October 14, 2004

Summary
|  Viewpoints  |  Demand  |  Supply  |  Implications  |

 

Viewpoint
|  Summary  |  Demand  |  Supply  |  Implications  |

Since our last report the prompt NYMEX crude oil contract has risen in excess of $10.00 per barrel in a virtual straight line. Over the last four weeks, the market was down on only three trading days.

During this same time period, major managed fund net length as measured by the CFTC data rose by almost 25,000 contracts. The data understate the total new commitment by speculators, however, due to the existence of off-exchange transactions between institutions such as pension funds and Wall Street refiners.

While intermittent problems and uncertainty in Iraq, Nigeria, and elsewhere have underpinned prices all year and the NYMEX began discounting an assumed tightness in heating oil supplies this winter, the largest single rationale for the price surge was the significant impact, both fundamental and psychological, of Hurricane Ivan.

The storm ended up reducing total U.S. crude oil production to the lowest level since 1950. Once the last barrels and cubic feet return following pipeline repairs, we believe Ivan will end up shutting in production for a longer period of time with a greater cumulative effect than any hurricane in modern history. The impact was particularly acute given the average quality and the extreme “short haul” nature of the crude oil.

Looking at 2005, however, we have concluded after much consideration that chaos in Iraq and elsewhere will continue for the foreseeable future, probably irrespective of who resides in the White House for the next four years.

We have always been optimistic, believing in eventual resolutions to uncertainties with confidence that there are solutions worked on behind the scenes that will eventually bear fruit.

Even if they do not, however, the international oil market has a history of becoming immune to disruption or the possibility of disruption, eventually eliminating any “security premium”. Today, however, because the uncertainty not only reigns in a number of countries but there is a high probability that new risks will arise from unexpected or unforeseen sources, it is difficult to see how the market will eventually become immune, at least through 2005. We unfortunately live in a new environment and must adjust our price expectations accordingly.

Our updated balances imply excess sustainable producing capacity in OPEC next year of about 3.0 MMB/D. As such, prices should retreat from current levels, even though the bulk of excess capacity will remain sour crude oil. Clearly the uncertainty in 2004 has been compounded by the perception of a thin margin of total spare OPEC capacity and the reality of essentially no spare sweet crude capacity.

Therefore, even with most of the excess capacity next year still composed of sour crude oil, the substantially larger cushion should induce some marginal speculators to exit.

However, the ongoing chaos in producing regions leads us to conclude that WTI in particular will continue to trade above fundamental value. At this point, we are compelled to assume a 2005 average for WTI of $40.00 per barrel.

Since we are petroleum economists and not mere barrel counters, an upward revision in price expectations must concomitantly lead to a downward revision in demand. Such a revision helps contribute to our anticipated increase in spare OPEC volumes, as well as our belief that Saudi Arabia will retain some 11.0 MMB/D of sustainable capacity.

 

Global Demand Highlights
|  Summary  |  Viewpoints  |  Supply  |  Implications  |
|  Untied States  |  Europe  |  Japan & South Korea  |  Non-OECD  |

Under our latest outlook, world oil demand is anticipated to rise by 2.1%, or about 1.65 MMB/D next year, a downward revision from last month’s report by some 300 MB/D due to our higher price expectations.

Included in our revision is a lower anticipated recovery in discretionary driving in the United States for next summer, and a reduction in U.S. home heating oil consumption per heating degree day by 1.0%.

Europe heating oil demand has also been reduced while we have cut modestly demand growth in select Asian countries. In other regions where domestic fuel product price controls remain in effect such as OPEC countries, our estimated rate of growth has not been changed.

In all, we expect 2005 OECD oil demand to rise by 1.3%, or about 565 MB/D. This marks a cut from last month by 210 MB/D. Non-OECD oil demand next year is forecast to rise by 3.0%, or some 1.1 MMB/D, a reduction from our last report by 100 MB/D.

The disproportionately smaller revision in the non-OECD group of countries comes about because many, if not most of these countries have domestic refined product price structures that are controlled below world levels by their respective governments.

Clearly, to the extent these prices are deregulated or are amended to rise toward world levels at a faster pace, we would expect demand to be impacted accordingly. As we are seeing in Nigeria and elsewhere, however, such moves often lead to demonstrations and violence which may lead to a deferral of price increases.

United States

Refined product demand in the United States is forecast to rise by 1.6%, or some 320 MB/D next year, a reduction from our previous expectations by about 145 MB/D.

