Middle East Economic Survey

VOL. LII

No 49

7-Dec-2009

Signals Of A New Floor And Ceiling For Crude Oil Prices

By Behrooz Baik Alizadeh

Mr Alizadeh is Senior Oil Market Analyst at the 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.

Crude oil prices experienced their sharpest ever decline in the latter half of 2008. North Sea Brent was sold at $40.35/B in December 2008, which was $92.84/B lower than the historic oil price peak in July of the same year. This scenario was also true in the case of other grades of crude oil.

The financial downturn, which began in the middle of 2008 and soon after swept across the world, was the main reason underlying crude oil price falls. The global economy’s growth rate of 5% in 2007 dropped to as low as 3.1% in 2008. In 2009, however, the figure registered the record low of -1.4%. In this manner recession dominated the economic and business arenas and demand for oil dropped drastically. According to a recent OPEC report, demand for oil in 2009 dropped by 1.4mn b/d compared with 2008, while according to an International Energy Agency (IEA) report the decline was 1.7mn b/d. Other factors of less significance were also involved in the crude prices fall. The easing of geopolitical concerns in various regions of the world, the increase of OPEC’s spare capacity, and a build up of commercial oil stocks and floating oil storage amid a sell-off by speculators constituted other factors contributing to the speedy downtrend of crude prices that ended the bubble-like hike of prices.

Slipping prices caused concern among producers and consumers of oil alike. Oil producers complained that reduced incomes would undermine their ability to invest in the oil and gas industries. OPEC Secretary-General 'Abd Allah al-Badri warned on 15 March, following OPEC’s 152nd ministerial meeting, that the execution of 35 out of 150 upstream projects among OPEC member states has been postponed until after 2013. And some projects that were scheduled to be commissioned by 2008 have been delayed for at least one or two years. Mr Badri was of the belief that current prices are not sufficient to cover future investments and in case this trend continues, the market will certainly experience a sharp decline of investments.¹

Meanwhile, consumers were not satisfied with the status quo and expressed concern over dwindling investments in the oil industry. They were worried about a shortage of crude supply in the future and that would be synonymous with out of control upward oil prices. In a meeting of G8 energy ministers in Rome on 24 May 2009, the participants discussed the kind of price levels that would guarantee consistent investment in oil and gas industries without posing any threat to the trend of world economy improvement. The IEA reported that investment in gas and oil industries has fallen by 20% in 2009 compared to 2008. The IEA added that in the October 2008-April 2009 period, over 20 large projects worth more than $170bn had been cancelled or postponed. These projects were supposed to produce an additional 2mn b/d of oil and 1bn cfd of natural gas. In addition to that, 35 projects were delayed by at least 18 months. The report further stated that non-OPEC producers were expected to experience the highest rates of decline in investment while reduced investments in the existing fields has doubled the risk of production cuts. Oil prices were expected to jack up tremendously once the global economy recvered.²

What Price Ceiling?

Although the concerns of producers and consumers differed in nature, however, there was one concern they shared. Both producers and consumers were in favor of higher prices. But what price ceiling was preferable?

Twenty three energy and oil ministers as well as 18 managers from global oil and gas companies had attended the G8 meeting in Rome. The Saudi Arabian oil minister, the head of the Libyan national oil company who was in charge of the Libyan oil ministry and had served for years as manager of the research department at OPEC’s secretariat, the energy minister of Algeria and the Nigerian oil minister had been invited from among OPEC members to attend the G8 meeting, which was arranged only four days prior to OPEC’s 153rd ministerial meeting. Two days prior to the Rome meeting, the US secretary of energy, in a press conference, elaborated on the objectives of Rome meeting and urged OPEC member states to adopt such a production policy that would assist with stabilizing oil and gasoline prices, for sudden price jumps and cuts would damage all equally.³  One day prior to the meeting, the Saudi oil minister reiterated that oil prices would eventually reach $75/B, but the significant point however, was what mechanism should be used to stabilize oil prices at $70-80/B.⁴  The head of the Libya’s national oil company too stated that oil prices would ultimately reach $75/B.⁵  The head of Italian oil and gas company Eni believed that $60-70/B oil prices would serve to encourage investment and keep global economy immune from any likely damage, and he stated that in order to guarantee the blooming of the global economy, prices should not go beyond $75/B.⁶ 

These statements indicated that an unrevealed agreement is likely to have been reached on the price ceiling of perhaps $75/B. Lately, oil prices have risen and Brent’s average price in August 2009 came to $72.84/B. Then after remaining month below $70/B in September 2009 it rose again and on 16 October 2009 reached $74.90/B. One may ask how oil prices escalated to about $75/B from the earlier $40/B (Brent crude), registering a hike of about $35/B. It appears that at this stage, both producers and consumers have somehow collaborated in order to increase oil prices.

