Oil prices merit re-examining of supply/demand fundamentals

The supply and demand curves for oil aren't behaving the way we were taught they should. Consequently, every drop counts.

Last year's relentless upward surge in oil prices was different from other increases, and not only for the heights it reached. Never before had the benchmark price of West Texas Intermediate (WTI) crude passed even $45/bbl, much less $50. And the caveat that "real prices were higher in the late 1970s" was little more than cold comfort.

No, 2004's price surge was different because of what ýthe chartý said. Which chart? One of the first you see in Economics 101, with demand going in one direction along the price axis, supply coming the other way, and both intersecting nicely and neatly.

The problem with "the chart," however, was that, although every student could see that supply increased with price, they could also see that at a certain point supply couldnýt go any higher because there was none left. The price of oil has surged plenty of times in the past. But spikes in other years always seemed to be associated with a particular event that could be cited as their cause: the Arab embargo of 1973ý1974, the Iranian Revolution of 1979, or the disappearance from the market of Iraq and Kuwait in 1990ý1991 following Saddam Husseinýs invasion of the latter. Even during price surges in those times, the world always had enough surplus capacity to produce more oil. Always, there was the belief that once the ýtemporary market situationý was resolved, there would be a return to normalcy. Normalcy was essentially guaranteed by the worldýs spare capacity.

Defying expectations

But the oil price surge of 2004 wasnýt caused by any event. Instead, it could be explained by referring to that portion of "the chart" where the supply curve no longer follows the price curve. What's more, even as the price of oil moved into the $50 territory, on the chart the demand curve was defying Economics 101 lessons by refusing to flatten.

To be sure, factors that are somewhat political could be blamed for this year's imbalance, as in the past. But it remains to be seen whether those factors are temporary or should now be considered permanent features of the oil industryýs landscape.

For example, Venezuelan production, which was so battered in early 2003 by an oil workers' strike that it affected the worldwide industry, was showing no sign of rebounding in late 2004. Today, no one is even bothering to guess when it might come back to pre-strike levels. Platts data in fall 2004 put the current level of Venezuelan production at 2.65-mil bbl/day. Prior to the strike, it exceeded 3.1-mil bbls.

Another factor to consider is the continuing sabotage of Iraq's oil infrastructure. It means that Iraqi production and exports can no longer be included confidently in calculations of the worldýs regular supply. While production has been inching higher as a result of the sabotage, it is a long way from reaching the sort of pre-war bonanza that some had predicted would accompany the end of Saddam Hussein's regime.

Time for a new model?

Energy economists who believe the global oil industry is nearing its productive peak might refer to the events of the past several months as a sign that "The Big Rollover" is nigh. It was defined concisely in one presentation as "when demand for oil outstrips the capacity to produce it."

In October there was enough red meat in the International Energy Agencyýs (IEA's) monthly report to satisfy legions of Big Rollover believers. For example, the IEAý whose monthly numbers are both roundly criticized for their level of accuracy and awaited with almost religious fervorýsaid worldwide supply was clearly reacting to movement down the price axis. The report noted that it had risen in September to a new high of 84-mil bbl/day and had been boosted by output increases from Iraq and Saudi Arabia. The figure, the report added, would have been higher had it not been for scheduled North Sea maintenance and the unscheduled Hurricane Ivan, which ripped through the Gulf of Mexico. In other words, supply reacted to prices and demand, as expected.

However, the report also said that the world's total sustainable capacity sitting on the sideline was "well below" 1-mil bbl/day. Though it is acknowledged that - in a pinch - OPEC could bring on another 1.5-mil to 2-mil bbl/day of capacity, such an increase probably could not be sustained for very long. Accordingly, the academic model that says supply will always increase as prices rise may no longer apply in the oil industry due to the structural reality of limited capacity. Nonetheless, the IEA's October report does project that worldwide supply will rise in 2005.

It sees non-OPEC production rising from 50.1-mil bbl/day in 2004 to 51.4-mil bbls in 2005 - an increase of 1.3-mil bbl/day. With world demand forecast to rise by 1.5-mil bbl/day annually, OPEC will be called upon to fill the 200,000 bbl/day gap. And also worth keeping in mind is that demand estimates are just that, and are usually revised upward rather than in the other direction.

Something else worth pondering is the mystery of what will happen to OPEC's sustainable capacity next year. Will it rise as much as or more than the increase in non-OPEC output? Whereas energy economists occasionally can get a peek into the capacity of some OPEC members with extensive western investment - such as Algeria - the amount of oil that might come out of a place like Kuwait or Iran is not particularly clear.

