Business Week: Oil: OPEC in Charge, $90 on the Way?

July 20, 2007, 1:40PM EST text size: TT

With supply flagging, prices could reach exorbitant levels by fall, but experts say the world economy should be able to handle it
by Stanley Reed

Over the past few months, the oil markets have sharply changed course. After dipping below $60 per barrel in early 2007, prices have come roaring back. U.S. benchmark West Texas Intermediate (WTI) crude is now trading at $76.19 per barrel, its highest level since last August.

What’s even more striking is that the OPEC Basket, which is composed of heavier, lower-quality crude oils, hit an all-time peak of $73.23 per barrel on July 19. The OPEC Basket usually trades at a substantial discount to the Western marker crudes, Brent and WTI, but the differentials have narrowed as thirsty consumers in the U.S. and emerging markets push the pedal close to the floor.

In a relatively short time, the market psychology has turned around nearly 180 degrees. Last fall, there was worry about an overhang of non-OPEC supply, compounded by concern about a drop-off in demand growth. Added to that was a seeming willingness by OPEC to pump enough to keep plenty of oil in Western tanks.

A few months later, none of those assumptions turns out to have been correct—and traders have moved into record long positions in crude oil futures. Thanks to project delays, production outages, and steep declines in aging fields, the anticipated huge new supplies of oil from non-OPEC sources look unlikely to materialize (see BusinessWeek.com, 06/28/07, “The Problem’s Not Peak Oil, It’s Politics”). Paul Hornsell and Kevin Norrish, analysts at Barclays Capital, the London-based investment bank, peg new non-OPEC supply at a skimpy 500,000 barrels per day for 2007 and zero for 2008.

Low Supply, High Demand

Growth in demand is expected to be robust—in the range of 1.5 million barrels per day this year and next. But it will be almost entirely up to OPEC to slake that thirst. And the oil sheikhs, stung by the price plunge early this year, have responded by tightening supplies, taking significant amounts of crude off the market.

“Global crude oil production is over 1 million barrels per day lower than last year, while global demand is over 1 million barrels per day higher,” says Jeff Currie, an analyst at Goldman Sachs (GS) in London. Tracking rising oil prices, shares in majors such as Total (TOT) and Royal Dutch Shell (RDSA) are up more than 30% from their 2007 lows, set in early-to-mid March.

The runup in oil prices to date isn’t going to wreck the world economy, experts say. After all, prices are now comparable to their peak last year, so there has been very little actual energy price inflation—one reason demand hasn’t taken much of a hit. Europe’s economies, in particular, are likely to be insulated from the price rise by the concurrent weakening of the dollar—which is still used for nearly all oil trading—against the euro and British pound.

‘Full-On Bullish’

The big question is where prices go from here. Last summer, after the much-feared hurricane season turned out to be a pussycat, prices began dropping sharply. Analysts now say that hurricanes or not, this year will be different unless OPEC opens the spigot. In fact, Goldman’s Currie thinks that if OPEC doesn’t “bring on supply by autumn, prices by the end of the year will be over $90 per barrel.”

Currie calls the recent shift in the oil futures curve to so-called backwardation, meaning forward prices are lower than current prices, a “full-on bullish” sign. On the other hand, he says that a loosening signal from OPEC would immediately knock $5 to $10 off the per-barrel price of oil, as speculators liquidate their record long positions. But OPEC countries, whose own rising domestic consumption is cutting into exports, may be saving up their spare capacity for a more serious fight.

Not everyone is convinced that the likely trend is up. Indeed, David Kirsch, an analyst at Washington-based consultancy PFC Energy, says prices could even ease by the end of the year. “Supply concerns are somewhat overstated, with crude oil inventories in relatively good shape globally—and ample in the United States,” Kirsch says. “We expect prices to ease to an average of $68 per barrel in the fourth quarter.” Still, with concern growing around the world about long-term supplies and OPEC firmly back in the driver’s seat, the floor for prices seems likely to be quite high for the foreseeable future.

Reed is London bureau chief for BusinessWeek.

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