The oil market has been tightening since the middle of 2010, but OPEC has done little to try to prevent a repeat of the damaging surge in oil prices that we saw in 2008, which was followed by an abrupt collapse in global oil demand and, with it, OPEC oil production and revenues. Instead, OPEC has continued to claim that the world is well supplied with oil, stocks are high and prices are being driven by factors other than market fundamentals. Global oil inventories fell by 4.5 days’ worth of forward demand in 2010 and stock cover started 2011 just half a day above the level at which it began 2008. Oil demand growth has remained remarkably robust in the current quarter, growing at 2.7% year on year. As a result, oil prices have soared, with OPEC’s basket of crudes hitting $100/bbl, even before the revolt in Libya and its bloody suppression began to play havoc with oil supplies. In time, the net effect of the tragic events in Japan is also likely to be positive for oil demand, putting further upward pressure on prices. Over the past month, the world has lost most of Libya’s 1.6 mbpd of oil supply, production and exports having slowly ground to a halt as the Libyan strongman battered his population into submission with foreign mercenaries, heavy weapons and air strikes, before the UN finally imposed a no-fly zone. OPEC, meanwhile, has continued to insist that there is no need for it to take any action, since the world remains well supplied with oil. In an apparent contradiction of this assertion, Kuwait’s oil minister was quoted by the country’s official news agency as saying that ‘there are a lot of lifters that are asking for additional Kuwaiti crude oil volumes’. However, he went on to add that the higher demand did not mean that Kuwait was exceeding its output quota, despite holding 1 mbpd of spare capacity. This is the nub of the problem that the oil market faces at the moment. Buyers clearly want more oil from OPEC than it is currently producing, yet those with spare capacity, who repeatedly assure the market that they can and will act to address any shortfall in supply, actually seem to be doing very little. Furthermore, what they are doing is far from clear, at a time when the market desperately needs transparency from the world’s swing producers. Saudi Arabia clearly faces troubles much closer to home than North Africa. The protests in neighbouring Bahrain have already dragged in its troops, angering Shiadominated Iran across the Gulf. In such circumstances, it would not be surprising if the attention of Saudi Arabia’s government was not focused entirely on the oil market. The CGES’ supply/demand balance suggests that the world will need 30.3 mbpd of oil from OPEC in 2Q11, just to keep quarterly oil prices at around $110/bbl. Production in February was estimated at 29.85 mbpd and is now down at around 29 mbpd. Saudi Arabia, custodian of the lion’s share of the Organisation’s spare capacity, had already begun to increase its output in response to rising demand and higher prices before the explosion of violence in Libya, but even then its actions appeared to be lagging behind the market’s real needs. The Kingdom has tried to assure customers that it can and will raise production to meet their demands, but tanker tracking data suggest that production has only risen by around 200,000 bpd since the Libyan crisis broke out, far less than is required to raise aggregate OPEC production to where it needs to be to balance the market. OPEC member-countries clearly feel the need for higher incomes, as some of them face protests of their own, hence the evident lack of urgency among them to act to bring oil prices down. The pursuit of ever-higher prices, though, risks a repeat of the collapse in oil demand and the concomitant fall in OPEC’s own revenues that we saw in 2008. THE CGE S OUT LOOK Residual supplier There is no shortage of threats to the still fragile global economic recovery, ranging from the conflict in the Libya to the threat of an economic slowdown as a result of the calamitous earthquake that struck Japan earlier this month. Nevertheless, the fact remains that because of this economic recovery, as well as the loss of Libyan output, the oil market remains tight, following on from a 1-mbpd decline in global inventories in 4Q10. Realistically, only Saudi Arabia, the world’s main residual supplier of oil, can address this problem. According to our estimates, the country is already supplying the market with additional crude, since its output was 260,000 bpd higher in February ’11 compared with December ’10. However, with Libya effectively producing no oil and with every sign that the conflict there could escalate after the recent UN Resolution authorising action against Gaddafi, inaction by Saudi Arabia might mean that the current price of Dated Brent – $115/bbl at the time of writing – could go higher still.The Reference case We now expect global oil demand to grow by 1.4 mbpd (1.6%) in 2011. There has been a slight recalibration in our prediction of OECD demand this year. On the one hand, the higher price of oil – with Dated Brent $15/bbl above where it was a month ago – is expected to drag down demand in much of the developed world, inducing motorists, for instance, to make fewer unnecessary journeys due to high pump prices. On the other hand, Japan will surely require additional supplies of both crude and oil products to replace any electricity