The Forum for Partners in Iran's Marketplace

September 2004 / No. 31

Oil & Gas

Powerless to Lower Prices

Fundamentals would suggest prices in the low-to-mid-30s, but fundamentals are not all that’s driving this market.

OPEC can do nothing to douse scorching oil prices when markets are already oversupplied by 2.8 million barrels per day (bpd) of crude, Iran’s OPEC governor said, warning that prices could fall sharply.

“Now there are more than 2.8 million bpd of crude more than demand,” Hossein Kazempour Ardebili was quoted as saying on the Iranian Oil Ministry Web site. “There is no reason for OPEC members to increase production. This organization is unable to do anything at present.”

Oil futures prices raced to record highs recently, further boosted by a U.S. refinery fire, underpinned in a long term rally but soaring demand led by China and fears of disruption to supply, particularly in Iraq.

Iran is OPEC’s second-biggest producer but like all its fellow members, but for Saudi Arabia, it has no spare capacity left to contribute to a further rise in OPEC’s production after the organization’s most recent 2.5 million bpd quotas hike agreed in June. Iran’s attempts to lift capacity further are weighed down by cumbersome investment deals.

“It seems that prices will continue to go up without taking into consideration the basic elements of the market, supply and demand,” Kazempour said. “The current trend of prices stems from political and military developments.” He reiterated that oil prices could still crash if security fears subsided. “If a calm political and military situation prevails in the market, the amount added to crude reserves will pressure the price.”

The Organization of the Petroleum Exporting Countries, due to meet next on September 15th, is already pumping at a 25-year high of 30 million bpd, casting aside the restraint of official quotas.

Saudi Arabia is producing around 9.5 million bpd, against a quota of 8.45 million bpd, and is expected to reach near 10 million bpd in September. Iran, however, is straining to produce nearly four million bpd against a quota of around 3.8 million bpd. Saudi Oil Minister Ali al-Naimi pledged to stop high oil prices from stunting world economic growth, and thereby cutting demand for its oil in the longer term.

Fundamentals Not Driving Market: Though the Organization of the Petroleum Exporting Countries (OPEC), the organization that supplies about 40% of the world’s oil production, is pumping oil as fast as it can to get prices under control, the problem for the market is not necessarily one of supply and demand. In fact, oil supply in June exceeded demand by about 2 million barrels per day.

Some analysts still believe that, since the price of oil is so bubble-like, driven more by psychology than by fundamentals, it’s subject to sudden declines.

What’s keeping oil prices higher, analysts said, is a built-in premium to account for potential headaches, including terrorist attacks on major oil facilities, problems with the Russian oil firm Yukos, further political unrest in Venezuela, OPEC’s No. 3 oil producer, and more.

“Fundamentals would suggest prices in the low-to-mid-30s,” said Lawrence Goldstein, President of the Petroleum Industry Research Foundation, an industry research firm. “But fundamentals are not all that’s driving this market.”

Of course, the oil industry faces such headaches all the time. Most of the world’s production capacity sits in the tinderbox of the Middle East, and bad weather, accidents and political upheaval cause endless supply headaches.

What’s different this time, however, is that most of the cushions protecting the industry from such woes—including spare production capacity, spare refining capacity and spare inventory—have all disappeared amid an unexpected surge in global demand.

“The market has an asymmetrical bias towards upside risk because we’ve lost those cushions,” Goldstein said. The only curb left on prices, then, is demand. Ordinarily, a surge in prices will cut demand, which in turn will cut prices—the market is somewhat self-correcting, in that sense.

But global demand, driven by a synchronized global economic expansion, has been exceptionally strong, with China and India—economies growing like wildfire—guzzling a good bit of the world’s oil and showing little sign of losing their appetite for it.

“India and China are big importers of crude oil, and they’re both at the stage of their development where they’re energy intensive,” said Kevin Norrish, oil analyst with Barclays Capital. “We have seen no pullback in demand in those countries, or in western countries—demand doesn’t seem to be an issue that would help keep prices in check.”

Help on the Way?: Still, help may be on the way. The summer driving season is ending soon, which may help keep gasoline prices in check. Gasoline refining becomes easier in the fall and winter, when quality standards are lowered and overseas refiners can help out. There will soon be more clarity about the situations in Venezuela and Russia. If the U.S. election passes without a terrorist incident, traders could breathe a huge sigh of relief.

Some analysts still believe that, since the price of oil is so bubble-like, driven more by psychology than by fundamentals, it’s subject to sudden declines.

“We continue to believe that fundamentals of supply and demand will be in play, bringing oil prices down to approximately $35 per barrel by the end of this year, and to $25-30 per barrel in 2005,” said Prabhas Panigrahi, Managing Director of Research at Ehrenkrantz King Nussbaum.

But there’s still a chance such a decline could be short-lived, since the lack of spare capacity will not go away any time soon—it takes years to build new production capacity—and the world will remain a risky place in which to pump oil.

Prices did drop sharply after Saudi Arabia said it had brought new oilfields on line faster than expected, and Yukos said Russian authorities would allow it to keep operating. But those same authorities froze Yukos’ accounts, and oil rebounded to a new record.

“I look at the futures curves, and they’re shifting up; we’re looking at, a year from now, the price being $40 a barrel,” said Schenker of Wachovia Securities. “Oil won’t be at $30 any more—that’s gone.”


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  Sep.  2004 / No. 31