For some time now, crude oil prices have been pointing to an oversupplied market. Over the last two months, the OPECReference Basket has fallen by nearly $19/b from a peak of $72.7/b on 8 August, the sharpest drop in prices since 1991, as a result of changing fundamentals and easing geopolitical tensions. At the same time as spot prices were declining, the Nymex WTI spread between the first and twelfth month stood at $6/b in September, the widest difference since the market moved into contango in May 2005.
Additionally, as a result of increased OPEC production, commercial crude oil inventories in OECD and the USA have risen to very comfortable levels. With the end of the driving season and the start of autumn refinery maintenance, crude stocks could see even further builds. In the USA, crude oil inventories stood at 331 mb in the week ending 6 October, 14% above the five-year average (see Graph 1). At the same time, with the approach of the winter season, seasonallyimportantmiddle distillate stocks in the USA are also at the highest level since 1999 or about 19% above the five-year average. In Japan, kerosene inventories stand close to three-years high, while in Europe gasoil stocks are ample.
Apart from the immediate seasonal decline, the demand picture for the remainder of 2006 and for 2007 appears far from robust. The strong growth in demand seen in 2004 declined sharply in 2005 and then continued at roughly the same level in 2006. This lower demand growth came despite the strong momentum in the global economy. More recently, the expected slowdown in the US economy following monetary tightening and the weakening US housing sector has added considerable uncertainty to the economic outlook and consequently oil demand. A further factor that may dampen demand are policy responses in consumer nations both developed and developing to rising oil prices aimed at conservation and substitution away from oil. As a result of these factors, demand growth in 2006 and is expected to remain moderate at 1 mb/d and reach 1.3 mb/d in 2007.
Meanwhile, non-OPEC supply growth has been markedly weak over the last few years, particularly in OECD, requiring OPEC to meet the bulk of rising demand, while at the same time having to accelerate plans to expand production capacity. Recently, however, the outlook for non-OPEC supply has changed dramatically. Supply has already picked up in 2006 to 1.1 mb/d and is expected to grow next year at 1.8 mb/d, the highest rate since 1984, pointing to a clear imbalance between supply and demand.
Given these trends, the demand for OPEC crude in 2007 will be lower than this year. non-OPEC supply is expected to exceed oil demand by around 0.6 mb/d in 2007 indicating the need for measures to rebalance a market already flush with stocks. As a result, the demand for OPEC oil would be 28.1 mb/d, around 1.6 mb/d lower than total OPEC production inSeptember. If OPEC were to continue to produce at the September level of 29.7 mb/d the lowest output in four months this would still lead to a contra-seasonal build in the fourth quarter of 1 mb/d and 0.5 mb/d in the first quarter of 2007. In the second quarter, these production levels would result in a strong seasonal build of 2.6 mb/d, compared with a typical build of 1.1 mb/d. Such a build-up could overwhelm inventory capacity, as OECD commercial stocks are currently approaching the historic high seen in 1998.
Even prior to the recent price decline, a consensus was evident within OPEC about the need for a proactive response to changing market circumstances. In attempting to bring supply in line with fundamentals, voluntary downward adjustments in output were an option left to the discretion of individual Member Countries. In the meantime, OPEC has called for a consultative meeting to take place in Doha, Qatar on 19 October to review and consider further action needed to balance the market.
In recent weeks, the speed and magnitude of the decline in crude oil prices has caught the market by surprise. Uncertainties about global economic prospects particularly in the USA, slowing demand growth, rebounding non-OPEC supply and high stock levels have triggered a strong bearish sentiment in the market. This has led to some concern that the downward momentum might persist, causing prices to overshoot and fall below levels justified by fundamentals. Past experience has shown that it is in the long-term interest of both producers and consumers to maintain prices at levels that both support healthy economic growth as well as encourage much-needed investment to ensure sufficient capacity to meet future demand, particularly in an industry with long lead-times, high financial risks and in an environment of rising costs.