Middle East Economic Survey
VOL. L
No 44
29-
Reasons Behind The Recent Hike In Oil Prices
By Behrooz Baik Alizadeh
The following article was written for MEES by Behrooz Baik Alizadeh, senior oil market analyst, Ministry of Petroleum of Iran (balizadeh@nioc.org). This analysis is based upon the personal opinion of the author and does not represent the official view of the ministry.
Oil prices have recently hiked to unprecedented levels. Since the beginning of current year up to the week ending 19 October 2007, the average price of the OPEC basket increased to $64.72. The first question regarding such prices is: what is the reason for price increases? To answer this question, attention should be paid to the following points:
1. Currently, there exists no sufficient excess production capacity in the oil market. Estimates made by the Energy Information Administration (EIA) indicate that OPEC’s excess capacity in September 2007 stands at 2.02 mn b/d of which 1.8mn b/d is concentrated in Saudi Arabia. In other words, 89.11% of OPEC's excess production capacity is located in a single country. In its latest report, the International Energy Agency (IEA) has also estimated OPEC’s excess capacity (without Indonesia, Iraq, Nigeria and Venezuela) at 2.66mn b/d of which Saudi Arabia holds 2.15mn b/d, or 80.83% of the total.
2. Investigations show that the production cost of 5% of world crude oil supply, equivalent to 4mn b/d, has reached $70/B. In case of omission of this 4mn b/d (produced at the cost of $70/B) from the supply chain, there would not be sufficient excess capacity to replace this volume of oil. Therefore, under prevailing price conditions, such marginal production should be defended. Otherwise, such high cost production will be halted, leaving the oil market with serious shortage. Under this situation, it can be claimed with more confidence that the market's structure has risen to a higher level termed at “Structural Bull Market”. This situation has more perpetuity than the “Cyclical Bull Market”.
3. The rate of growth of world demand for oil in the years 2007 and 2008 has been estimated by OPEC at some 1.3mn and 1.4mn b/d respectively. Estimates made by IEA for this growth is respectively 1.2mn and 2.1mn b/d. An examination of the average rate of demand growth in previous years also indicates that the figure was about 1.45mn b/d in during 2002-06. Thus, estimates for demand growth for the years 2007 and 2008 indicate that higher oil prices since 2004 and subsequent years have not been able to weaken the rate of demand growth. Meanwhile, the world economic forecast published by OPEC shows that the world economy will continue its growth rate at 5.1% in 2007 and 4.9% in 2008. That is to say the world economy also supports higher oil demand, meaning firmness of oil prices.
4. Based on OPEC’s estimates, seasonal demand will be increased in the fourth quarter of 2007, reaching 87.1mn b/d and will be 1.5mn b/d more than the level in the third quarter of the same year. Since non-OPEC countries will provide 55.6mn b/d of this volume, the demand for OPEC oil in the fourth quarter will average 31.5mn b/d. However, it is predicted that OPEC production in the fourth quarter will reach 31.2mn b/d, inclusive of 500,000 b/d output increase approved in the latest 145th Conference of the organization. Therefore, the market will face a shortage of 300,000 b/d in the fourth quarter of 2007, forcing it to take this deficit from oil stocks. Of course, taking from stocks in the fourth quarter of the year is natural and usual. Also, on average 300,000 b/d had been taken from stocks during 2002-06. However, if the weather is colder than usual in the fourth quarter of 2007, the demand for oil will increase, leading to a rising trend of oil prices. Indications of this are already evident.
5. Regarding non-OPEC oil producing countries, it is necessary to note that they operate at their maximum oil production capacities. Statistics published about their oil supply also show that non-OPEC oil producers have not been able to fulfill anticipation of their oil production levels. Many oil projects in non-OPEC countries have faced delays. Natural disasters, technical problems and costs increase have caused lack of progress in the projects and consequently reduction of oil supply growth from those countries. It was predicted at the end of 2006 that non-OPEC countries would be able to increase their production by about 2mn b/d in 2007. But due to factors mentioned, non-OPEC supply growth has declined to about 1mn b/d. Under circumstances it is evident that crude oil prices should enjoy strength.
6. Downstream bottlenecks have also played a fundamental role in consolidation of high oil prices. The shortage of excess refining capacity, reduced to less than 1mn b/d, has attracted the oil market’s attention. Under prevailing conditions, any unforeseen event in the refineries could lead prices to higher levels. Particularly, it is also anticipated that total global refining capacity will be increased by only 1.4mn b/d in 2008. Meanwhile, shortages in the capacities of refining conversion has also a special significance, because the requirement for lighter and cleaner products has put pressure on conversion units. It is also noteworthy that in the US, the biggest oil consumer, no new refinery has been constructed since 1970s. Recent refinery accidents, in the US and other oil consuming regions, have also caused prices to increase.
7. At the end of September 2007, the level of commercial oil stocks in the US was 75.8mn barrels less than the same period last year. Such stocks in Europe were 18.4mn barrels less than the same period in 2006. Also, the total volume of oil stocks in Japan at the end of August 2007 were reduced by 0.9mn barrels compared to the same time last year. Meanwhile, the prices for physical oil transactions during previous weeks had risen to a higher level than those in the subsequent few months. This is because current oil prices have been under mounting pressure from the chaos prevalent in the market. The tendency for oil storage reduces under such a situation which is commonly known as backwardation. In addition, refiners prefer to withdraw from their stocks for their consumption. Thus, reduction of the level of stocks will press oil prices to soar even more. The market vulnerability will also increase with the reduction of oil stocks. In other words, any event leading to the withdrawal of oil from the supply chain can drive prices to higher levels.
