OIL

Oil Price To Stay High On Upside Risks Oxford Analytica, 12.05.05, 6:00 AM ET Oil prices have fallen from post-hurricane highs this year. If market oversupply materializes, they will continue to fall. However, risks on the upside are more likely to prevail in 2006. There are two ways the oil market may evolve in 2006: -- Weaker Market. In the aftermath of Hurricanes Katrina and Rita, oil prices fell by around $10 per barrel. Since the hurricanes, Organization for Economic Cooperation and Development (OECD) commercial stocks of crude and products are now at the higher end of the figure during the last five years. Combined with the threat of high oil prices on demand for oil, the market could move into an oversupply situation unless Organization for the Petroleum Exporting Countries (OPEC) takes action soon. -- Tighter Market. However, falling oil prices are a normal market reaction after hurricanes, as happened following Hurricane Ivan in 2004. The anticipation of hurricanes typically pushes prices above that justified by actual supply and demand balances. Market signals are pointing to tighter rather than weaker market conditions. On the demand side, there is so far little sign of any response to high prices, though the International Energy Agency (IEA) and others have been lowering their demand forecasts for both 2005 and 2006. Demand strength has been largely driven by economic growth--forecast at 3% for 2006--which shows few signs of slowing: -- OPEC. OPEC countries are showing exceptionally strong demand for oil, fueled by the sharp increase in oil revenue. -- China. In China, during the first half of the year, the government tried to ration demand. Initially, demand stagnated but, since September, it has picked up again and China may add 500,000 barrels per day (b/d) this year. -- United States. Earlier numbers suggesting lower demand in October appear to have been misleading; unsurprisingly since three-quarters of U.S. consumption consists of light products that are unresponsive to higher prices in the short term. Also, where dual firing capability exists, exceptionally high natural gas prices have helped boost oil demand. Oil demand is also affected by winter weather. If the current forecasts of an exceptionally cold winter in the Northern Hemisphere prove to be correct, this could significantly increase demand. On the supply side, both non-OPEC and OPEC may disappoint in terms of additions to capacity and supply: 1. Non-OPEC. Non-OPEC supply is being revised downward, as anticipated projects face increasing delays due to constrained capacity in the service industry and the aftermath of the hurricanes: OECD. Production is expected to decline by 850, 000 b/d in mature OECD economies this year. Russia. Russia is a cause for concern. Political uncertainty, inflation and rouble appreciation all increase costs and reduce profitability, inhibiting production growth and discouraging further investment. While there are signs of greater resources being invested in upstream activities and the service industry globally, the long lead time on projects means these will not bear fruit for a number of years. 2. OPEC. OPEC countries are currently producing around 30 million b/d, although the official quota is only 28 million b/d: Spare Capacity. The IEA estimates OPEC capacity of 32.1 million b/d at the end of 2005, while the U.S. Energy Information Administration puts the surplus in October at only 1 to 1.5 million b/d. Saudi Arabia has promised to meet shortfalls in crude supply, but refused to discount the price of its heavy sour crude, leading to few takers. It is unlikely that significant extra capacity will emerge outside of Saudi Arabia, though OPEC is expected to increase its natural gas liquids production by some 350, 000 b/d. 2006 Projections. Expectations of increased supply vary between 700,000 b/d and 1 million b/d by the end of 2006. This will largely consist of light sweet crude, which may alleviate some of the constraints facing refineries. Refining Shortage. A shortage of upgrading refinery capacity also remains a problem. This was aggravated by the hurricanes pushing up the price of light sweet crude. Unless gross domestic product growth collapses, the market looks as though it will remain tight throughout 2006. The market is still vulnerable to the threat of losing another major exporter through, for instance, another natural disaster. In such circumstances, a large price spike could be expected. If any market weakness does emerge, OPEC is likely to step in to protect the price. Even if the market weakens, OPEC is well placed to defend the price, while any potential shock to the market will lead to a price spike. Oil markets will probably remain tight during 2006 and prices are likely to continue around their current levels. Risks are on the upside rather than the downside. To read an extended version of this article log on to Oxford Analytica's Web site. Oxford Analytica is an independent strategic consulting firm drawing on a network of more than 1,000 scholar experts at Oxford and other leading universities and research institutions around the world. For more information please visit www.oxan.com, and to find out how to subscribe to the firm's Daily Brief Service, click here.