Supply is ahead of demand — but falling prices probably won’t last long

Can oil consumers breathe a sigh of relief? After a 25% drop in the price of benchmark West Texas Intermediate crude since late October, there’s reason to think so. Even an attack on the U.S. consulate in Saudi Arabia on Dec. 6 did little to rattle investors. But with OPEC pondering production cuts and the peak winter heating season still ahead, the pullback, to about $42, might be short-lived. Even those forecasting lower oil prices later next year point to wild cards: unexpected growth in demand or the sorts of supply disruptions that have jolted the market all year.

For now, oil traders and speculators are shifting their positions following reports of better-than-expected inventories. With OPEC producing more oil than it has in 25 years, “what we’re seeing is supply in excess of demand at a time when we don’t typically see that,” notes James Burkhard, director of global oil-market research at consultant Cambridge Energy Research Associates Inc. Excluding Iraq, he figures OPEC’s production is up more than 2 million barrels per day since April. And for all the fear of supply shortages from war, terrorism, and political upheaval in places like Russia and Venezuela, such outages haven’t happened.

The herd mentality among oil speculators leaving the market has exacerbated the price drop, says independent energy trader Eric Bolling. Barring a harsh winter, he predicts a further retreat to $33 to $35 per barrel. Hedge funds, banks, and other speculators “have been really exaggerating the potential for supply disruptions from day one,” says analyst Fadel Gheit of Oppenheimer & Co. “Remember, volatility is their best ally. If the market is stable, they go out of business.”

The swift drop has OPEC worried for a change. The cartel is looking toward the second quarter, when demand always falls. OPEC members are considering production cuts to support prices and trying to scare the speculators. While $42 oil is still up about 30% from a year ago, OPEC sells much of its lower-quality oil for far less than the benchmark West Texas price. And its members have also been squeezed by the dollar’s slide. Energy prices are keeping consumers and companies on edge — and few are counting on relief anytime soon. Chrysler Group chief economist Van Jolissaint says the possibility of continued high oil prices remains the biggest threat to auto sales. America West Airlines is planning its 2005 budget based on $45 a barrel. “We can’t run the business assuming things are going to be better than they are,” says CEO W. Douglas Parker. And the country’s huge budget and trade deficits are bigger economic problems than the price of oil, says analyst Gheit. “Lower oil prices will help [the economy], but not by as much as many people think,” he says.

Oil producers are mindful that this year’s increase in demand, the biggest since 1978, could slow in 2005, even as production capacity grows. CERA projects that with slower global economic growth next year, including a cooling economy in China, spare oil-production capacity could climb from 1 million to 1.2 million barrels a day to a more normal 3 million barrels by the middle of next year.

With a normal winter, oil prices could fall to the mid-$30 range by midyear. Unless OPEC acts in a “very unified way” to restrain production, oil prices could even hit $25 a barrel or lower, predicts analyst Frederick P. Leuffer of Bear, Stearns & Co.

But as this year’s skyrocketing energy prices have shown, a lot could happen to derail that forecast. Demand could surge anew. Disruptions in Russia, Iraq, Nigeria, and elsewhere could yet curtail supplies, while refinery capacity, oil tankers, and other infrastructure are stretched thin. “If there’s a fear factor, it’s there for a good reason,” insists Matthew R. Simmons, CEO of Houston investment bank Simmons & Co. International. For the time being, though, fear seems to have loosened its grip on the market.

By Wendy Zellner in Dallas, with Christopher Palmeri in Los Angeles, Laura Cohn in London, and bureau reports