Table 1: Estimates Of Global Oil Demand (Mn B/D)

* October 2009 estimates.

Source: Reuters, 27 July 2009.

The endeavors of the industrialized states aimed at containing the global economic downturn and improving their economic situation, and particularly the decision adopted by consumers in the course of the G20 meeting in April 2009, indirectly impacted oil prices. In that meeting, where Saudi Arabia was also represented, the industrialized states decided to spend $1.1 trillion for the reinforcement of the global economy and to impose still more strict regulations and restrictions on banks and financial institutions. The decision sprinkled hope on the market, heralding the good news that the global economic crisis would come to an end sooner than was earlier expected, that demand for oil would grow and prices would be back to normal. The global crude oil demand estimates released by oil and research institutes revealed that global demand in 2009 would increase by an average of around 1mn b/d. This meant that the downward trend of demand, which had started in 2008, would come to a halt (Table 1).

On the other hand, OPEC member states adhered to their responsibility as well. In its 151st meeting in December 2008, OPEC had decided to cut production by 4.2mn b/d from the beginning of 2009 to fix output at 24.845mn b/d. OPEC’s production of 29.045mn b/d in September 2008 became the basis for specifying the rate of production cuts. In OPEC’s 152nd meeting on 15 March, 153rd meeting on 28 May and 154th meeting on 9 September, OPEC adhered to that decision. Statistics released by secondary sources indicate that OPEC member states have largely kept to their obligation and cut production by 2.955mn b/d in the first half of 2009. If they keep on adhering to their September 2009 production levels, in the second half of this year too about 2.7mn b/d of crude oil will remain out of the market (Table 2).

Table 2: Adherence Of OPEC Member States To Production Cut Targets In 2009

Source: OPEC Monthly Oil Market Report, October 2009.

Without doubt, OPEC’s measure removed a major portion of surplus crude oil from the market and supported prices. Of course, some additional factors were involved in this upward trend since the beginning of 2009. The emergence of refining problems, implementation of the plan for increasing strategic oil stocks by China, conflicts in Gaza, a weaker dollar, halt in the supply of natural gas from Russia, increase in refining margins, colder climatic conditions in the northern Hemisphere and bad weather in the Gulf that led to oil production and export disruption, political unrest in Nigeria, disruption of a 130,000 b/d pipeline operation in Ecuador due to an oil spill, unrest in Saudi Arabia, reduced crude and gas stocks in the US, higher demand for gasoline in the US, promising performance of the stock exchange markets, al-Qa'ida’s terrorist operations in Kuwait and recently, a stock drawdown due to backwardation and risk of a military strike against Iran’s peaceful nuclear facilities are all included in this list, although all of these factors had a marginal role.

Thus, both producers and consumers of oil have collaborated directly and indirectly in order to increase oil prices to some extent to make the new and costly production of oil economically viable. So it is clearly understood that the marginal cost of non-conventional oil, which is estimated to be $70-80/B is going to form the price floor. It is evident that under the present circumstances, one cannot expect that oil prices will touch the level of $100/B or even higher, for it is generally believed that such prices would delay the trend of global economic recovery. In the course of OPEC’s 153rd meeting, Saudi Arabia opposed further cuts by OPEC, this time with more clarity, and reiterated that OPEC has adopted an accountable approach and does not plan to create a crisis.⁷  On the other hand, OPEC’s recent production cut left idle a portion of the organization’s production capacity, thus OPEC’s spare capacity has gone up to the level of 6.43mn b/d.⁸  Such a production surplus will not allow prices to jump significantly, so it appears that oil consumers and producers have reached consensus to specify oil prices between the floor defined by the marginal cost of developing unconventional resources and the ceiling determined by the limit of the global economy’s tolerance. Such a trend will continue for as long as the global economy has not been revived and supply concerns have not been removed. Forecasts of WTI and Brent oil prices by various institutions testify to this view (Table 3). One may call this floor and ceiling a pragmatic price band forced by market realities and necessities.

Tables 3: Forecasts Of WTI And Brent Prices ($/B)

Source: Reuters, 25 August.