lost as a result of shut in nuclear power plants and to fuel the colossal reconstruction effort required after such a disaster. As a result, oil demand in the OECD overall drops only fractionally in 2011. Outside the OECD, oil demand growth remains strong at 1.5 mbpd for the year. However, the majority of this increase occurs in 1H11 (+1.7 mbpd), with the rate of growth slowing in the second half of the year as a result of the impact of tighter monetary policy in countries such as China. On the supply side, there is a 1.2-mbpd rise in non- OPEC and OPEC NGLs output this year. Qatar supplie the extra OPEC NGLs as a result of its increasing LNG production, while the increase in non-OPEC liquids is due primarily to additional output from Brazil, Canada and the FSU. Although this is a welcome addition to a tight oil market, we believe this leaves the call on OPEC at a high level of 30.9 mbpd for 2011, assuming there is an increase in desired stocks as we expect. Given the Organisation's current production rate of 29.8 mbpd and its previous form in reacting slowly when the market requires more oil, this is likely to be a tall order, especially if Libyan output is disrupted for a sustained period. In our Reference case, OPEC output falls short of this target, averaging 30.2 mbpd this year (+900,000 bpd year-on-year), with Saudi Arabia’s crude output inching closer to 10 mbpd over the next three months and Kuwait, the UAE and Iraq all producing a bit more oil. This increase in OPEC's oil production is enough to keep global stock cover roughly at the level at which it was at the end of 2010, i.e. at around 70 days’ worth. This more-or-less keeps prices in line with where they are now, Dated Brent rising from $104/bbl in 1Q11 to $113/bbl by the third quarter, roughly in line with the forward curve. The North Sea benchmark averages $110/bbl over the course of the year, $30 higher than in 2010. High price case Such an outcome is perhaps worrying enough for the global economy, but things could end up being worse if OPEC manages a smaller increase in output than in the Base case. This is entirely possible if Saudi Arabia is slow to step up to the mark, while Nigeria, Iraq and Angola’s output could also be affected, by political unrest in the case of the former two and technical problems at deepwater fields in the case of the latter. Equally, OPEC’s members might become too distracted by the political events in the Middle East and North Africa to act coherently. Either way, if OPEC’s output rises by only 700,000 bpd, compared with 900,000 bpd in the Base case, and all the other variables are unchanged, then there is a stock draw this year rather than a stock build. Given that the oil market is already tight, this puts Dated Brent on a steep upward trajectory, with the price climbing from $104/bbl in 1Q11 to $123/bbl in 3Q11 and averaging $119/bbl in 2011. Low price case As things stand, the only factor that would bring about lower prices, in our view, is weaker global demand growth and this forms the basis of our low price case. It is certainly possible, for example, to envisage that the disaster that has struck Japan may well lead to slower global economic growth as the country’s exports dwindle over the next few months due to the extent of the damage and disrupted production, since many Japanese components are key ingredients of the global supply chain. In this scenario, global oil demand increases by 1.2 mbpd, compared with 1.4 mbpd in the Reference Case, and with oil supplies remaining unchanged Dated Brent declines from a high of $108/bbl in 2Q11 to $95/bbl by 4Q11. EXP ECTATIONS AND THE US FUTURES MARKET 'What a difference a month [day] makes', to paraphrase the popular song that became a big hit for Dynah Washington in 1959. The price of WTI had been falling from the start of the year, dropping by 9.1% between the end of Dec-10 and mid-February 2011, when along came the Libyan crisis to upset the proverbial apple cart. The prior toppling of the autocratic regimes of Ben Ali in Tunisia and Hosni Mubarak in Egypt were significant political events but hardly caused a flicker on the oil seismometer. However, the uprising in Libya, which started on the 16th February, was portentous for the oil market because the country is tribal, Gaddafi was deeply unpopular, especially in the east, and — most importantly — Libya is a big supplier of oil and gas, mainly to Europe. To make matters worse, civilian unrest broke out in the small Gulf state of Bahrain, an event insignificant in oil terms but which nevertheless rattled traders' nerves, because the island state hosts the US' Fifth Fleet (principal protector of crucial sea lanes in the Middle East Gulf) and has a large (70%) Shia population ruled by a Sunni royal family, just like the eastern Hasa region of Saudi Arabia where most Saudi oil comes from. The sharp 26% WTI price rise between Feb-15 and the week ending Mar-8 was partly in belated recognition of a tightening oil market, which started back in 3Q10 and continued into 2011, and partly in acknowledgement of a rapid decline in Libyan oil production that has not elicited thus far a formal reaction from OPEC. We are sure the surge in oil prices was not due to speculation, since the CGES indicator of the intensity of speculation has been heading in the opposite direction (see Figure 1). This indicator, comparing the speculators' short positions with the hedgers' net