This article has been reproduced from the January edition of Argus Fundamentals by kind permission of Argus Media Ltd.

Uncertain future

Oil prices remain highly volatile at the start of 2005, reflecting uncertainty about future supply and demand trends. Tighter supply and colder weather are supporting higher prices this quarter. But can this continue?

The prospects for oil prices this year look increasingly uncertain. Fears that supply was running ahead of demand this winter now look unfounded as WTI prices bounce back towards $50/bl. And Opec may be having second thoughts about its plan to cut output. Like last year, the future could turn out to be very different from the picture painted by forecasters.

The consensus view — which Argus shares — is that the pace of oil demand growth will slow in 2005 as the global economy slows and special factors — such as problems with Chinese electricity — play a less important role. Last year, world oil demand grew by a massive 2.6mn b/d (3.3pc) as the global economy boomed, creating a huge supply deficit that could only be filled by much higher Opec output. This year, world oil demand is expected to grow at about the same rate as non-Opec supply, leaving the call on Opec crude broadly unchanged in 2005.

So what can go wrong? First, demand may turn out to be stronger than the consensus view. Although oil demand growth slowed last quarter, the pace remains impressive. Argus preliminary estimates suggest an increase of just over 2mn b/d in the fourth quarter compared with last summer’s massive 3.2mn b/d rise. Oil demand in both the US and China — the twin forces behind last year’s boom — remained robust, raising legitimate questions about the forecast economic slowdown which underpins the consensus view of demand for this year.

Instead of slowing as many expected, the US economy appears to have accelerated last quarter. At the same time, China looks remarkably resilient and there are no signs yet that its economy is really slowing down. China’s oil imports hit record levels in November, boosting apparent demand to over 7mn b/d. Argus now expects world oil demand to increase by 1.5mn b/d this year as the global economy is not slowing as fast as expected.

With such uncertainty about the future levels of supply and demand, Opec will continue to face serious problems deciding how much oil to produce in advance. Last year, producers were slow to acknowledge that oil demand was growing so strongly — ignoring the clear signals from the market until it was nearly too late. This left the organisation with a huge gap to fill in the second half of the year that strained its upstream capacity to the limit and sent oil prices spiralling upwards. This year, Opec could be about to make the same mistake — deciding on output cuts based on out-of-date supply and demand forecasts when the market is once again calling for more oil.