Editorial - Oil market: 2005

Jan. 10, 2005
Will the oil-market strength of 2004 continue through 2005?

Will the oil-market strength of 2004 continue through 2005? The question can have no certain answer so soon in the year. There are too many variables, too many of them impossible to predict.

It is possible, however, to isolate three major factors in a market that pushed crude prices briefly to more than $55/bbl last year and to speculate about their durability in the year just begun.

Prime among those factors is demand. The International Energy Agency estimates average global demand in 2004 at 82.4 million b/d, up 2.6 million b/d from 2003. The increase was the biggest since 1976.

Demand grew despite the surge in oil prices. Simple economics says this can't continue. Complex economics suggests something different. In its December Oil Market Report, IEA asserts, "Oil demand is more sensitive to income gains than to price increases." Demand growth in 2004 was greatest where economic growth was strongest: in China and the US. A crucial question for 2005 is whether those economies will continue to grow.

Income effects

China's boom reflects development born of modernization. And its energy consumption per unit of economic growth, in a pattern typical of developing countries, is increasing. This will sustain demand growth even if the economy cools.

US economic growth, too, has seemed immune to oil-price increases. Part of the explanation must be that energy has diminished as a factor of growth in the service-oriented US economy. Another part must be the income effect noted by IEA: With their economy strong, Americans and American businesses can afford the energy they consume.

As an oil-market influence, the income effect also has overpowered weakness of the US dollar. Elevated, dollar-denominated oil prices should slow economies tied to the dollar more than those with stronger currencies. But the reverse is happening. IEA says the reason, at least in the US case, is the economic lift from exports stimulated by the dollar's decline.

Adjustments are inevitable in fluid relationships like these. Because prices, though down from their peaks of 2004, remain high enough to restrain economic growth and discourage consumption, moderation of last year's consumption growth is likely. IEA expects average global oil-demand growth in 2005 to ease back to 1.4 million b/d.

Adjustment also is under way in the market's other key factors, both related to supply. Commercial inventories of crude oil in developed countries have recovered from the abysmal levels at which they loitered from late 2002 through most of 2004. Although product inventories remain low, the gain in crude stocks means spare production capacity—the other major supply variable—no longer represents the market's only cushion other than government stocks.

That's important because spare capacity, despite gains in and outside of the Organization of Petroleum Exporting Countries, remains thin. At 850,000-1.35 million b/d, according to IEA, it's well below the historic average of 3-4 million b/d. And it's not enough to cover loss of supply from any of the exporters that have experienced production shutdowns in recent years: Iraq, Nigeria, and Venezuela. So the build-up of crude stocks can relieve only some of last year's nervousness about supply disruption.

Trends at the beginning of 2005 thus point to demand growth consistent with economically healthy years before 2004 and enough gains in production capacity to add modestly to supply buffers. It's too soon to declare an end to supply jeopardy, however, and bottlenecks persist in transportation and processing.

Wild cards

Other market influences are wild cards. Weather always drives demand but can't be predicted. Last year, with hurricanes crimping production in the Gulf of Mexico by an average of 200,000 b/d for several months, it was an unusually strong supply factor, too. Similarly unpredictable at this point is the extent to which the Kremlin's seizure and sale of core OAO Yukos assets will limit investment in otherwise rising Russian production.

Beyond unpredictability lurks pure surprise. Of all the factors at play in the tumultuous 2004 oil market, in fact, surprise is the one most likely to reassert itself in some way in 2005. This might sound facile. But no one should forget that the size of the Chinese demand surge wasn't just the major factor in last year's market strength. It also was a surprise.