Oil: Comfortable cushion disappears

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Oil markets have shifted from flush to strained, with big implications for the global economy.

As recently as January, the world was sitting on what appeared to be a comfortable cushion of extra supply. Thanks to output cuts made in response to the recession, Opec, the producers’ cartel, maintained spare capacity of 5m barrels a day, or more than 5 per cent of global demand.

Then anti-government protests in Tunisia spread elsewhere in north Africa and the Middle East, first raising fears about oil shipments and then curbing output as they reached Libya, an Opec member now embroiled in civil war.

The International Energy Agency estimates Opec’s effective spare capacity has since fallen to 4m b/d – and benchmark Brent crude is well north of $100 a barrel.

The global economy, on the upswing from the financial crisis, has so far weathered the rise better than when crude first breached $100 three years ago. But analysts worry that sustained high prices or another surprise loss to output would sabotage the recovery.

Oil companies from Exxon­Mobil to Petrobras, the state-controlled Brazilian producer, have reported surging profits this year, owing to high prices. Cash has flowed into the coffers of oil exporting nations, enabling Saudi Arabia to boost social spending in the face of regional unrest.

The US Energy Information Administration forecasts crude will average $103 this year and $107 next, because of demand in emerging economies and slowing supply gains outside Opec.

Higher prices are putting pressure on consumers and have revived government inquiries into the cause. In the US, oil executives have been hauled before lawmakers to defend tax breaks, while government lawyers are scouring markets for evidence of manipulation. Rising oil costs are contributing to inflation, forcing central banks from China to India to raise interest rates.

Fast-moving prices have also prompted more companies to hedge risks – and encouraged hedge funds to wager on them. Trading volumes in crude oil futures have notched new records this year.

The uncertainty has also boosted the commodities desks at banks where the fee pool is expected to rise to between $9bn and $11bn this year, from $6bn to $7bn in 2010, according to Nomura Securities.

“Volatility has clearly almost doubled since the second half of 2010,” says Fasil Nasim, head of energy sales at BNP Paribas in London. “This has meant that clients are getting a lot more serious about managing risk. Also, from a general trading perspective, it’s definitely a lot more exciting than what we saw in 2010.”

New supplies are opening up in response to higher prices. Canada’s production, led by its western tar sands region, is expected to rise 18 per cent to 3.3m b/d by 2015, according to the Canadian Association of Petroleum Producers. Brazil’s offshore fields have turned it into a net crude exporter. US production is at the highest level since 2002.

Last year’s Macondo oil spill in the Gulf of Mexico highlights the costs and risks of bold drilling programmes, however. And some expected supplies are not appearing as quickly as hoped: Iraq, which hoped to quadruple production to 12m b/d by 2017, is unlikely to reach this target because of constraints in pipelines and export terminals, industry executives say.

The International Monetary Fund, in its latest economic outlook, says global oil markets have entered a period of increased scarcity. It also warns of a price spike similar to 2008, when crude surpassed $145 a barrel, if the tension between falling supply and rising demand intensifies.

The IEA projects oil consumption will grow to a record 89.2m b/d this year on the back of surging demand in Asia, the Middle East and Latin America. The agency recently shaved its demand forecast, saying $4-a-gallon petrol is chastening US drivers.

Countries such as Russia, Brazil and China have struggled to pass on the full force of price increases, bolstering demand, the IEA says.

Yet Amrita Sen, commodities analyst at Barclays Capital, notes that even when retail fuel prices have climbed, as in China and India, demand is stronger.

“Even with these kinds of price levels, the reason we’re not seeing any significant reaction is because these countries’ oil demand is rising from a very low base. They are nowhere near the US in terms of per capita oil consumption. For these countries, income effects dominate the price effect. When you earn more, you will spend it on luxury goods such as cars, irrespective of price,” Ms Sen says.

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