Wrong number

A quick look at the IEA numbers for the fall of 2004 could provide some comfort to consumers. The IEA does not project OPEC output. What it does provide is an OPEC "call," what the organization says the world will need from OPEC to fill the gap between non-OPEC production and world demand. That call in the fall of this year was less than 28-mil bbl/day - which appeared to be great news, because OPEC at the time was producing about 30-mil bbl/day.

The only problem with this picture is that it looked a lot like the one painted in the fall of 2003, and a year later oil was at $50. In both 2002 and 2003, IEA projections at the end of the year indicated that non-OPEC supply growth would just about match total world demand growth, and that any additional OPEC output would lead to downward pressure on prices. During that period, there also was talk about significant strife in OPEC, as members with growing productive capacity wanted to bring more oil to a market that was having all of its increase in demand serviced by non-OPEC members.

That didn't happen. The reason is simple: Demand surged. In the fall of last year, the IEA projected that worldwide demand for oil in Q1 2004 would be 79.8-mil bbl/day. It turned out to be 82.4-mil barrels. The IEA also projected that Q2 2004 demand would be 77.4-mil bbl/day. It ended up being 81.1-mil bbl/day. That meant that rather than OPEC fighting over a static market share, as was predicted, the world needed just about every last barrel that both the cartel, and anybody else with a rig, could bring to the market. The specter of the Big Rollover loomed. Underestimating Chinese demand.

What the IEA and just about everyone else missed was the big surge in Chinese demand. The Chinese have now moved beside Japan as the worldýs second-largest consumer of oil, behind the US. The IEA projects full-year 2005 Chinese demand at roughly 6.7-mil bbl/day. If it materializes, the demand figure will represent an increase of almost a half-million bbl/day from the beginning of 2004 and a whopping 1.1-mil bbl/day increase over the average full 2003 level. In other words, Chinese demand for oil will have grown 22% in just two years if the IEA number pans out. (For the record, the IEA projects Japanýs average daily consumption next year at 5.4-mil bbls.)

When looking at Chinese overall demand figures, it's interesting to examine some of the component numbersýparticularly the numbers quantifying the way China now interacts with the rest of the world. For example, China has become a huge importer of fuel oil, which increasingly powers the country's electricity generators and factories. Between January and June of 2004, Chinaýs imports of the fuel rose a stunning 54%. But even more stunning is that during the same period, Chinese imports of gasoil rose 172%. However, in physical terms, Chinese gasoil imports over the six-month period were far smaller than those of fuel oil: 1.1-mil mt of the latter versus 16.4-mil mt of the former. Despite the enormous growth in the number of cars on Chinese roads, the country still is a net gasoline exporter. But gasoline exports for the first six months of the year were down 35% from the same period in the previous year because internal Chinese markets were consuming ever-rising quantities.

Waiting for demand to drop

However, China's unanticipated appetite for oil wasnýt the sole cause of the IEA's underestimation of worldwide demand. For example, going back to those IEA projections of fall 2003, the IEA said it expected Organisation for Economic Co-operation and Development demand for crude in Q1 2004 to be 49.3-mil bbl/day; it came in at 50.1-mil bbls. For Q2 2004, 47.3-mil bbl/day was the projection, but 48.1-mil bbl/day was the reality. Consistently, through at least the first half of this year, demand was 700,000 to 1-mil bbl/day higher than the levels the IEA had projected last fall. Even in developed Western countries, the lofty price of oil seemed unable to put a dent in demand - unless, of course, one assumes that consumption would have been even greater had it not been for high and rising prices.

So today the world looks for anecdotal evidence of a drop in demand for oil, because recent history suggests that only a demand drop can curb prices. Accordingly, notice is taken when the IEA says Chinese growth in oil demand between August 2003 and August 2004 was well below the doubledigit rate regularly racked up earlier this year. As another piece of anecdotal evidence, consider a recent New York Times story that reported one-time "order-taker" car dealers in China now have to work a little harder to move their wares. Additionally, reports have it that used-SUV prices in the US are falling because it now costs $60 to fill up the behemothsý tanks. Thatýs what those hoping for lower prices now have to resort to: looking for a hint that the demand rates weýve seen in the past are going to be pared back.

On top of all this supply/demand misery for consumers, be aware that at the time you're probably reading this, the postý Hurricane Ivan cleanup still isn't done. When the storm traversed the Gulf of Mexico in September, its enormous waves and mass movement of sea mud damaged oil platforms and pipelines there and on the US mainland. Not all of the lost production is expected to be back on-line by Ivan's one-year anniversary. One month after Ivan, the loss stood at about 475,000 bbl/day, or about 28% of pre-storm Gulf capacity. Although that figure isn't even 1% of total world supply (or demand), in a market so tight it continues to matter a lot.