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Oil prices will not edge below $50

Reasons for high oil prices in a nutshell: Worldwide petroleum demand growth is projected to remain robust during 2005 and 2006, although not as strong as in 2004, despite high projected oil prices. The three main drivers of oil consumption-energy, transport, and petrochemicals — all continue to grow rapidly.

It is expected that worldwide oil demand will grow at an annual average growth rate of 2.5 per cent in 2005 and 2006, or in other words, 2.1mbpd. Although the projected growth rate is a slowdown from 2004's 3.4 per cent, it is still a rapid rate when compared with an average annual growth rate of 1.5 per cent since 1990.

China is the single most important factor behind the surge in demand. Chinese demand growth is expected to remain robust at an annual average of 600,000 b/d in 2005 and 2006. This figure, however, is a little lower than that witnessed in 2004 where Chinese oil demand growth averaged about 1mbpd.

It is also expected that China will build another large strategic oil reserve later this year amid rumours of continuing power shortages, implying that diesel-fired generators could again be needed to meet electricity needs. These generators will in turn require large fuel imports.

Moreover, the US demand growth will still be strong in 2005 and 2006 as it is projected to average 300,000 b/d, or 1.5 per cent per year. This too, however, is down from the 480,000 b/d, or 2.4 per cent increases in 2004.

The growth in non-Opec supply is not expected to accommodate worldwide demand growth. Non-Opec supply is projected to grow by an annual average of 0.8mbpd during 2005 and 2006, below the annual average growth in the 2002 through 2004 period. Thus, the outlook for oil production is not encouraging.

Russian oil output, the driver of non-Opec supply, has been experiencing a sharp decline in growth rates in recent months. Output growth reached 12 per cent in mid-2003, and eased down to 10 per cent in early 2004. However, in the first quarter of 2005, year-on-year growth slowed to 4.6 per cent.

Worldwide spare crude oil production capacity has diminished. Actually, only Saudi Arabia has any available spare production capacity. However, that Saudi spare production capacity is now down to just 0.9-1.4mbpd, leaving little room for increased Saudi production if needed.

In addition, although it is expected that there will be capacity additions in Saudi Arabia and other Arabian Gulf countries in 2005 and 2006, spare capacity is not projected to grow significantly over the next 2 years.

Refining capacity: Downstream sectors like refining and shipping are expected to remain tight. The Economist Intelligence Unit (EIU) points out that there is little sign of additional investment in upgrading or expanding refineries. As the demand for products is likely to remain strong, refiners will be working at full capacity. US refinery utilisation rates averaged 93 per cent in 2004. Thus, any refinery outage would be felt immediately and possibly for an extended period of time.

Geo-political risks, as seen in the continued insurgency in Iraq, the terrorist attacks in Saudi, and the troubles in Nigeria will keep the level of uncertainty in world oil markets high.

High levels of production from Opec members contributed to inventory build in OECD countries from February through November 2004. Nevertheless, the Energy Information Administration (EIA) points out that the OECD stocks have not grown in terms of days-of-supply (the number of days that inventories would satisfy demand) since demand has grown rapidly too.

It is expected that there will be little growth in OECD commercial oil inventories over the next 2 years. Moreover, even though US crude oil inventories are much improved compared to this time last year, the EIA expects this improvement to dissipate over the mentioned period.

With non-Opec production slowing, the global market will increasingly turn towards the major oil group to meet its incremental needs. Indeed, the year 2004 witnessed an increased demand on Opec supply. This 'call on Opec' led to a gradual rise in official quotas which continued into 2005 as demand continued to grow.

The implications for Opec members and the world oil market are of great significance. With little new capacity currently expected to come on stream in the short term, the increase in Opec production means that the group's members are producing near full capacity. Thus, the expected rise in demand will further place an upward pressure on 'the call on OPEC' and possibly spot prices if Opec cannot respond because of the limited spare capacity.

Risk to global economy: Whatever the outcome for global demand growth, global spare capacity is likely to remain low, leaving the global economy exposed to the risk of significantly higher oil prices arising because of an unanticipated supply disruption. This suggests that prices will continue to be sensitive to ongoing geopolitical tensions. Thus, capacity expansion projects undertaken by Opec members will be crucial and more likely to take place than in non-Opec countries, as the competitive nature of the non-Opec sector suggests that non-Opec producers are unlikely to play a strategic role in maintaining spare capacity.

In fact, the effect of the increase in the production of producers such as Opec Middle Eastern countries and African states is being limited by the declines in mature producing regions like non-Opec Middle East, Australia, and the North Sea. As the EIU indicates, as Russian production growth slows, gains from new deep-water and off-shore projects will be critical for keeping non-Opec supply growth near the averages of the last few years. However, the recent huge revenues have not led to further exploration and production spending, as most major international oil companies have been preferring to invest in share buy-backs and other schemes.