RIYADH, 29 January 2007 — The story of oil prices last year was all too familiar and well documented — a strong and sustained run up in oil prices, due to unforeseen demand in China and India, and a risk premium associated with global tensions (as high as $10 per barrel), followed by a drop. Continued growth in oil demand in China, India and the US and supply shocks combined to raise oil prices to a new record. US light crude (WTI) smashed through its previous year peak of $70.86 to rise to $78.40 per barrel on July 14. Since then, oil prices have been on a downward path, reaching below the $50 a barrel level for the first time in over 19 months in mid-January.
Three factors were responsible for this decline. First, a decline in the risk premium on oil prices even though global geopolitical risks have increased. Second, three years of high and rising oil prices finally maybe doing what high prices always do — slowing down demand for crude. And third, a seasonal factor, namely unusually warm winter temperatures in December in the US and Western Europe, at a time when oil prices tend to be at their seasonal peaks.
In its latest monthly report, the IEA again reduced its estimate of 2006 oil demand growth by 100,000 barrels per day to 800,000 bpd (from 900,000 bpd the previous month, and 1.1 million bpd the month before). However, it maintained its 2007 growth forecast at 1.4 million bpd. The IEA said, “While some of the reduced demand is attributable to the unseasonably warm weather in the US, the report adds that the decline is also structural, notably in the key US Northeast and German markets, as well as in some Asian countries, as consumers switch to natural gas and coal is used increasingly in electricity generation”.
On the supply side, the report estimates that there was an oversupply of crude by 0.9 million bpd, on average, in 2006. In this context, it is remarkable that non-OPEC crude oil production has increased by a measly 700,000 bpd in 2006, despite three years of high oil prices and huge investments in explorations around the world. This echoes our view that the world maybe running out of crude oil. Credit Suisse states in a recent report, Life on the Plateau, that there was “lack of any convincing supply response from non-OPEC to the last three or four years of high and rising prices.”
For 2007, if the recently announced OPEC cuts totaling 1.7 million bpd take hold, then we estimate supply to total 82 million bpd vs an IEA estimated global demand of 86.1 million bpd in the 1st quarter of 2007. This expected oversupply of about 4 million bpd is huge given recent past trends and, is a key weakness on a fundamentals basis for oil prices as we enter 2007.
Last year at this time, there were hardly any economist or market analyst that expected oil prices to fall, and some were even talking about “$100 a barrel oil”. Today, forecasts have diverged (up, down, flat). Demand side weaknesses mentioned above will continue to exert downward pressure on oil prices.
However, two factors can turn things around: OPEC’s response to further price declines (especially below $50), and reversal in weather patterns (as happened this week). For the moment, OPEC is comfortable with the current situation, despite a fall in prices below the $50/brl level in the US in mid-January.
We expect oil prices to fall, but not by much. Saudi oil prices will fall by $3 a barrel to $55 in 2007 (after averaging $58 in 2006).
This is on the assumption that OPEC will make another production cut of 500,000 bpd in its next meeting on March 2007, after cutting production by 1.5 million bpd, effective in November 2006 and by another 500,000 bpd from February 2007. This means a cut in Saudi oil production to 8.44 million bpd in 2007 (vs. 9.12 million bpd in 2006).
(Khan H. Zahid is chief economist and vice president at Riyad Bank. He is based in Riyadh.)
