Oil above USD 100/Bbl: get used to it Market momentum skipped a chance for a pull-back in early Q2’08, rallying instead USD 30+/Bbl in April to mid May. NYMEX WTI raced past seasonally weaker refiner demand for crude oil and recovering oil stocks. The window for the current correction is closing as the summer season begins. Extended strength into Q2’08 derived from the distillate product complex, notably in Europe but also in Asia. Gasoil and jet fuel premiums to crude oil traded in excess of USD 30/Bbl while those for gasoline, until recently, traded below USD 10/Bbl (forcing discretionary throughput cuts) and discounts of fuel oil deteriorated further. Given maintenance and unplanned outages, European refiners incrementally bid up light sweet crude oil to maximise yields of distillates and meet tight sulphur requirements. High Chinese import demand came from reportedly pre-Olympics stockpiling but also ‘emergency’ imports in the wake of extreme weather in Q1’08 and recently earthquakes. The front month July futures contract on the NYMEX closed in excess of USD 130/Bbl and options see budding interest for USD200 calls. We revised our WTI 2008 average from USD 104/Bbl to USD 124/Bbl as we continue to raise the averages for Q2 and Q3’08. However, we retain a correction past the summer Olympics in Q4’08, albeit with a caveat, that non-OPEC supply growth does not disappoint.

Supply side fears Time spreads between the front and the back of the curve have changed dramatically and prompt prices saw their premium to long-dated prices evaporate. The back of the curve shifted higher on increased consumer hedging and a restructuring of producer hedges. Nigerian outages grabbed headlines but supply concerns have focused more sharply on the future. Non-OPEC crude oil supply is expected to contract year-on-year in H1’08 and the growth outlook for hitherto historically strong contributors, like Russia, turned sour along with more medium-term prospects for more recent contributors like the Caspian region. Total liquids supply growth from non-OPEC areas (excluding Indonesia that withdrew from OPEC recently) is concentrated in Q4’08. The first three quarters of 2008 are expected to average around 50 mb/d while Q4’s average is expected to rise to 51.5 mb/d (up 1.8 mb/d against Q4’07). Given this late timing, projects can easily be deferred in a rising cost environment and supply growth can easily slip into 2009. This leaves the oil market heavily dependent on the marginal barrel that OPEC chooses, or not, to supply both today and in the future. OPEC 10 crude supply returned (after deep cuts in the first three quarters of 2007) to December 2006 levels in Q1’08, most of the increase coming from Saudi Arabia, Kuwait, UAE and Qatar. At its 5 March meeting, OPEC left its quotas unchanged, only to be reassessed in September. The cartel maintains its usual rhetoric of “the market is well supplied” and prices are only a symptom of USD weakness and speculation. OPEC’s willingness (or ability for that matter) to supply significant additional volumes of oil has to be considered relative to effective spare production capacity at the wellhead which remains tight at circa 2.3 mb/d (most of which is located in Saudi Arabia and the UAE). Excluding quality as well as marketability (and related pricing issues of this crude), more OPEC oil can be helpful. However the market remains sensitive to supply disruptions (actual or potential) around key producing countries. While non-OPEC supply growth at year-end can help to moderate prices, the question is whether OPEC will seek to defend a price floor if prices fall – we think this would be politically unpalatable in a USD 100/Bbl environment.

Oil and the economy: what will it take? With further downgrades to economic forecasts have come downward revisions to oil demand forecasts and, unsurprisingly, the US has borne the bulk of the revisions. Yet, global oil demand growth in 2008, pegged at 1 mb/d (or 1.2%), is about the same as in 2007 when prices made an unrelenting climb to USD 100/Bbl. The issue of de-coupling in economic activity between advanced and emerging markets (the centres of oil demand growth) will remain high on the oil agenda this year, as will the sustainability of subsidised retail pricing policies in emerging markets. Many Asian economies are seeing their trade surpluses shrink with weakening external demand and higher import costs. In this context, inflation will be a determining trend this year. Central banks in emerging markets face a dilemma: they can let national currencies appreciate relative to the USD (and harm already weakening export growth) or they can raise reserve requirements and interest rates to tame credit growth (and harm fixed asset investment). Either measure has consequences for GDP and, therefore, oil demand growth. In this connection, the sustainability of subsidised retail prices for oil products will be tested as fiscal balances come under strain in some emerging markets. Large demand growth contributors, like China and the Middle East region, are unlikely to effect material changes this year. However, subsidies in smaller Asian countries, such as Indonesia, Taiwan and Malaysia, are being lifted. More recently and notably, India has joined this group in a highly charged political environment.

2009 supply constraints remain in place

If the weather is mild, then, in combination with end 2008 supply growth from non-OPEC, it may momentarily hold off price strength in Q1. However, directionally, supply constraints still point to yet another strong year for crude oil prices in 2009. Refining constraints relative to product specifications are likely to upset seasonal trends again, notably in the EU which officially moves to ultra-low sulphur diesel. Product trade can arbitrage regional imbalances but aside from sulphur mandates, other properties like varying mandates in cetane levels for diesel mean that imports can still require blending. OPEC is expected to add effectively (net of field decline) some 500-600 kb/d of capacity in 2008 but the pace of future additions is uncertain. Saudi Oil Minister Ali Naimi is cautious on his country’s future, citing demand uncertainty and opportunity costs in developing and maintaining spare capacity. Nigeria, Angola and Brazil rely on deep water developments, and non-OPEC more broadly on non-conventional oil sources (oil sands, bio fuels) for future supply. Setting aside access to reserves, new supply is capital and resource intensive, and comes with considerable timing risks June 2008 Click the link in the left download box to read more.   The information published in this document has been obtained from public sources believed to be reliable. BNP Paribas does not make any representation or warranty, express or implied, in connection with the accuracy of the opinions or statements contained herein. The information provided by this document is only indicative, not to be relied upon as substitution for the exercise of judgment by any recipient, and subject to change without notice. BNP Paribas shall not accept any liability whatsoever for any direct or consequential loss arising from any use of material contained in this document. This document is not intended as, and does not constitute, an offer or a solicitation to buy or sell any instrument or to enter into any transaction. Any reference to past performance should not be taken as an indication of future performance. This document should not be reproduced (in whole or in part) without BNP Paribas’ written consent. © BNP Paribas (2008). All rights reserved.