8. Almost every year from June to the end of the year hurricanes occur in the Caribbean and the Gulf of Mexico. The probability for the occurrence of hurricanes is in September is high. In the current year, the storm in the Gulf of Mexico also caused a few days’ halt in crude oil production from this region. On 21 August, Mexico's crude oil production, amounting to 2.65mn b/d was stopped by flooding caused by Hurricane Dean. Lost output was equivalent to 80% of Mexico’s production of 3.2mn b/d. Two days later, Mexico was capable of producing oil at a rate of only 342,000 b/d. Only on 3 September did the Mexican government announce that it had restored full production capacity.
Then on 21 September, some 62.2% (1.3mn b/d) of production from the Gulf of Mexico also came to a temporary standstill due to the likelihood of a hurricane. While the market lacks sufficient excess capacity to compensate shortages, these storms can easily cause oil prices to increase. In particular, the storms can disrupt the refining activities in this region, especially at a time when the market is suffering from a shortage of refinery capacity. The major part of the US capacity for refinery conversion is located in the Gulf of Mexico region. If these refineries sustain significant damage, the US oil market faces a crisis.
9. When the market confronts excess capacity shortage in the upstream and downstream sectors, political tensions leading to cutting off of oil supply or fear of supply cut, can increase oil prices. Political disorder and armed assaults by dissatisfied groups at oil installations in Nigeria have strongly influenced the oil market. Currently, unrest and disorder have halted production of about 547,000 b/d of crude oil from Nigeria. Also, three pipelines carrying natural gas, crude oil and LPG were blown up on 10 September by armed groups in Mexico, halting supplies. However, the Mexico’s state oil company (Pemex) managed to quickly provide replacement means of for transportation, preventing any harm to Mexico’s crude oil exports. Only the production of gas encountered some disorders and 25% of its production was halted. These terrorist actions were similar to those which took place in that country in July 2007. A group called the “Peoples’ Revolutionary Army” claimed responsibility. Given the vulnerability of pipeline routes in this country, the market follows with anxiety the developments in Mexico, especially because Mexico provides 13% of US oil imports.
Geopolitical concerns in the Middle East have greater intensity and significance since a major part of world’s excess oil production capacity is in this region. If a major crisis develops here, causing interruption of crude oil flow, there will be no chance to provide a substitute for the missing volumes. The situation in Iraq has made the Middle East security circumstances unclear and vague. Rising tension between Turkey and Kurdish rebels in northern Iraq has also threatened Middle East oil supplies. In addition, every now and then, the market observes activities by terrorist groups in Saudi Arabia where there is the most crude oil excess production capacity. Also, the market follows with concerns the behavior of a number of western countries which oppose the Islamic Republic of Iran’s peaceful nuclear activities. All these anxieties influence oil prices, raising them to higher levels.
10. Speculators have also had a significant impact on oil prices, accelerating the upward trend. Since the week ending 20 February this year, non-commercial net long positions in the NYMEX have been positive. The open interest also has followed an upward trend indicating there is an expectation that oil price strength will continue. All issues mentioned before have given strong impetus to speculators to get involved in the oil futures market. Recent US dollar weakness has also forced funds to use the oil futures market as a hedging tool. The US Federal Reserve’s move in September to cut interest rates by half a percent because of mounting losses in the US sub-prime mortgage market, sent the dollar to its lowest level against major currencies. In the week ending 19 October, one had to pay about $1.423 for €1. In fact, in recent weeks the euro traded above $1.40 for the first time since the common European currency was introduced.
11. OPEC decided in its 145th ministerial meeting on 11 September to increase output by 500,000 b/d, effective from the beginning of November. But the announcement failed to halt the trend of increasing prices. Because, as pointed out, the hike in prices has not resulted from a crude oil shortage. Therefore, an increase in OPEC output solely can not bring down prices. In addition, an increase in OPEC production also implies more reduction in the organization’s spare capacity, increasing, in turn, the market’s vulnerability. Of course, there is also a belief in the market that OPEC member countries are producing crude oil at their maximum capacities, lacking spare capacity for raising output. And only Saudi Arabia has an excess capacity. Some oil analysts are even uncertain about the existence of spare capacity in Saudi Arabia. They believe this country is not able to increase its crude oil production quickly. In addition to that, in case Saudi Arabia or other OPEC member countries have spare capacity, it inevitably takes the form of heavy crudes. Due to a shortage of capacity in conversion refining, production of heavy crude oil can not quickly provide oil for the market. On this basis, despite OPEC's endeavor to cool down prices in its 145th conference, the trend of prices has kept on increasing.
Sources:
1. Monthly Oil Market Report, OPEC, October, 2007.
2. Oil Market Report, IEA, October, 2007.
3. “Twilight in the Desert – Doubting Saudi Potential”, PIW, June 6, 2005.
4. Jeff Currie," Marginal Oil Output now costs $70/bl", Reuters, September 19, 2007.
5. Reuters, January-October,2007.