Chris Weafer of Uralsib -
Having headed into 2009 in freefall, the price of crude has defied the pessimists and recently found good support above $40 per barrel. This is mainly because the Organization of the Petroleum Exporting Countries (Opec) has been much more effective in reducing supply. Even though the demand side of the equation is still declining, there is greater expectations today that Opec can continue to act much more decisively than it has ever done in its history and quickly match eventual demand with supply. Why? The organisation is much more commercially focused than it used be, as most producers find themselves in greater need of higher oil revenues.
The year-to-date average price of Brent is just above $43/barrel. Opec ministers are targeting an average above $50/barrel for this year and are hoping to raise that to $70 in 2010. A big test of whether that is realistic, or merely hopeful, will come in the May/June period when winter heating oil demand ends and summer gasoline demand normally increases. If the latter doesn't materialise, especially in the US, Opec's resolve will be even more severely tested, as bigger cuts will be called for. Realistically, the current oil price rally cannot push much further and the price of crude is likely to fall below $40/barrel in the second quarter. But given the more effective approach by Opec this time, there is a realistic prospect the current average of $43/barrel could be realised for the year and Brent will end the year at between $50 and $60.
The two major changes that have re-shaped Opec's approach to the oil price are:
1) a widespread leadership change in the most important producer countries;
2) expanded budget spending since the start of this decade.
In the 1980s and 1990s, the major Opec producers, led by Saudi Arabia, were much more inclined to accommodate the demands of the western consumer countries. In the early 1980s, the Saudis agreed with the US that the price of crude should average approximately $20/barrel and, using a practice of swing production along with Kuwait, the UAE and Venezuela, the price of Brent did indeed average $20.50 in the two decades up to 2000. Since then, the average price has been just above $48/barrel and in 2008 it averaged $97. All major oil-producing countries substantially increased their spending programmes over the past eight years, especially for social projects and infrastructure. This makes the decisive issue no longer one of the cost of production, but how much revenue is required to maintain those spending programmes.
In November, the Opec countries that are subject to the quota regime produced an average of 27.94m barrels per day (b/d). In February, production averaged 25.39m b/d - only 2% over quota. Currently, the quota countries are scheduled to produce an average of 22.67m b/d, or 9% below the quota. That scale of compliance is unprecedented and reflects the new commercial focus. The political dynamic within Opec is also important. For example, in February, Saudi Arabia produced 200,000 b/d less than its quota while Iran over-produced by 350,000 b/d. The relationship between these two Gulf countries is an important factor for quota discipline, ie. for how long will Saudi "carry" Iran? The Iranian presidential elections, scheduled for June 12, may yet prove decisive in how well quota discipline is maintained in the critical summer period.
Russia's position is also an important ingredient in Opec's supply response. While Moscow didn't formally agree to a supply cut when the two sides met late last year, the government did convince the Opec secretary-general that, because of a cut in oilfield spending by the country's oil majors this year, Russia is facing a decline in production of between 200,000 b/d and up to 500,000 b/d over the next 12 months. All of that will be reflected in a cut in exports. As that decline becomes more evident to oil traders in the second half of this year, it will also be a strongly supportive factor for the oil price.
The previously urgent moves to increase spending in alternative energy sources and to develop new oil production in places such as Canada, West Africa, the Caspian and offshore Brazil have all eased with the falling oil price. Many of those projects require a sustainable average oil price equal to that required by many Opec country budgets. As these projects are scaled back, the prospect of so-called "peak oil" happening within the next 5-10 years also looms ominously. That fear is also now acting as a break against oil falling much further or staying too cheap for too long.
The uncertain future value of the US dollar is another important factor for oil-price planning. One of the drivers of the rising oil price in years up to 2008 was the declining value of the dollar relative to other major currencies. The fall in the oil price since last July has been partly cushioned with a strong rally in the dollar. For example, the dollar has rallied by almost 20% against the euro since the middle of last year. But the outlook for the dollar for the rest of this year is again uncertain. The planned spending increases announced by the US administration have give rise to a concern that the value of the dollar will fall sharply. That prospect is yet another reason for Opec countries to maintain tight compliance.
Chris Weafer is Chief Strategist at Uralsib
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