In late 2007, oil prices trends epitomised the complex interplay of many determining factors, with prices pushing towards record highs of almost $100 a barrel in early November, then retrenching in early December.
OIL PRICE FORMATION
Stock levels have, of course, been a key influence with lower crude stocks helping to push West Texas Intermediate (WTI) prices above $98 a barrel, though constrained supplies and ongoing geopolitical tensions have also played strong roles in the rise.
In September, for example, OECD industry stocks fell by over 29.5 million barrels, with Japanese crude stocks reaching their lowest level for at least 20 years.
However, by early December 2007, WTI crude prices had fallen to just around $88 a barrel soon after topping $99 a barrel. This represented the biggest price drop ever seen in one week.
The fall suggests that strong pressures on price are not, however, confined to the supply side. According to the International Energy Agency (IEA), there are strong indications that high prices are depressing demand, with increased supply from Saudi Arabia, Iraq and Nigeria cooling prices.
"Oil price formation has become very complex," says Lawrence Eagles, head of IEA's oil division. "In the 1980s you looked at stock levels to indicate prices and it was that simple. Now there are many more factors to take into account. There is OPEC, the issue of spare capacity and refinery capacity and so on. There is a multitude of factors that we must now consider. For now, the key issue is sharp falls in crude stock, which may still tighten even further."
Much will depend on whether OPEC chooses to increase output, which some felt was likely to be the result of its December meeting, although its recent sell-off and the resulting fall in prices may make this less likely.
The IEA revised its forecast for global demand downwards by half a million barrels a day for Q4 2007, partly because of higher prices, disappointing economic data from the US and FSU, and delays in heating oil restocking in Europe. Its forecast for demand growth in 2008 has also been adjusted down and it is set to average 85.7 million barrels a day in 2007, up 1.2% on the previous year and 87.7 million barrels a day in 2008, up 2.3%.
COOLING DEMAND AND GROWING SUPPLY
Eagles recognises, however, that estimating trends in global demand is not straightforward, given the many complex factors at play.
"Historically, in the summer, we see prices influenced by gasoline trends in the US," Eagles explains. "For now we are seeing better supply to that market from the Atlantic Basin. The big unknown is the level of global demand, particularly when winter weather hits some parts of the world. In recent years milder winters have dampened demand, but it is hard to predict global weather conditions accurately."
Furthermore, the unsettled behaviour of global financial markets will also have a say in determining both supply and demand. "We also have to consider the turmoil in financial markets, the effect that will have on OECD economies and whether that will spill over into the oil market," remarks Eagles.
The world economy is still growing on the back of burgeoning economies, such as China, but growth in the US is looking weaker. "There are a number of demand side pressures that will come into play if the world economy keeps on growing in line with recent trends," comments Eagles. "Demand is very strong and there are also clear constraints on the service sector, such as a lack of equipment, which is putting pressure on supply."
Additionally, historically high price averages are bringing more investment into exploration and production, though there are worrying constraints on these developments, notably the lack of equipment and engineering expertise.
"Prices have been in the $50 to $75 a barrel range for some time, but the push to around $100 is something new," notes Eagles. "A key issue will be the supply response to these high prices. Although we have had high prices for a while, only now are we seeing investment in exploration and production. Any supply response from current investment will, of course, take time to bring on, given the size, scale and complexity of projects.
"I don't see a significant supply side response until 2012 or later. The industry needs new engineers to be trained and rigs to be built. No matter how much money companies throw at it, it will take some time for projects to come through," he said.
The key to the success of supply side initiatives will be the ability of E&P companies to tap reserves in more challenging environments. "Technology development is important," says Eagles. "After all, just look at where people are exploring for oil.
"Fields are increasingly in deep water, and many are marginal fields. In Brazil, for instance, wells must be drilled through salt, which means costs are high.
"Oil sands are expensive to exploit, arctic drilling is expensive, as are ultra-deepwater projects in the Gulf of Mexico," adds Eagles. "For expensive projects like these, the industry needs strong returns. At the same time, companies need to dedicate resources to developing enhanced oil recovery techniques." Great importance has been placed on the development of new technology to increase the feasibility of developing complex and marginal oilfields, but once again these efforts may take
time to bear fruit.
"Technology is a very important area, and there is already a lot of technology with the potential to stave off the decline or even enhance the return from wells," says Eagles. "However, these technologies may need to be put in place at the start of a new project. Furthermore, they may also need to be tested over at least a decade. People must be prepared to take risks on new technology."
The prospects for new capacity to come online, or at least begin construction, seem positive. High oil prices are feeding investment in new projects, but there are still constraints on such large capital projects. "We have seen a very significant increase in investment spending, but that has been met by increases in cost, which will neutralise some of the return," observes Eagles.
The development of additional supply from OPEC also seems to be on course, though the impact of this will depend on the policy the organisation adopts. In late 2007, all eyes were on the meeting of OPEC ministers in Abu Dhabi, which would decide whether there would be any increase in export quotas (see images on right).
"There will be growth in OPEC capacity," says Eagles. "It looks likely that more spare capacity will be built in the next few years. We don't see a shortfall in supply until 2012 and beyond, so there is certainly time to bring on new fields."
Towards the end of 2007, increased supply was seen from Angola and Iraq, where the potential for further short-term rises remains strong. Saudi Arabia and Nigeria were among others boosting production, though field maintenance in UAE offset some of this growth in November.
The behaviour of the market in 2007 showed clearly that one can no longer assume that demand is immune to the pressure of high prices. The sudden drop from record-high prices is evidence that there is a price ceiling, though for 2008, much will depend on how close to that ceiling OPEC would like the price to be.
"What is very important now is the demand side response to high prices," says Eagles. "There are signs that current price levels are tempering demand, so it may be easier to achieve a balance in the market."
In response to questions regarding quotas, OPEC representatives felt the global market to be well supplied, putting high prices down to a weakening US dollar, geopolitical tensions and the influence of speculative money in the market. Certainly, capacity increases around the world will help to meet growing demand. Exploration is uncovering new reserves and technology is taking production into previously inaccessible territory, but some doubt that this will meet future demand.
"We are seeing new supply come on and recent discoveries have shown new deposits of oil," says Eagles. "So, in our medium-term analysis we know that more supply will come on-stream. It is true, however, that we need supply to grow by 3.5 million barrels a year, just to offset declining production at existing fields, but there are signs that plenty of oil is being found."