About 70 MB/D, or almost half of the revision derives from our view that under somewhat higher pump prices than previously assumed our recovery in discretionary driving next summer off the reduced levels of 2004 will be more restrained than it other wise might have been.

Although there appears to be a reduction in large SUV sales at the expense of smaller more fuel efficient SUVs and hybrids, we do not expect much impact on next year’s average fleet fuel efficiency. For 2005, therefore, we are looking for motor gasoline demand to rise by 1.6%, lower than our previously forecast gain of 2.4%.

Another source of our downward revision in U.S. oil demand growth next year is distillate fuel oil. Our model assumes that because of higher home heating oil prices this winter, consumers will reduce consumption per heating degree day by one percent from our estimate of the 2003-2004 winter.

The net effect is a cut in first quarter distillate demand by about 45 MB/D. We have also assumed some modest conservation in diesel consumption by industry is possible plus a slight moderation in manufacturing activity. For the year as a whole distillate demand is now expected be lower by 40 MB/D.

Finally, we have reduced our estimate of heavy fuel oil demand to no growth compared to our previous forecast recovery by 2.5% after this year’s decline. The net effect on this fuel is a cut in demand by almost 20 MB/D.

 

Europe

Preliminary data suggest a recovery in OECD Europe heating oil apparent demand in the middle and toward the end of the third quarter, the first such gains in several months. We had discussed in previous reports that compounding the secular decline in heating demand in Europe due to fuel substitution and conservation was the delay in pre-winter consumer storage tank fills under the expectation of lower prices.

The recent data suggest that consumers felt they could wait no longer, and likely began to fill up. This action would be confirmed by recent gasoil stock declines at the primary, or oil company level.

For 2005, however, we expect further weakness in heating oil demand relative to heating degree days as well as some impact on driving from higher pump prices.

The significantly higher tax structure in Europe shelters the consumer from the same percentage gain in price he would face in the United States, but higher absolute prices result nonetheless. We have anecdotal evidence that the European motorist is now in fact beginning to respond to higher pump prices and we expect this to continue through next year.

For 2005, therefore, we no anticipate a rise in OECD Europe oil demand of 0.7%, or about 80 MB/D, a reduction from last month’s assessment by 35-40 MB/D.

Japan  and South Korea

It now appears that the restart of most of Kansai Electric’s idled nuclear power plants will be delayed at least through the end of 2004, but we believe our numbers had already taken this scenario into account. As we write this report, Kansai has indicated it will restart this weekend one of the idled plants, the No. 1 unit at the company’s Ohi plant in northern Japan.

For next year, however, under the assumption that both Japan and South Korea will experience some level of conservation compels us under our latest oil price outlook to revise demand growth for select products relative to economic activity in these two countries.

In the case of Japan, we have trimmed slightly industrial fuel use and gasoline consumption. The net result is our anticipation that Japan oil demand will gain by1.3%, or about 65 MB/D next year, a reduction of 15 MB/D from last month’s report.

For South Korea, we are looking for a rise in oil demand of 0.9%, or some 15 MB/D, unchanged from last month. We were in the process of raising our expectations for South Korea under our previous price forecast on the basis of updated statistics and revised prospects for economic activity, but incorporating higher consumer prices returns us to our previous Base Case.

In the case of both Japan and South Korea, there is mounting evidence of a structural decline in heating oil demand which has been partially offset by stronger kerosene consumption. Higher prices for 2005 should modestly accelerate this decline.

 

Non-OECD

Over the last several months China has obviously remained the focus of world oil markets outside the OECD. In their latest monthly Oil Market Report, the IEA notes that apparent oil demand growth eased to only 5.7% in the month of August, and are concluding from the data that the expected slowdown in oil demand growth is beginning to pan out.

The IEA cites the fact that July growth was 12% while the second quarter gained by 25%. We would emphasize, however, that the second quarter comparisons were obviously “easier” as a result of the SARS impact in 2003.

We have discussed in previous reports that we expected some slowdown in apparent summer oil demand growth in China due to a combination of factors, but that it would be unwise to extrapolate any such moderation. Apparent demand growth should recover in the fourth quarter from the August lows.

Granted, there is growing evidence of some conservation of electricity which has eased the pressures on the national grid and led in turn to some reduction in diesel demand by portable generators. The seasonal gains in diesel demand for fishing and harvesting, however, are expected to offset this phenomenon over the short term. As a result, we are looking for fourth quarter apparent oil demand in China to rise by 15% over the previous year.