short positions, is a measure of the extent to which speculators in oil are taking positions that are not merely counterbalancing the hedgers' net requirements. During this period the hedgers boosted their net short positions by both increasing their shorts and reducing significantly their longs, while the speculators as a group reduced their short positions and increased their longs by a significant amount (see table below). However, the substantial 28% rise in the non-commercials' long positions was largely a result of acting as counterparties to the hedgers' growing net short positions. After such a sharp rise in the price of oil in a relatively short time (9% per week over three weeks) the producer and consumer hedgers expect oil prices to fall, as do the smallscale speculators (non-reporting), leaving the large-scale speculators as the only people on NYMEX expecting oil prices to continue to rise. Indeed, the largest single group of speculators, the managed money operators, have boosted their net long positions by 68% in the last three weeks, jumping onto the upside price waggon and raising the correlation between their positions and WTI to 93% since the beginning of September 2009. Given the latest developments, who can blame the managed money operators for being bullish on oil prices. The Libyan conflict, affecting oil supplies, looks likely to drag on now that the UN Security Council has approved a no-fly zone and 'necessary measures' to prevent the Libyan dictator from attacking civilians, Japanese oil demand is likely to improve once the current slowdown of Japanese industry comes to end and reconstruction begins in earnest, and global forward stockcover is likely to remain on the low side through to the end of this year. The only consideration that would lead to lower oil prices is more output from a Saudiled OPEC, but thus far there has been no appetite in the Organisaton for a formal quota increase. The Kingdom has been raising its output slowly month by month since last September, but it has been doing so tentatively, leaving the markets unsure whether Saudi Arabia really wants to bring prices down below $100/bbl. Since September '10, a rolling, 3-month WTI hedge for an oil consumer has been in the money (see table opposite), because spot oil prices have been on an upward trend and this is likely to continue into the summer. Unsurprisingly given these turbulent times, aggregate WTI open interest is at its highest level since 1999, while speculators as a group are holding the largest long positions and the smallest short positions for twelve years, indicating that they expect oil prices to remain high — and we agree with them, although it must be said that the oil market is always capable of surprises. UNCERTAINTIES AND PROBABILITIES Our base case this month has Brent averaging $110/bbl in 2011, 38% up on last year and 12% higher than the crisis year of 2008, when the price of oil hit record levels in July. Considering that this is our likeliest scenario, this year looks like being a difficult one for oil consumers — and many others besides; moreover, it might end up being worse than expected, going by the uncertainties discussed below. As is customary, we examine four upside price uncertainties and four downside cases. Unfortunately, two of the upside cases could occur and because they involve relatively large volumes of oil that are at risk they may lead to serious repercussions for the oil price. The UN finally imposed a no-fly zone on Libya and authorised 'all necessary measures' short of occupation to protect civilians in the country. The Gaddafi regime countered by declaring a ceasefire, but the market does not believe that Col. Gaddafi will comply with UN Resolution 1973, which is why the price of oil rebounded after initially falling. From our present standpoint the Libyan crisis looks like rumbling on (with a probability of 20%) until either Gaddafi capitulates or the Western powers are thwarted, which means that around 1.4 mbpd of Libyan oil will continue to be absent from the global oil market for the foreseeable future. Even if the West happens to lose this particular game because of its dilatoriness, it is unlikely that Gaddafi would be allowed to export significant volumes of crude oil or refined products. Of even greater potential seriousness is the unrest that has surfaced in Bahrain, which has been suppressed with considerable severity with the assistance of Saudi troops. Bahrain is not important in oil terms; it is significant because of its population mix, around 70% of which are members of the Shia sect, many with Iranian ties, constituting the same ethnic and sectarian makeup as Saudi Arabia's Hasa region where most of the Kingdom's oil happens to be. Iran and Saudi Arabia are old antagonists in the Gulf and reports that Iran is stirring up anti-Sunni resentment in Bahrain are deeply disturbing. Saudi Arabia exports around 7 mbpd of oil these days, 4 mbpd of which could in extremis be sent across the Arabian Peninsula and exported from Yanbu in the Red Sea, leaving 3 mbpd of exports at risk in the Gulf. It is this eventuality that has spooked the oil markets, but we ascribe a low probability to it (3%) because the Saudi state apparatus seems capable of containing this type of unrest. Although the volume of oil involved is much less, there is a higher probability that Iraqi oil exports via Ceyhan will continue to be