The Observer: For once, the worry is that oil may be getting a little too cheap

But analysts are divided as to why – and what might happen next. Oliver Morgan reports

Sunday October 1, 2006

Nothing spooks the markets like the oil price. The fear of running out, the threat of terrorism, panic over US house prices, all of these are built into that most volatile of sums: the price of a barrel. Now, after years of fretting over rising prices, traders and economists are finding reasons to shiver over its fall, and what it tells us about the global economy.

So last week, instead of worrying about confrontation between the US and Iran – concern that helped drive oil to a $78 August peak – the fears were of a nasty US slowdown, thanks in part to a crumpling housing market, that will undercut demand for crude. The price fell to $60, a six-month low.

Is that fall here to stay, and is it really a harbinger of economic doom? It depends whether what has happened in recent weeks is driven more by real changes or by the feverish speculation of traders.

Recent economic data offer some support for the fears. In the first quarter, US GDP grew by 5 per cent year on year, falling to 3 per cent in the next. In August US house prices fell for the first time in a decade. Morgan Stanley sees a 23 per cent chance of a recession next year.

Paul Horsnell, oil analyst at Barclays Capital, understands the worry: ‘There are plenty of traders in the market who believe that the US will grow by only 1.5 per cent next year.’ In a note last week he went further, saying that this is the ‘modal expectation’ across the market, as is a hard landing in China, whose voracious economy has supported commodity prices in recent years.

Short positions have multiplied, indicating that the market expects short-term falls. But are the bears right? Horsnell thinks not. He points to his own bank’s forecasts for US growth next year of some 3 per cent (the IMF has 2.9 per cent, down from 3.4 this year), and global economic growth of 4.7 per cent – admittedly down from this year’s 5.1, but not, he says, ‘a path that could be described as a hard landing’.

Economists elsewhere point out that the oil price will have its own effect on the US economy in particular. Kevin Gaynor of RBS says that with oil making up 8-10 per cent of consumption, a fall in the price of 15 per cent would add up to 1.5 per cent on consumption. He believes that US growth will be about 3 per cent next year, and consequently says he is ‘not bearish’ about the oil price.

Concerns about economic demand, however, are not the only cause of the recent price fall. Fatih Birol, chief economist at the International Energy Agency in Paris, says: ‘The reason it has come down is not market fundamentals, it is the easing of geopolitical tensions in Iran, Lebanon and elsewhere.’

Here, analysts are not convinced that there will be a lasting effect. Birol explains: ‘This is a key reason why people have expected high prices in the past. But there is no reason to think there has been substantial change. The media go from one day to another looking at Lebanon and Iran; they also look at Venezuela and Russia, where some companies have been having problems with Sakhalin. I do not think there has been a major change in the geopolitical situation, and I would be surprised if prices this year or next go much below $50 a barrel.’

But they could if there were a dramatic change in the balance of supply and demand. The key players here are the Opec nations, chiefly Saudi Arabia. While non-Opec countries produce some 62 per cent of the world’s oil, investment in regions such as the Gulf of Mexico and Siberia is only maintaining production at current levels.

Opec, however, at an estimated 29.9 million barrels a day, is pumping out 400,000 barrels fewer than at this time last year. At its last meeting in Vienna it said that increased production over the past few years had led to growing stockpiles and, although it would not announce a cut in production to support the price, it did not rule one out later this year.

As with the oil market in general, however, nothing with Opec is simple. The difference between what it does and can produce should be accounted for by the quota system which limits individual countries’ production. Few pay attention to this – the official limit should be 28 million barrels per day (mbd).

Leo Drollas at the London-based Centre for Global Energy Studies (CGES) says that Saudi Arabia will determine whatever Opec does. The kingdom has taken a hands-off approach in the past year by allowing its production to drift down by some 300,000 barrels rather than orchestrating any cuts. It manages this by not selling its crude – which is ‘sour’ and medium-weight, a grade that costs more to refine than the lighter and ‘sweeter’ US grades – at a discount.

Drollas says that if Opec production continues at present levels, prices could fall below $50 a barrel. ‘If you want to keep prices at $60, Opec production has to fall to 29.4mbd (a 500,000 cut) in the last quarter of this year and to 29mbd in the first quarter of next. The big question is: who is going to do it?’

There are few candidates. According to CGES figures, Venezuela is producing at well below its quota; it will not want to cut because it needs to maximise revenue. The same is true of Indonesia, Iran and Nigeria. The north African countries – particularly Libya, where Colonel Gadaffi is seeking favour with Western oil companies – may try to increase, but are harder to read.

Drollas believes that Saudi Arabia, which is producing above its cap, but some 2mbd below capacity, will not move until either the price falls below $50 or it finds its production drops by too much. ‘If the Saudis have to cut by 500,000, they will demand action by the others,’ he says.

According to most analysts, with no fundamental change to geopolitical threats, much will depend on the supply of oil. A lot has been made of investment in Canada, the Mexican Gulf and Russia. However, Birol maintains that in the long term non-Opec investment will continue only to keep production standing still. As he says, only one in every four dollars invested in new capacity around the world will add to production.

In the Middle East, particularly in Saudi Arabia, there has been high investment. But Birol points out that much of the capacity will be in medium-sour grades, and could result in a mismatch with refining infrastructure, causing a bottleneck downstream after 2010.

There are also concerns that much construction work has been delayed, and that if, as forecast, demand continues to rise between now and 2010, hopes of a 6mbd surplus of capacity over demand look hopelessly optimistic.

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