THE BUSINESS REVIEW FOR PROCUREMENT LEADERS
by Kona Haque
International oil prices have been climbing steadily since the beginning of
the decade amid tightening global supply and demand conditions. From lows of
about $25/barrel in 2001, crude oil prices soared to a record high of $70/barrel
in September. Although prices have come off their recent highs, at about $60/barrel,
they are still some 40 per cent higher than at the beginning of 2005.
While the world has become more efficient in its use of oil since the 1970s
and 1980s (the oil intensity of economic activity has fallen by half over the
past 20 years), high prices are inevitably placing a heavy burden on oil consumers.
Why have oil prices been rising?
Rising prices over the past
two years have been primarily driven by rapidly increasing demand, at a time
of only limited investment in capacity expansion.
While the world’s major oil consumers – namely the OECD nations – have
been maintaining healthy rates of demand, it has been the emerging markets
(notably China) where the most significant increases have taken place.
In 2004, global oil demand grew by 3.5 per cent – the fastest rate of growth in more than 20 years. This unprecedented rise caught oil producers unaware. The Organisation of Petroleum Exporting Countries (Opec) and other oil producers found themselves having to pump out oil at record levels to keep up with demand, squeezing spare production capacity to uncomfortably low levels. The reduction in this cushion against potential global oil supply disruptions, coupled with a bottleneck in refinery capacity, has heightened the market’s vulnerability to supply shocks, increasing the sensitivity of prices.
What are oil producers doing to meet rising demand?
Although there are plenty of oil reserves left in the world, overcapacity,
lower prices and high production costs in the 1990s led to underinvestment.
Oil companies enhanced existing reserves rather than exploring new ones.
However, with prices so high, oil companies are finally beginning to spend more on exploration and production. The Economist Intelligence Unit forecasts that global oil supply will rise by 2 per cent in 2005 and 3-4 per cent in 2006 and 2007.
Several Opec members (including Saudi Arabia, Libya and Nigeria) are expanding their crude oil capacity over the next two years. Producers in non-Opec countries are also expanding production, although weaker supply growth in the Gulf of Mexico, the North Sea and Russia will offset growth in Angola, Canada, Azerbaijan, Brazil and Sudan.
Are the high prices affecting demand?
Rising prices have had remarkably little impact on overall demand levels so
far, suggesting a low degree of elasticity. The backdrop of strong economic
growth has allowed most countries to better weather the price rises.
However, there are growing signs that the major oil-importing countries are beginning to hurt. This is particularly so in non-OECD economies where governments maintain artificial oil price ceilings. As these are gradually lifted, demand is becoming more price-responsive and falling back. In the US, the soaring of gasoline prices following last summer’s hurricanes had a psychological impact on fuel consumption there. Chinese apparent demand growth has also been softening in 2005 (expected to rise by just 4 per cent, compared with 16 per cent in 2004), although we believe there is still substantial pent-up demand.
Overall, global oil consumption will grow by about 2 per cent a year through 2006-07, reflecting the expected moderation in global GDP growth and some adjustment to the high prices.
What is the price outlook for 2006-07?
We expect the market to remain very tight for some time, with prices
for Brent crude oil averaging $56/barrel in both 2005 and 2006. In the short
term, the
onset of the winter season will support prices as demand for heating oil strengthens,
but in the second half of 2006, prices will start to ease as new capacity is
built.
In 2007, prices will weaken more sharply (to less than $50/barrel) as demand decelerates, while stock levels continue to build up and further investment is made in expanding global oil production.
Prices will remain volatile, however, as many of the risks prevalent in 2005 are unlikely to disappear in the next two years. Ongoing supply-side delays and interruptions, renewed terrorist threats, political uncertainty in Iran, Iraq, Nigeria and Sudan, and unpredictable weather factors all provide upside risks to our price forecasts.
Kona Haque (konahaque@eiu.com) is chief commodities analyst at the Economist Intelligence Unit in London.