For next year, however, we have increased confidence that demand growth will slow to our targeted gain of 8.0%, to the extent that anyone can have confidence in forecasting demand for a country where information and data, let alone accurate information and data, are more lacking than almost anywhere else on the planet.

Nonetheless, by necessity we must give it our best attempt, and we believe that likely official increases in domestic refined product prices, although lagged, should begin to have a greater impact, while substitution of oil by alternative sources in industrial and electric utility applications should begin to accelerate.

Elsewhere, we have trimmed modestly oil demand growth expectations in a few countries where domestic product prices are allowed to rise more quickly, but retained our previous growth rates in countries where price controls are likely to remain. On balance, we anticipate that total non-OECD oil demand will gain by 3.0%, or about 1.1 MMB/D in 2005, a reduction from last month’s report by 100 MB/D.

 

Global Supply Highlights
|  Summary  |  Viewpoints  |  Demand  |  Implications  |
|  Non-OPEC  |  OPEC and Inventory  |

Non-OPEC

The largest impact this year on world oil supply remains the shut in production in the U.S. Gulf of Mexico as a direct result of Hurricane Ivan. At the writing of this report the Minerals Management Service reports that 471 MB/D of crude oil and 1.7 BCF/D of natural gas remain offline.

The cumulative volumes shut in from September 11 through October 14 total 19.864 million barrels of crude oil and 84.326 BCF of natural gas. Although it appears that about one third to one half of the shut in output will be back online by the end of October, whatever remaining volumes are to recover will not do so until some time in the first quarter of next year.

The shut ins have led to total United States crude oil production falling to the lowest levels in over half a century. For 2004, the impact of hurricane season combined with underlying decline rates onshore will lead in our estimate to a 5.4% drop in U.S. crude oil production.

On the other side of the “pond”, we estimate that U.K. production will decline by 3.7% this year, and aside from the impacts of Ivan the declines in output in these two important Atlantic Basin producers has contributed to the widening of the light/heavy crude oil price differentials to historical levels.

The other component of the widening spread has been the concomitant “pull” by China of light sweet crudes out of the Atlantic Basin to balance its refinery crude oil slates.

While we believe we have correctly identified the declines in the U.S. and U.K. as major factors that distinguish our view of non-OPEC supply from that of the IEA and others, we freely admit we underestimated the price impact of the phenomenon in 2004.

Looking at next year, we continue to believe that the IEA in particular will end up overestimating the growth in non-OPEC production since their latest report still anticipates a rise of about 1.3 MMB/D.

Due to the impact of Ivan this year our numbers now reflect a small gain in U.S. production in 2005, but we would still suggest the decline curves in mature onshore areas will be steeper than consensus expectations. Likewise, we would be looking for a further decline in U.K. production.

The picture for the FSU and Russia in particular remains blurry, but if the government ends up parceling out Yukos assets to other Russian companies, we would be surprised to see production rise at a stronger rate than what we have assumed.

On balance, we expect total non-OPEC production to increase by 870 MB/D next year, an upward revision in the rate of growth due to the depressive impacts of Ivan this year, but a reduction in our forecast level for next year of some 25 MB/D.

 

OPEC and Inventory

Recently Saudi Arabian oil minister Ali Naimi has tried once again to talk the market down, but to no avail. Although he emphasized that the Kingdom now has sustainable capacity of 11.0 MMB/D due to new projects coming onstream this year, speculators have recognized that the implied 1.5 MMB/D of spare capacity is not in demand by refiners since they are “maxed out” in terms of desulphurization capacity.

The magnitude of the sour crude oil surplus now on world markets is reflected in the WTI-Dubai differential of about $13.00 per barrel. Our customary table below lays out our estimates of production for the “OPEC 10” for the month of October compared to the November 1 quotas. We do not believe that production levels have changed materially over the last month or so.

Some OPEC ministers have indicated they are considering raising the official ceiling once again when the Organization meets in December, but as we have discussed in the past such action has less meaning today than it might if, as we anticipate, the demand for Saudi crude declines next year.

Our updated balances suggest that for 2005 the demand for Saudi crude oil will not materially exceed 8.5 MMB/D under our latest demand assessment, which implies a decline in Saudi production of 1.0 MMB/D from current levels. This fall includes the impact of our reduced forecast average for Iraq next year to a bit under 2.7 MMB/D under the assumption that some degree of chaos will continue accompanied by intermittent disruptions to exports.