disrupted. Finally on the price upside, there is a high probability (15%) that more oil will be used (0.25 mbpd) as a consequence of the prolonged shutting in of around 9 GW of Japanese nuclear power generation in the aftermath of the gigantic earthquake that struck Japan. As for the downside price risks, there are a couple with reasonably high probabilities of occurring: it is quite possible that Saudi Arabia will open its production valves a bit wider than expected (15% probability of yielding an extra 0.7 mbpd) in order to keep the price of oil from retarding the global economic recovery, which in any case is likely to slow up (12% probability) because of the high price of oil itself, among other negative factors like the possibility of China growing at a slower rate, higher worldwide inflation leading to higher interest rates, etc … The bottom line is that at this juncture the upside oil price risks greatly outweigh the downside ones, leading to a one in 14 chance that the price of oil over the next nine months will be higher than in our base case. There is always a chance, of course, that the price will be lower than expected, but at the moment the likelihood that this will happen is only 3%. When the Chinese want to curse someone they say 'may you live in interesting times'. The current period of tribulation reminds us of the real import of this curse. Lost Libyan oil leaves crude market tight The oil market was already tightening before Libyan exports came to a halt and the Japanese earthquake devastated the country's power and refining infrastructure. Global oil stocks have fallen sharply in the last nine months, Asian refineries are running at record levels and strong demand for diesel, particularly in the non-OECD economies, has pushed middle distillate margins to two-year highs. In January, crude runs in the main refining areas were 3 mbpd up on the previous year, outstripping the increase in crude production. Onshore crude stocks in the US, Europe and Japan plus crude in floating storage have fallen by 90 mn bbls since the middle of last year. In Europe, which has been hardest hit by the loss of Libyan oil, crude inventories were at their lowest end-February level since 2004. Italy, Germany, Spain and France between them imported almost 900,000 bpd of crude from Libya in 2010. Europe and the US are currently in the midst of refinery maintenance. Throughputs in the two regions last month were 1.3 mbpd lower than in December and further shutdowns are taking place this month. Global crude demand will also be restricted early in the second quarter by turnarounds in China and India, but by early summer crude runs will be rising, putting further pressure on supplies — unless Libyan exports are restored quickly. Westbound shipments rising There are some signs that extra supply may be on its way from Saudi Arabia, which now claims to be producing 9 mbpd. Consultancy Oil Movements puts westbound Middle East liftings for the four weeks to 2 April at 4.9 mbpd, an increase of 200,000 bpd since January. This includes one fixture to load a VLCC at the Red Sea port of Yanbu, an unusual event, which shortens the voyage time for Saudi crude into the Mediterranean. However, most of the oil replacing Libyan crude is likely to come from other light sweet suppliers in Africa, the North Sea and the Caspian, offering refiners similar yields of high quality products. Note that this is not extra crude, but cargoes that previously had been moving to refineries in Asia. Eastbound shipments from the Middle East and the Atlantic Basin climbed to a record 15.5 mbpd in February, but the March volume will be 1 mbpd lower. Japan will burn more oil The crisis in Japan will have both negative and positive effects on oil demand this year. In the short term, a fall in economic activity will lead to lower energy use. However, this will be offset by the country’s need to replace electricity supplies from damaged nuclear power stations. The latest estimates from Japan show around 9 GW of nuclear capacity and a further 1.3 GW of thermal capacity is now offline. Some of the shutdowns are likely to be lengthy and some permanent. This shut-in capacity is equivalent to around 170 GWhours of electricity each day, assuming recent utilisation rates of 70% at nuclear power stations. If all of this were to be replaced by output from oil-fired plants running at 35% efficiency, it would require at least an extra 300,000 bpd of oil — more if the plants are old and inefficient. Gas and coal-fired stations can provide some of the additional power, but most of the spare generating capacity available to boost electricity output in the short term consumes oil. When the 8GW Kashiwazaki-Kariwa nuclear plant closed due to earthquake damage in July 2007, demand for fuel oil and crude in 4Q07 and 1Q08 increased to 750,000 bpd, up from 525,000 bpd in the previous year. A number of Japan’s refineries have also been damaged, shutting in around 800,000 bpd of capacity. The rest of the refining system is boosting output to compensate and the government has authorised a cut in the private sector’s mandatory stocks from 70 to 67 days of net imports, allowing the release of 8 mn bbls of products from storage. Product exports, which were 550,000 bpd in January and February, have been cut to supply the domestic market. Two-thirds of these are diesel and jet fuel which go mainly to neighbouring Asian countries.