Oil prices have soared from $32 a barrel at the beginning of the year to an all-time high of $50 a barrel at the end of September largely on the fear of supply outages stemming from terrorism and a series of odd events. Interestingly, virtually every fear so far has gone unrealized.
Terrorism has not removed a single barrel of oil production. Oil output in Saudi Arabia, instead of falling due to terrorism as some have feared, has increased by more than 1 million barrels a day this year. OPEC has steadily increased production — by a total of 1.7 million barrels a day since January — and has consistently outpaced analysts’ estimates of its capacity. Production at Russian oil giant Yukos has not fallen — it is up 6 percent so far this year. And despite a difficult war in Iraq, production in that country has averaged 2 million barrels a day — a 900,000 barrel-a-day (or 78 percent) year-over-year increase — with production currently estimated at more than 2.5 million barrels a day.
Although there have been labor strikes at various oil installations, ethnic violence in certain oil-producing countries, guerilla attacks on Colombian oil pipelines, and mechanical problems at producing oil fields — all typical events for the oil industry — non-OPEC production has been higher and less volatile than in the past.
The only meaningful event to hit the oil industry in recent months has been four back-to-back hurricanes in the southeastern U.S. This has caused temporary interruptions in oil and oil-product flows. Experience shows that inventories tend to rebuild quickly after these storms subside. Yet oil traders continue to speculate that oil supplies, in large quantity, will be cut off.
Perhaps there will be a supply interruption, but the likelihood of a prolonged outage is low.
What makes oil analysis difficult is that in addition to speculation and fear, there has been improvement in oil demand — so fundamentals have played a role in the rising price of oil. This has led to concern about the level of spare production capacity and a debate about how much of the upswing in oil prices is due to speculation and how much might be due to fundamentals.
Well, let’s look more closely at the fundamentals. While demand has been strong (according to the International Energy Agency, world oil demand rose 3.8 percent in the first half of 2004, more than twice the historical growth rate), supply has been stronger. IEA figures for the first half of the year show an increase in world oil demand of 3 million barrels a day against an increase in supply of 3.5 million barrels a day. About 60 percent of the supply increase is coming from OPEC and 40 percent from non-OPEC sources.
Excess supplies are borne out by rising inventories. In the U.S., crude oil inventories increased by 50 million barrels in the first eight months of this year, the second-largest build in history, and oil inventories for the OECD (the Organization for Economic Cooperation and Development, which includes 30 member countries) increased by 83 million barrels in the first seven months of this year.
Recently, the growth in oil demand has begun to slow in response to high prices and slower economic growth. According to the American Petroleum Institute, U.S. oil demand rose only 0.5 percent in August, owing to a fall in gasoline demand. Oil demand through August is up 1.7 percent, compared with growth of 2.9 percent in the second quarter. Demand-growth in August for China, at 10 percent, was less than half the rate estimated for the first half of the year.
It comes down to this: Fundamentally speaking, oil prices should today be in the high-$20-a-barrel range. That’s based on an assessment of supply/demand economics and current inventory levels (adjusted for hurricane effects). Eventually, that barrel price should decline into the low $20s as oil inventories rise. Why the more-than $20-a-barrel difference between where prices are and where they should be? In large part, speculation.
And what will cause oil prices to fall? Three factors will put downward pressure on oil prices. First, a continued rise in inventories should justify a lower price fundamentally and reduce the fear premium. (OPEC production should exceed fourth-quarter 2004 and full-year 2004 demand by 2.55 million barrels a day and 2.75 million barrels a day, respectively.) Second, the absence of a supply shock should also reduce speculation. In other words, no news is bad news for oil prices. Third, a weakening price will feed on itself. Traders are driven by momentum. A break in the oil price could trigger a liquidation of large speculative positions which, in turn, could lead to even lower prices.
These are the things that usually cause bubbles to burst.
– Frederick P. Leuffer, CFA, is senior managing director and senior energy analyst for Bear, Stearns & Co. Inc.