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Fundamentals in the Oil Pricing Game

In the past few weeks oil prices have easily regained losses that for a short while drove prices down to a low point around 45 USD/bbl for WTI. Apart from the perennial folkloric story of US weather, that is cold weather drives up oil prices like those for spring vegetables or iceberg lettuce - positive sentiment was reinforced by IEA data uprating previous forecasts for world oil demand growth in 2005.

The IEA forecasts were raised by the tiny amount of 80 000 barrels-per-day or 0.08 Mbd, to the suspiciously and in fact impossibly modest number of 1.52 Mbd.

Why this is hard to fathom or credit is simple: the IEA also raised its final estimate of world demand growth in 2004, to 2.68 Mbd.

In percentage terms, growth in 2004 was very close to 4%, the highest for over 25 years. This big number sharply conflicts with forward planning ideas and beliefs of the IEA and other energy players - especially the world's 10-biggest oil corporations. None of these players figure and plan for demand growth being anything over 1.75%-per-year on a long-term basis. Some, such as BP and ENI, still claim today that the 'normal' long-term rate is about 1.3%-per-year!

On the consumer side, to back the notion of slow growth being a fixed paradigm, oil users are everywhere thought to show 'price elastic' response to higher prices, that is they instantly cut their consumption whenever prices rise. On the supply side, the same high prices are expected to rapidly bring new and big suppliers into the market.

If this does not happen, we have an oil crisis.

This pre-crisis context is directly reflected in the market by rising volatility on a longer-term upward price profile. The IEA forecast of growth in 2005 dropping about 42% against 2004 is, we can surmise, purely wishful thinking. The wish and hope of the IEA is very clear: hoped-for slower growth in 2005 will pull the growth trend down to more manageable numbers, and limit oil price rises.

OPEC has been wheeled into the pricing melee by no less (or more) than Saudi Arabia's oil minister, saying that he "can live with" oil prices of "around 40 USD/barrel", now that prices go well above 50 USD/bbl whenever the US Northeast has a few snowflakes in February!

OPEC oil ministers waited until December 2004 to say they were no longer 'defending' a price range of 22-28 USD/bbl, this 'preferred price range' having competely disappeared off the screen since 2002 !

SUPPLY SIDE FUNDAMENTALS

The basic or 'fundamental' question is what exactly can OPEC's current 11 members (OPEC-11) produce and export? Using data from 'Oil & Gas Journal' ('Worldwide Look at Reserves and Production', 16 Dec 2004) on world daily average production in 2004 and 2003, total OPEC-11 production averaged 28.93 Mbd in 2004, of which Saudi 8.75 Mbd.

Only Iran, Qatar, Kuwait and Saudi Arabia are credited with production hikes better than 3% in 2004 compared with 2003, excluding the very special case of Iraq. For 'Oil & Gas Journal' there was about a 55% increase in Iraq's daily average production, to about 2.05 Mbd in 2004 - while US EIA and DoE figures give about 1.55 Mbd, almost identical to 2003 average output. BP places Iraq's 2003 production at a daily average 1.33 Mbd. The total of 28.93 Mbd, above, credits Iraq with a daily average of 1.75 Mbd in 2004.

Any production numbers for OPEC are subject to the key question: net or gross? What is the export capacity of each OPEC supplier?

Iraq, for example, soon recovered its pre-war domestic oil demand of about 0.65 Mbd, despite shattered economic infrastructures and 60% unemployment. US occupation forces in Iraq are credited with about 0.35 Mbd demand. During the economic reconstruction phase that may now be about to start, Iraq's domestic demand will certainly increase rapidly.

Saudi Arabia's domestic or internal oil demand increased by more than 5% in 2004 (much more than its 3.2% increase of production). Saudi domestic oil demand was about 1.23 Mbd in 2003, according to BP Satistical Review of World Energy, resulting in actual or net export capacity of Saudi Arabia being about 7.5 Mbd. This is far less than 3 years of world oil demand growth at the 2004 rate (about 32 months).

Kuwait's domestic oil demand, again according to BP, has been growing at over 10%/year in recent years (19.8% in 2003), dwarfing all and any increases of its national oil production.

This pattern, of domestic oil demand increasing much faster than production, is common to far more than 9 out of 10 oil producers, both OPEC and nonOPEC. Net exports, therefore, will always tend to grow slower than national production. Conversely, also because of declining production in nonOPEC countries and increasing demand for oil, world oil import demand increases faster than world oil demand (about 3 Mbd in 2004 for a consumption growth figure of 2.68 Mbd).

We then move on to actual declines in production. For the majority of nonOPEC producers - in fact nearly all except Russia and some Central Asian producers - rates of decline are stubbornly high, despite vaunted technology improvements.

Taking the OECD's three-largest producers, USA, Norway and UK, these are losing oil output capacity at around 4% to 5.5%-per-year (decline of UK production in 2003-2004 was estimated at 13% by 'Oil & Gas Journal'). In the case of Norway and UK these rates are certain to increase, sharply in the case of Norway, despite any conceivable technology uprates, through simple geological limits and the types of oil basins exploited offshore by Norway and UK.

OIL PRICES AND ECONOMIC GROWTH

One of the biggest problems facing the IEA, the EIA and a host of analysts and 'experts' who claim that 'high prices cut demand', either directly or through damping economic growth, is that this does not happen in the real world. Since early 1999 oil prices have risen about 400%. Oil demand growth in 2004 at nearly 4% was the highest in 25 years. In each year since 1999 world oil demand gowth has been higher than the previous year - as prices rise !

These are simple facts - that very clearly conflict with received notions and nostrums about 'price elasticity'.

World oil demand, for a host of easily-described reasons, tends to be bolstered by 'high' oil and gas prices, until and unless 'extreme' prices are attained. This is the real fundamental, on the demand side.

The supply side fundamentals are equally clear, and completely opposed to notions of 'unlimited' growth of supplies being achievable.

The net read-out from this is: rising prices and the dusting off of energy conservation and renewable energy development strategies. Both of these, we can add, are sorely needed to limit adverse climate change, now at least better understood - and feared.

Andrew McKillop is an energy economist and consultant. He has held posts in national and international energy, economic and administrative organizations and entities in Europe, Asia and North America. Professional experience includes: engineering and technology information management in the oil and petrochemicals industry (OAPEC, Kuwait and AREC Abu Dhabi); petrochemicals development and financing (AREC, Abu Dhabi); electricity, gas and road transport industry (British Columbia Hydro & Power Authority, Canada); energy infrastructure development and administration (Dept of Minerals & Energy, Govt of Papua NG); Policy analysis and policy development (Divn A – Policy, DG XVII-Energy, EC, Brussels).

© Copyright Andrew McKillop 2005

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