Graph 1: Inflows Of Funds To Commodity Indexes (S&P GSCI AND DJ-AIG) For Crude OIL And WTI Prices

Source: OPEC Monthly Oil Market Report, August 2009.

There is still an unanswered question that is worth pursuing. The question is whether the determination of producers and consumers and the measures they have adopted have been enough to push up oil prices to the current levels. In search of a plausible answer, it seems that besides the recovering the oil market fundamentals, another important factor has affected oil market and helped push up the prices. In fact the role of funds in oil market in recent years is quite apparent. Inflows of funds to commodity indexes for crude oil have been significantly increased since early 2009 (Graph 1).

Maybe investment funds have been aware of the unwritten consensus between consumers and producers and the above-mentioned signals have influenced their expectations. So, they have responded to these signals by increasing their inflows. As shown in Graph 1, there is a close correlation between their inflows and WTI prices, so it is valid to say funds have supported the upward trend of oil prices, which is supposed to guarantee further investment and future adequate oil supply. 

Notes:

1.   OPEC Secretary-General 'Abd Allah al-Badri: “We have 35 projects out of more than 150 that have been delayed until after 2013. Some projects that were supposed to be finished in 2008 are delayed to 2009, and some from 2009 to 2010. There is a delay because the costs of these projects were high. Some countries are renegotiating the cost. This current oil price does not permit investment and I will assure you that if this price continues, you will see a lot of reductions in investment… The advanced countries which created this mess have to take more of a burden than the poor countries, than us, because we did not contribute to this crisis. The costs of equipment, spare parts, food and commodities have not come down yet. They are slowly coming down. Prices of oil dropped, but the cost of commodities and spare parts and equipment and our investment cost has not really reduced.” Petroleum Argus, 8 June 2009.

2.  The IEA presented a report to a Group of Eight energy ministers meeting, at which energy leaders debated the oil price needed to sustain investment without hurting a wider economic recovery. “We estimate that global upstream oil and gas investment budgets for 2009 have already been cut by around 21% compared with 2008,” the report said. The IEA said that between last October and the end of April over 20 planned large-scale upstream oil and gas projects – valued at a total of more than $170bn – were deferred indefinitely or cancelled. Those projects involved around 2mn b/d of oil output and 1bn cfd of gas capacity. A further 35 projects were delayed by at least 18 months. “Oil sands projects in Canada account for the bulk of the postponed oil capacity,” the report said. “Investment in non-OPEC countries is expected to drop the most,” it said, adding that spending cuts on existing fields also risked pushing up decline rates. Investment cuts will only affect capacity with a lag, so in the near term weaker demand was likely to result in an increase in spare or reserve production capacity, the IEA said. But it said that that if the current trend was sustained, there was a danger it could lead to a shortage of capacity and another spike in energy prices once the global economy recovers. Reuters, 24 May 2009.

3.  US Energy Secretary Steven Chu called for OPEC to carry out an oil production policy that will help keep oil and gasoline prices stable as much as possible. “Sudden drops and sudden rises (in oil and gasoline prices) hurt everybody equally, and it’s that stability that we seek,” Mr Chu said in an interview to preview the G8 meeting. “Another price spike would be bad for the economy and they (OPEC members) know it.” Reuters, 22 May 2009.

4.  Saudi Arabia’s Minister of Oil and Mineral Resources Ali Naimi said crude prices would “eventually” rise to $75/B, but the “trick is how you keep it between $70/B and $80/B.” Reuters, 23 May 2009.

5.   Libya’s Shukri Ghanem, Chairman of the National Oil Corporation (NOC), said on the eve of a meeting of the Group of Eight energy ministers that “oil prices would ultimately hit $75/B – the level producers say is needed to encourage investment in new production over the long term - but not very soon.” Reuters, 23 May 2009.

6.  Eni Chairman Roberto Poli said the “magic range” for oil prices high enough to spur investment without hurting the economy was $6070/B: “The experience of the last price cycle demonstrated that to ensure steady economic growth, price should not rise higher than $75/B. Oil price instability and unpredictability are the worst enemies of any well thought-out plan to build a different energy future.”

7.  Mr Naimi said: “I have always said that OPEC is a responsible agency. We take the environment in which we are living into consideration. I think that what we are doing is absolutely responsible, and that we are not trying to create hurriedness or a crisis.” Petroleum Argus, 1 June 2009.

8.   IEA Oil Market Report, October 2009.