What now for oil prices?

Jonathan Waghorn and Mark Lacey, portfolio managers and energy specialists at Investec Asset Management, comment on the outlook for oil prices following recent record highs.

Let’s start with OECD demand, which has started to show some signs of weakness

OECD-North America demand fell around 3% in the first quarter, despite near normal weather conditions that should have supported distillate demand. We believe that the weakness is in transportation – both in terms of the gasoline usage and major airlines retiring 4% of global capacity. We have repeatedly stated that per capita oil consumption in the US (which is currently at around 25 barrels per year per capita) would have to reduce over time, given that OECD is closer to 15 barrels per year per capita.

But what about non-OECD demand?

Interestingly, 85% of global demand growth for oil over the next two years is from countries that are subsidising prices. The three regions that subsidise prices are China, India and the Middle East. China’s net subsidies are around $45bn a year (a figure which we believe is affordable). However, the two countries where we would question the sustainability of the subsidies on a long-term basis are Indonesia and India (NOTE: we would not expect India to reduce subsidies ahead of the election this year).

China’s demand for both crude and products has been strong for the year to date, but the year on year growth rate slowed in April to around +3.7%, which compared to around 5.5% for the first 3 months of the year. One month’s data is NOT a trend, but we will be looking closely at this, stressing that a further reduction of the year on year growth rate over the next few months will likely result in some weakness in near-dated crude prices over this period. Oil demand from Russia remains robust and the fact that car registrations are up around 60% year on year has flowed through into very strong transport product demand.

So with this ‘mixed’ demand data, why has the Brent crude price been so strong?

Just like the last seven years, non-OPEC supply continues to be well below expectations. Recent data suggests that Russian oil production is at its lowest in 18 months (April production at 9.7million barrels per day (b/d) was down 0.8% year on year).There are two major projects starting up over the next 18 months, but even taking this into account, Russian production has downside risk over the next few years unless we see a significant increase in the pace of capital spending. Mexico’s production continues to disappoint, with their largest oilfield (Cantarell) suffering a decline in production rates of 25% year on year. Other projects operated by ‘the major’ oil companies also continue to be delayed, with the well known giant Kashagan field now expected to start up in 2013, eight years behind the original schedule!

The International Energy Agency (IEA) reported that for the first quarter non-OPEC supply was effectively flat year on year, with a 200 000 b/d increase in ‘biofuels’ offsetting a similar decline in oil production. Whilst the IEA are forecasting an increase of 425 000 b/d in non-OPEC production in 2008, we believe that this is likely to prove optimistic, given that decline rates continue to exceed expectations. Like the first quarter of this year, we expect non-OPEC production to remain flat in 2008.
Saudi Arabia does to a certain extent come to the rescue, with the giant ‘Kursiniyah’ field coming on stream recently, which will add 500 000 b/d of crude production and a further 300 000 b/d of natural gas liquids. Following this, two other fields (Shaybah & Khurais) will add around 1.5 million b/d of capacity by the end of 2010. We would stress, however, that this new production could well be partially offset by the natural decline rate of Saudi's oilfield over this period.

So what about the recent sharp increase in oil prices?

We have never tried it, but apparently if you boil a frog slowly he will not jump out! Similarly, we continue to believe that while consumers react to significant percentage increases in prices over a short period, over time they actually do ‘structurally’ adjust to gradual increases in commodity prices. Given that crude has increased an incredible +40% in the last five months alone, we would expect to see some continued near-term negative demand data, which is likely to limit the upside in crude prices from current levels. Ultimately, however, costs will provide downside support, and we estimate that the ‘marginal’ cost of extraction is likely to be over $100/bl for 2008 and beyond.