Possible tight oil market may give way to competition, analysts say

By OGJ editors

HOUSTON, July 3 -- Now that the Organization of Petroleum Exporting Countries has extended its production quotas through the third quarter, industry analysts are focusing on potentially tight market fundamentals through the rest of this year and increased competition between OPEC and Russia in the future.

The likelihood for a tight market through the rest of this year is supported by the seasonal increase in demand, increased industrial activity, and low exports of Iraqi crude, estimated at 650,000 b/d in the first 3 weeks of June under the United Nations oil-for-aid program, said Matthew Warburton with UBS Warburg LLC, New York.

On June 27, the day after OPEC members voted to hold the line on production, the August contract for benchmark US light, sweet crudes settled at $26.86/bbl on the New York Mercantile Exchange. That's the highest level for a front-month oil futures contract in that market since mid-May, Warburton noted. And it occurred "despite the end of official 'cuts' from key non-OPEC producers (Norway and Russia) as well as no explicit reference to (maintaining) a $25/bbl price target in OPEC's communique," he said.

Reversed situation
The rest of this year should be "something of a reversed situation as compared with the first half' of 2002, said Stephen A. Smith, founder of Stephen Smith Energy Associates, Natchez, Miss., in a recent report.

Oil inventories among the Organization for Economic Cooperation and Development (OECD) countries should "return to near normal levels," with prices for benchmark US crudes spending "less time above the $25/bbl mark," he predicted.

"OECD stocks appear to be trending from well-above-normal levels on Mar. 31 back towards normal, but at a slower pace than we had previously expected," Smith said.

World oil demand is expected to average 76.4 million b/d for all of 2002, up 0.6% from 2001 levels, Smith said. During the first quarter of this year, demand was about 1.4% lower than in the same period of 2001, largely as a result of mild winter weather. But with some economic recovery, it is estimated to have increased by 0.4% over year-ago levels in the second quarter.

"Our forward balances are based on a 0.9% year-over-year world demand increase during the third quarter and a 2.1% year-over-year demand increase for the fourth quarter," said Smith. "The relative strength of fourth quarter growth is due in part to being measured against the immediate aftermath of Sept. 11 last year."

Meanwhile, OPEC's official production quota of 21.7 million b/d will be padded by cheating among its members averaging 1.3 million b/d during the second half of the year, up from 1.2 million b/d in the first half, Smith figures. Assuming Iraq's production averages 2.5 million b/d, he calculates total production among all 11 OPEC members at 25.5 million b/d through the last half of 2002, up from 25 million b/d during the first half.

Despite that increase and a net gain of 160,000 b/d in non-OPEC production, world demand for oil will still outstrip production through the rest of this year, Smith predicted.

Yet he also expects prices for benchmark US oil to be lower than the $25-2/bbl that prevailed for most of the second quarter.

He sees four main reasons for the "aberrational" strength of oil prices during that quarter:

-- The "extraordinarily high" level of Middle East tensions stemming from the Israeli-Palestinian conflict.

-- The perceived risk to oil supplies stemming from the "next step" in the US war on terrorism. "Iraqi oil supply is one obvious concern, and energy-directed terrorism is a second," Smith said.

-- OPEC's apparent success in regaining control of its own output and the ability to influence non-OPEC production.

-- A "perception" that the surprising early economic rebound from the Sept. 11, 2001, terrorists attacks created a false impression as to both the strength and timing of (a generally) global economic recovery that "may have spilled into energy markets." Smith said, "Outlooks for the world economy have become more subdued over the last 2 months, and this implies weaker growth in oil demand."

Russia's potential
In any event, he said, "Oil prices have only one foot planted in politics; the other is firmly planted in the marketplace." The most visible threat to OPEC—the "one that appears to have forward momentum"—is Russia and the other former Soviet Union oil-producing countries.

The International Energy Agency estimates that oil production from Russia and other FSU countries will average 9.17 million b/d this year, up from 7.95 million b/d in 2000. "This is a staggering increase for only a 2-year period," said Smith. "In total, all other non-OPEC producers are expected to increase by 0.35 million b/d over the same period. Adding all non-OPEC producers together (including Russia and the Caspian) yields a 2-year increase of 1.57 million b/d, or almost 0.8 million b/d per year for non-OPEC."

Such an increase in non-OPEC production "might be acceptable if world oil demand were increasing at the pace of the 1.4 million b/d per year that it averaged for 1993-1999," he said. "But IEA's world oil demand projection for 2002 implies a 3-year average annual increase from 1999 to 2002 of only 0.4 million b/d per year. If world oil demand and non-OPEC supply trends of the last 2-3 years were to persist, then OPEC would be losing (market shares totaling) 0.4 million b/d per year."

Future trends
That "suggests several trends going forward: increased bickering within OPEC for larger shares of a slowly growing or perhaps constant pie, increased cheating, and increasingly aggressive OPEC efforts to pressure Russia, Mexico, Norway, and others to participate in production management," said Smith.

"This problem may not come to its first serious testing point until the next pullback in world oil demand. This could be as early as next January if the winter is mild again," he said.

"We are not suggesting an imminent price collapse. This would be akin to attempting to pinpoint the location of the next tornado," Smith said. "We are merely arguing that the conditions that tend to spawn tornadoes have become more pronounced."