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Supply cuts key to how far oil prices plunge

Bob Tippee
Editor

With equity markets gyrating and economies in peril, attention gravitates to demand in questions about oil prices. But no one should overlook supply.

That's not to say demand has lost importance.

The International Energy Agency now expects global oil demand to average 86.5 million b/d this year, up only 0.5% from last year's level. That's 240,000 b/d less annual average demand than IEA projected last month.

At the beginning of this year, IEA was projecting global oil-demand growth for 2008 of 2.3%.

As demand unravels, crude oil prices plunge. In New York futures trading, marker crude fell below $70/bbl to a 14-month low Oct. 16. That's half its level of only 3 months ago.

The question of the day: How low will crude prices go? The answer depends greatly on supply.

And supply depends first on action by the Organization of Petroleum Exporting Countries. The group's rescheduling of an extraordinary meeting to Oct. 24 from Nov. 18 signals a production cut. The only question, which group members already may have decided, is how much.

Beyond OPEC's production response lie supply reductions emanating from the same economic malaise that's slashing demand.

Constrained credit has become a new limit on oil industry investment.

"In the upstream," IEA notes in its October Oil Market Report, "this will intensify the impact already accruing from access restrictions, tightening fiscal barriers, and manufacturing/service capacity constraints. In short, expanding production capacity, even in line with moderating demand growth, becomes more difficult."

Investment difficulties will hit small independent producers and possibly several Russian operators hardest, IEA says. Most large international companies and state producers will survive; those with heavy debt will have trouble. Rig orders may be cancelled. A new phase of industry consolidation is likely.

"A cash liquidity crisis also affects storage, refining, and trading activity," IEA says. "Oil market liquidity itself is already suffering, so underlying price volatility could persist, or even increase, in the months to come, something that further complicates investment planning for the future."

Supply constriction thus looms—from OPEC and from curtailed investment.

Atop those two joists rests the next price floor.

(Online Oct. 17, 2008; author's e-mail: bobt@ogjonline.com)


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