Can oil price hold?

The strength of the recovery in oil prices was the major surprise of last year. After several months of demand downgrades, the International Energy Agency (IEA) in the fourth quarter admitted that its forecasts for 2009 and 2010 were too negative. Robust growth in China combined with the global fiscal and monetary stimuli resulted in the forecast cut in demand in 2009 being reduced from 2% to 1.6%. This was the first reduction in global oil demand since 1993.

With global demand falling to a level below that of 2006, it was not only surprising that the oil price nearly doubled in 2009, but that it managed to rise at all. The contribution to demand made by China that helped stabilize oil prices should not be underestimated, nor should the contribution of Saudi Arabia on the supply side. The kingdom had an extremely difficult balancing act to stop a collapse in demand, particularly in the OECD, with a surprisingly strong supply contribution from the non-OPEC countries. This must have been particularly troubling for Saudi given that it had pledged to cut its 2009 output by 16% and encouraged its partners to make similar sacrifices. OPEC compliance can be difficult in the best of times, particularly with consistent “cheaters” – Iran and Venezuela – and there were the additional factors of reduced terrorist disruptions in Nigeria and a steady increase in production in Iraq. Despite a fall in the level of compliance to the quotas, OPEC production in 2009 is forecast to have been only a fraction above the original target, which would make it nearly 8% lower than in 2008.

Normally at the beginning of each year, oil analysts scratch their heads wondering how the non-OPEC producers failed yet again to meet their targets, but not this year. The three major contributors to the positive surprise were the US, Russia, and Mexico. After the hurricane disruptions of 2007 and 2008, 2009 was a relatively benign year for the Gulf of Mexico. In addition, much higher production at BP’s Thunder Horse field and a switch to offshore drilling due to a collapse in US gas prices, have cast doubts on the theory that the area’s production has peaked and that oil reserves there are in terminal decline. That theory was given another blow when BP discovered reserves of around 3 Bbbl of oil at its Tiber prospect after completing one of the deepest wells ever drilled. Russia has been plagued by problems including claims of favoritism towards its domestic producers, charges of corruption, and an unfair tax system towards resource holders, but a faster ramp-up in new production meant it too managed to produce above expectations. Finally, Mexico, whose giant Cantrell field has seen production fall by 60% in the two years to Q3 2009, actually experienced some stabilization in output in the fourth quarter.

With non-OPEC countries producing above expectations and OPEC producers desperate to turn on the spigots, an increase in supply is going to put pressure on oil prices, absent an extraordinary event. However, if OPEC production does increase in 2010, this will imply a reduction in spare capacity, unless there is a corresponding increase in new reserves. Non-OPEC production should increase a little in 2010, helped by the first production from the Tupi deepwater subsalt field in Brazil. However, this only covers the expected fall in production in the UK and Russia.

The extent to which OPEC spare capacity is tested (and therefore the outlook for oil prices) will depend on the recovery in global oil demand and the ability of non-OPEC producers to beat the odds again. In terms of global demand, it is the BRIC (Brazil, Russia, India, and China) countries (with perhaps the exception of Russia) that are leading the world out of recession. China overtook the US as the largest buyers of cars in the summer of last year and shows no signs of letting that lead slip. The US, on the other hand, also shows signs of a recovery in car demand. With no current signs of governments turning off the fiscal tap, world demand for oil in 2010 should recover, but would still be below the 85.7 MMb/d of 2008.

The real test for the oil price will come in the higher demand season, which tends to coincide with the May to September driving season in the US. There is evidence that commodity funds are taking advantage of the weak dollar to accumulate oil contracts, which, combined with the cold snap, should help support oil prices.

Iain Armstrong

Equity Analyst, Brewin Dolphin

This page reflects viewpoints on the political, economic, cultural, technological, and environmental issues that shape the future of the petroleum industry. Offshore Magazine invites you to share your thoughts. Email your Beyond the Horizon manuscript to Eldon Ball at[email protected].