Oil Prices at Risk in the Near-term

Oil prices are at risk to further declines based on weaker demand in the OECD stemming from the credit crunch that began in the summer and rising production from both OPEC and non-OPEC sources. This leaves energy producers at risk to softer prices in the near term. However, any weakness should be considered a buying opportunity.

The International Energy Agency (IEA) reported a change in the supply/demand balance recently that suggests oil prices would continue to soften over the next few months. Firstly, demand was revised down for the balance of the year and for 2008. I suggested in September (Dollar Parity is Only a State of Mind) that the IEA would be forced to revise demand lower due to softer growth in the developed world stemming from the recent credit crunch.

In its November Oil Market Report, the IEA indeed lowered third quarter demand estimates for 2007 by 0.5 mbd and for 2008 by 0.3 mbd based on lower OECD economic growth forecasts for this year and next. These numbers may well be revised lower should growth continue to slow over the next eighteen months. The one risk to this forecast is the possibility of a colder than average winter as appears to be shaping up in the US Northeast.

Oil supply has also risen strongly in recent months increasing by 1.4 mbd in October due to greater output from Iraq and Angola and non-OPEC gains as well. In fact, the OPEC-12 production levels rose for the first time in October since August 2006, which represents a major reversal of OPEC production, cuts since that time, according to the IEA.

All this spells softer conditions for oil markets over the next eighteen months. Oil stocks are not particularly high nor are they uncomfortably tight either, hovering around their 5-year average, having fallen since OPEC introduced production cuts in November 2006.

The long-term picture for oil is very attractive, however, and investors should accumulate oil stocks on weakness. Several executives of the global oil majors have gone on record questioning the industry’s ability to increase production beyond 100 mbd in response to the IEA’a calls for production increases to 116 mbd by 2020. Chrisotophe de Margerie, head of French Oil giant Total called production beyond 100 mbd an “optimistic case.” Current production is averaging roughly 86 mbd.

In a separate speech, James Mulva, CEO of US oil major ConocoPhillips doubted that the oil industry has the necessary infrastructure to push production beyond 100 mbd: "I don't think we are going to see the supply going over 100 million barrels a day” said Mulva who questioned “…where is all that going to come from?"

The fact that the chiefs of the world’s biggest oil producers are uttering these comments is downright disturbing and suggests that oil prices are likely to head higher over the long term. The other lesson here is that the oil majors are likely to have the toughest time increasing production despite the fact that they have the best technologies for finding and extracting oil. The oil majors are dealing with a number of problems including production sharing agreements that reduce their share of reserves as oil prices rise and increasingly hostile governments in many of the regions where oil is found.

Investors are best-advised to accumulate mid-sized oil producers including those operating in the Canadian oil sands on possible weakness over the next twelve to eighteen months. Any fall in oil prices should be considered a long-term buying opportunity.