $98.62/bbl in overnight electronic trading Nov. 7, the oil market essentially split into two main groups, said Paul Horsnell at Barclays Capital Inc. in London.
One group sees the possibility of $100/bbl oil "as being almost magical in that it is the result of external and near mystical forces and supposedly unconnected with any real fundamentals," Horsnell said. "Explanations include a weak dollar, speculation, and, most entertainingly of all, negative gamma from options positions." However, he said, "In our view, none of those factors are particularly significant. Indeed, they miss the main point. If the supply side still looks bust above $90/bbl, then prices are rising simply because they are too low."
Horsnell puts himself in the opposite group who claim the recent spike in crude prices resulted from "worsening supply-side weakness" and "steady but not spectacular demand growth" among countries outside of the Organization for Economic Cooperation and Development. "For us, the main question is whether we have seen any more sign of an amelioration as prices approach $100/bbl than we saw when prices approached $70/bbl." He said, "If anything the supply-side is now looking weaker short term, medium term, and longer term. In other words, the path of least fundamental resistance still seems to lie to the upside."
An opposing view
Michael C. Lynch, president of Strategic Energy & Economic Research Inc., Amherst, Mass., finds it "hard to credit" a paradigm shift in the oil market "where oil is much harder to discover and produce than before, demand is growing much faster, and prices have much less effect on demand. Lynch said. "Demand growth at present is one-half to two-thirds the long-term trend, and while Chinese oil demand is growing rapidly this year, it is growing much more slowly than in the pastabout 6% versus 8-10% previously. The easy oil didn't suddenly disappear 5 years ago, and the Organization of Petroleum Export Countries' surplus capacity has been low for most of the last decade and a half, without prices soaring."
The push towards $100/bbl crude "seems to have been driven more by hedge funds and traders, that is, speculators not investors, (over)reacting to relatively unimportant news," said Lynch. "However, while a short-term reversal taking prices back to $70-80/bbl is probable in the next few weeks as speculators sell off, the 'investors' who have been buying energy derivatives for several years are less likely to pull out."
Price drops have two causes: overflowing inventories or a price war within OPEC (or between OPEC and non-OPEC), Lynch said. "The latter often causes the former, but not always," he said. "The market next year appears increasingly likely to experience a sharp price drop, especially from current elevated levels but probably even below the $75/bbl or so that many forecasters expect, as it appears that weak oil demand combined (possibly) with unexpected additional supply from Iraq and Nigeria will mean that surplus capacity in OPEC will grow by as much as 2 million b/d.
Lynch sees improvement in two important producing areas. "Iraq has been able to operate its Ceyhan export pipeline at nearly 50% capacity (or 300,000 b/d) for about 2 months now, reportedly due to better security on the pipeline, which had previously been sabotaged whenever it operated," he said Nov. 12. "Royal Dutch Shell PLC is in the process of restoring its Nigerian production, as the new Nigeria President Umaru Yar'Adua is attempting to stabilize that region through negotiation. Neither is guaranteed to result in long-term resolution, but it is important to remember that there are upside production risks as well as downside. (That upside could easily mean an additional 500,000 b/d of production next year, which isn't factored into current projections.)"
Horsnell noted third quarter oil production by some major integrated oil companies was "rather poor." Combined production from Shell, BP PLC, ConocoPhillips, ExxonMobil Corp., Chevron Corp., and Total SA fell 720,000 b/d, or 6.2%, to 10.86 million b/d from the third quarter of 2006.
"These output falls from major companies are not in themselves directly responsible for $100/bbl oil," Horsnell said. "However, they are strongly symptomatic of a mounting supply-side weakness, particularly within non-OPEC areas, that is in our view one of the main reasons why prices have been testing ever higher. If major oil companies have in general been finding it difficult to increase output even after a multiyear rise in prices, a fairly powerful signal about the sustainability of the upwards trend does appear to have been sent."
(Online Nov. 12, 2007; author's e-mail: email@example.com)