High Oil Price vs. Old Doctrines

The recent frenzy in the oil market is unprecedented in modern history says Norway’s broking house Lorentzen & Stemoco. When prices have risen above US$45/b (Brent) in the past, this has been due to an imminent threat or outbreak of war. But the recent oil price rally has been driven by strong oil demand and not least by the perception that the world oil production reserve base is too small in light of the risk of further disruptions. This latter fear factor has been amplified by the problems in Venezuela, Nigeria and Iraq and the continued risk of terrorist attacks.

For years there has been three main doctrines in the market. The first is that high prices will cause economic growth to stall and thus affect demand negatively. The second is that the general growth in world production combined with the reserve production will always be sufficient to cater for spikes in demand. The third doctrine is that OPEC as the actual manager of the market will always balance the market by providing the required volumes to keep the price within a defined range, that in recent years has been $22-28/b.

All these doctrines have apparently been rendered more or less useless in the face of the massive buying interest that has been hiking up the price at the futures exchanges. The “oil price doctrine” is possibly the most interesting one as there seems to be little or no effect of high prices to read out of the demand data for recent months. In the US, gasoline demand is up during the summer despite record high prices at the pump. This suggests that demand from the rapidly growing SUV fleet is overriding any negative demand development from the rest of the car fleet. With robust demand also from the other sectors (highway diesel) US demand is set for a 0.35m bpd increase (2004).

The same can be found in China where demand is powering ahead with a projected 0.9m bpd growth rate. Many expect Chinese demand to slow next year when it is expected that the government’s efforts to curb economic growth will start to impact on oil demand taking it to a somewhat lower growth rate of 0.5-0.6m bpd next year.

World oil demand is projected to grow by 2.5m bpd this year which is the strongest growth rate seen in modern times. It is perhaps difficult to find strong arguments against a continued positive development in 2005, but history suggests that it is extremely rare to record several years of growth at this kind of pace. The common denominator in this respect is that “something” always seems to happen that causes the rosy outlook to diminish. Oil traders have been helpful in this respect in that their relentless gambling surely is causing inflation to pop up across the US and other major economies.

Heavy investments in exploration and new refineries are detrimental to measuring this factor wherefore mergers and acquisitions in existing oil production have been preferred. But current pricing of publicly quoted companies are generally preventing attractive M&A deals wherefore exploration activity is bound to pick up in the time ahead. The ODS world count of mobile drilling rigs for July shows that the total utilisation rate is now at 84.5%, up from 81.5% in May. Additions to world oil supply resulting from renewed exploration is 3 to 5 years into the future, but money talks and it seems clear that the industry recently has raised its future oil price assessments significantly. The second doctrine will therefore reinstate itself in relation to the market with a two or three year time lag. With the third doctrine; OPEC is reaping the benefits of the general under investment in oil production, which by the way includes their own acreage, but OPEC will, in our opinion, continue as the manager of the oil market for the foreseeable future.

The bottom line is therefore that the three doctrines in effect will remain as useful guidelines, but the concept of time has to be taken into consideration when making further assessments of the oil market. This implies that the oil price will remain high as long as demand is strong and supply tight. Right now it seems safe to predict a tight oil market at least for the rest of the year, but next year might be different. History has nevertheless taught us that it is prudent to be careful wherefore we still recommend sticking to “old” doctrines.