Crude oil prices have continued their downward trend with the OPEC Reference Basket declining more than $42/b or roughly 30% in the space of two months from a peak of almost $141/b reached in early July. By the second week of September, the Basket price had fallen below the $100/b mark and currently stands close to $91/b pressured further by the fallout from the financial sector. Futures market activity has declined in parallel. The strengthening of the US dollar, with a strong correlation to crude oil prices, was also an important factor in relieving some of the upward pressure on oil and other commodity markets. The misguided perception that the oil market was tight and headed toward a price spike has also given way. As a result, the associated premium has been reduced considerably.
This shift to bearish market sentiment has been precipitated by a growing awareness of weakening fundamentals, mainly due to deteriorating economic prospects, the continued decline in oil demand growth and improved supply situation. The economic slowdown is now spreading beyond the US to Europe and Japan with contagion risks to other regions. Financial sector turbulence continued leading to a government takeover of troubled US mortgage lenders Fannie Mae and Freddie Mac, the sale of Merrill Lynch as well as to the collapse of Lehman Brothers, the fourth largest US investment bank. Recent data in the US show a sharp rise in the unemployment rate in August, while the housing sector downturn is still to reach bottom as seen from the recent fall in pending home sales in July. Consumer expenditure is widely expected to slow down in the second half of the year, as the effects of the stimulus package fade. Data in the Euro-zone and Japan also point to stagnating economic activity, as consumers and businesses retrench amidst falling confidence and exports. Both the Euro-zone and Japan risk a mild recession this year given the low prospects of improvement in the second half of this year. Meanwhile, emerging markets growth is decelerating from the very high levels seen in the past years as the lagged effects of tighter monetary policies impact growth in the coming quarters.
The weakening economic situation has been reflected in a slowdown in world oil demand growth. This can be most clearly seen in the US, where total demand has fallen by about 900 tb/d in the first eight months of the year. Moreover, monthly June data shows the lowest level of consumption since 1998. The negative trend in OECD demand growth, which began in 2006, is expected to continue with a drop of around 300 tb/d this year as well as in 2009. In recent years, higher growth in non-OECD demand has helped to offset the decline in OECD. With the moderation in non-OECD growth, it would be even more difficult for world oil demand growth to move above the 20-year average of 1.1 mb/d in the coming years.
Although world oil demand was weak in the first half of this year, it still exceeded the growth in total non-OPEC supply. However, the picture is expected to change in the second half of 2008 and in 2009 due to the expected improvement in non- OPEC supply. Combined with higher OPEC production, this trend has resulted in a build in OECD commercial inventories of 47 mb in July to now stand above the five-year average. Taking into account current demand prospects, OECD inventories are expected to reach a healthy level of more than 54 days of forward cover, which is above the five-year average. Additionally, autumn maintenance combined with the contango structure of the market could lead to further builds in crude oil inventories.
With indications that the current oversupply in the market will further expand in the coming quarters, the OPEC Conference agreed in its recent meeting in Vienna to strictly abide by the production levels set in September 2007. Despite prevailing uncertainties, OPEC output in line with the last Conference decision will be more than adequate to meet demand ahead of the winter season, as well as contribute to an above-average build in commercial stocks.
In light of the downside risks to the outlook, the OPEC Conference stated its readiness to respond swiftly to any developments that might place oil market stability at risk. OPEC will continue to closely monitor the market and will reassess the situation at its next meeting in Oran, Algeria, on 17 December.