Our balances do not anticipate that the sweet crude producers within OPEC will reduce output to any material degree in large part because the demand for their crudes should remain high. In terms of capacity, we believe there will be modest increments in sweet crude production capacity in Algeria, Nigeria, and Libya, but the total may not exceed 100-200 MB/D.

Under our current Base Case with the demand for Saudi crude oil averaging about 8.5 MMB/D next year, we believe excess capacity in Saudi Arabia will rise to 2.5 MMB/D, under the assumption that some wells will not be closed as originally planned when this summer’s projects came onstream.

For the rest of OPEC, we are looking for an increment to capacity of about 500 MB/D, with the additions by sweet producers discussed above complemented by modest gains in Kuwait and elsewhere.

Our balances imply a need for “OPEC 10” crude oil production next year averaging about 26.0 MMB/D assuming no net stock build relative to the end of 2004. Comparing this to capacity expansions and the reduced demand for Saudi crude, our numbers imply total OPEC spare capacity of about 3.0 MMB/D in 2005, but largely composed of sour and heavier crude oil.

.

Implications for Price
|  Summary  |  Viewpoints  |  Demand  |  Supply  |

We have discussed over the years the inability to accurately forecast crude oil prices, specifically WTI, on the basis of world oil balances due to a number of non-fundamental factors and quality issues, particularly in terms of WTI.

We had discussed previously that we had been commissioned a number of years ago by Saudi Aramco to try and quantify a precise relationship between the days supply of world usable commercial, or discretionary, inventories and price.

We were able to conclude that based on the broad history of the industry between 1980 and 2000, there was a loose, but roughly consistent relationship between the days supply of global discretionary stocks and WTI.

Those relationships have obviously been thrown out the window this year for a variety of reasons. We have argued previously that because of the overall status of oil as a “depleting” resource, not because the reserves are finite but because of the rising cost of maintaining capacity, that periodically an upward “correction spike” is required to adversely impact demand and elicit supply to rebalance markets. Such a periodic “step function” adjustment has characterized the international petroleum industry since inception.

While we remain convinced that over the next several years today’s oil prices will lead to accelerated conservation and fuel substitution, our monthly report tends to concentrate on the following calendar year.

In this regard, in recent briefings we have emphasized our lack of optimism regarding the situation in Iraq and the existence of what we have termed a “rotating powder keg” amongst producers worldwide.

In our new and unfortunate age of terror and terrorism, we cannot rule out surprise uncertainties and even supply interruptions from a variety of sources. Such a scenario will tend to underpin oil prices even if, as we suspect, there will never be a material or sustainable disruption from Saudi Arabia.

This is an altered situation from the past, where whenever there has been an interruption in supply leading to a price spike, the market rightly appreciated the fact that the problem was localized with little probability of spreading. This led, over time, to immunity on the part of market participants, who then refocused on prevailing fundamentals.

In this new and altered state of supply risk, therefore, we believe prices will incorporate a security premium for the foreseeable future, and it is completely unpredictable when such a premium will completely erode.

In terms of fundamentals, while as we discussed before select OPEC countries should be able to increase sweet crude oil capacity in 2005, the increment is expected to be modest, perhaps some 100-200 MB/D.

This argues for a continued historically wide sweet sour/crude oil differential, although we would expect the spread to narrow from current levels under our anticipation that the demand for Saudi crude oil will decline next year, leading to a curtailment of Arab Heavy sales.

Also, even though we believe that oil demand growth in China will finally slow, it will still rise by some 400-500 MMB/D. This will lead to some continued pull on sweet crudes out of the Atlantic Basin, though perhaps not quite to the extent of this year.

There is also no evidence at this time that managed funds and CTAs will exit their oil length en masse. Commodity exposure has now become de rigor among many conservative institutions as well as hedge funds, and given the recent sell off in metals and other commodities, oil may end up the “last game in town” due to its status as a heating fuel whose demand will rise this winter irrespective of world economic growth. Adding to its allure, as discussed above, is that likelihood that political uncertainty will remain with us indefinitely.

We remain confident that heating oil supplies will prove to be adequate this winter, and thus the current hype that has resulted in $50.00+ WTI should wane. Nonetheless, for all the fundamental and psychological reasons outlined above, it now appears that a 2005 average of $40.00 per barrel is more appropriate under the environment we envision.

William H. Brown, III