Oil price shock

Rising demand and limited supply are expected to keep the oil market tight again this summer, reawakening fears of a supply-side shock.  

The oil industry is struggling to cope with rising demand. After a brief respite during the fourth quarter of last year — when growth stalled following the price spike caused by the two US hurricanes — strong demand is re-asserting its grip on the oil market. Oil prices are now over $70/bl as upstream problems constrain crude supplies from both Opec and non-Opec producers and refiners face difficulties meeting changing quality specifications for US gasoline and diesel.  

Despite growing geopolitical concerns about the row over Iranian nuclear processing facilities, the real driving force behind rising oil prices is still demand. The global economy remains remarkably robust in the face of higher energy prices because globalisation is helping to keep inflation in check, allowing central bankers to keep interest rates low. Although growing trade imbalances between oil producers and consumers — as well as the US and China — worry economists, the IMF is optimistic about the prospects for this year, revising up its forecast for global economic growth to 4.9pc in the latest World Economic Outlook.  

But, with the oil industry facing capacity constraints both upstream and downstream, strong economic growth now has a bigger impact on prices than on demand. In 2004, the world economy expanded by 5.3pc, lifting oil demand by over 3mn b/d (4pc) in an unexpected surge that used up most of the spare capacity available to the industry and boosting oil prices by 35pc in the process. Last year, the economy slowed to 4.8pc, but oil growth slumped back to under 1mn b/d (1pc) as a further 41pc increase in oil prices limited demand to what the industry was able to supply.  

This year, the supply chain is starting to look tight again. Global oil demand grew by just over 1mn b/d (1.3pc) last quarter, but output failed to keep pace. Upstream production was limited by unrest in Nigeria and Iraq and unexpected problems with non-Opec supply (see p28). And crude runs were down sharply in the Atlantic basin as refiners went into extensive turnarounds. At the same time, Asia-Pacific refiners boosted runs to record levels in order to rebuild stocks after a cold winter.  

If the global economy stays on track for recovery this year, oil prices may have to rise even higher to deter demand growth while supply remains constrained. Although oil demand is only expected to increase by 1.4mn b/d (1.7pc), continued disruptions to Opec output and shortfalls in non-Opec supply could make it difficult for the industry to rebuild product inventories this summer. The IEA’s recent revisions to historical data for developing countries has boosted the underlying level of demand by 400,000 b/d this year, limiting the scope for a normal seasonal stockbuild.  

With a strong global economy and growing uncertainty over world oil supplies, there is a risk that the current demand-led oil price increase could turn into a supply-side shock. Although oil prices are high and are clearly having an impact on oil demand, they are still not high enough to disrupt the global economy. In real terms, prices remain well below their previous peak of over $100/bl during the 1979-80 Iranian crisis. But with little spare capacity available to the industry either upstream or downstream this summer, any major interruption to supply could provide the trigger.  

Copyright © 2006, Argus Media Ltd.  

Argus Fundamentals is published monthly by Argus Media Ltd (www.argusmediagroup.com)  
This article came from the April 2006 edition.

Editorial: Margaret Chadwick, David Long
Statistical services provided by OPRA, Oxford Petroleum Research Associates Ltd (www.oxfordpetroleum.com)