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Fundamentals, fear to keep oil prices in a narrow range

ABU DHABI — Fundamentals and fear form the key ingredients of the oil market drama, pointing to a weaker market as the season is drawing to a close and stocks build up further, says a report of Centre of Global Energy Studies (CGES).

‘But the fear will remain as long as unrest continues in Nigeria, Iraq stays chaotic and Iran continues to defy the major powers over its enrichment programme,’ the report said.

According to CGES these two forces should offset each other, keeping the oil price within a narrow range over the next six months at least, but the uncertainties are great and the slightest deterioration in the fragile geopolitical scene could send the price soaring once again.

Meanwhile, other wider considerations are looming ever so larger on oil's radar screen. The world's main engine of growth, the US economy, is slowing and the upward trend of the major economies' interest rates in response to rising inflation — triggered in part by the surge in oil prices — will weaken global economic growth.

The oil price is thus being pulled in two different directions by the tug of war between real barrels and anxieties. Oil demand growth slowed up considerably last year (1.3 per cent) after the exuberance of 2004 (3.9 per cent).

‘This year we are expecting even slower growth of 1 per cent (+0.9 mbpd) and the US is already laying its marker with a zero increase in demand over the first seven and a half months of the year,’ the report said.

It is true that apparent oil demand is surging in China, up by 0.7 mbpd, year-on-year, but half of this increment may be due to re-stocking after last year's heavy inventory draws. Incremental non-Opec oil supplies, on the other hand, should be much healthier this year after their non-appearance in 2005.

Additional non-Opec oil and Opec NGLs of 1.1 mbpd yields a large 0.7-mbpd reduction in the need for Opec oil this year upon inclusion of last year's 0.5-mbpd global stockbuild.

So far Opec's output is indeed down, but only by 0.2 mbpd, suggesting that crude oil prices should have been weakening instead of surging. There are two explanations of the contra-fundamental movement of crude prices in 2006: one has to do with real barrels and one with the paper market.

Oil demand growth, although much weaker than before, is concentrated in the transport fuels sector and the world's refining system remains unable to produce enough of these fuels to satisfy demand.

Complex margins are thus at record highs, but simple margins do not cover variable refining costs. To do so requires much cheaper heavy, sour crudes, but the Saudis appear unwilling to discount their heavy grades sufficiently.

Refiners are thus facing a floor for crude prices and some are using abundant uncracked fuel oil in their upgraders instead.

Incidentally, the loss of Nigerian sweet, light crude oil has made the provision of transport fuels much more difficult and led to Brent commanding a premium over WTI.

To the 'demand pull' of certain product prices on crude we must add the 'tug' of futures prices, especially in the outer months. The market remains deeply concerned about the industry's ability to meet the demand for oil over the coming winter given the ongoing civil unrest in Nigeria, the mayhem in Iraq and Iran's threats to use oil as a weapon in its looming confrontation with the UN Security Council over nuclear enrichment.

These fears are channelled mainly into the futures market, where the non-commercials on NYMEX have been net long since the end of March '06.

An easing of tensions could cause a sell-off in the futures markets without hedgers like airlines and utilities stepping in to take the slack, in which case a combination of rising inventories and falling futures prices would cause a major oil price correction.

However, if anxiety levels remain high, the industry will want to hang on to its stocks — high though they may be — and the futures market will lend its support, as it has been doing for many months now.

On balance, the CGES thinks political uncertainties and product market constraints will keep crude prices from responding to the evolving fundamentals.