Why Oil Prices Are Skyrocketing: Production Collapsing Faster Than Demand

The International Energy Agency released its mid-year oil market report this week.  It helps explain the recent behaviour of oil prices.

First, demand is dropping, which is what caused the price collapse.  Second, however, production is also collapsing–even faster than demand.

The other factor in the recent price increase, according to the IEA, is the weak dollar.

Here’s a primer from the IEA on global supply/demand dynamics, as well as the key trends for the next few years.  The bottom line?  We may get a price reprieve until the end of the recession.  But then look out.


Global Supply And Demand

Over the long term, the price of oil is determined by the same factors as the price of anything else: Supply and demand.

For most of 2007, global oil demand exceeded supply, driving the price to the moon. Over the past year, however, the recession has clobbered demand, causing prices to collapse. But now supply is falling even more quickly, which is likely contributing to the recent rise in prices.

IEA Cuts Demand Forecasts

The IEA just cut its demand forecasts from the ones it made 6 months ago.

Normally, this would be good news for prices--and it has been, to some extent. But...

IEA Also Cut PRODUCTION Forecasts

IEA: 'The global oil supply outlook is revised downward sharply from our previous outlook due to project slippage in the wake of markedly lower oil demand, cash‐flow constraints and contract renegotiation.

Oil production capacity is projected to rise by 4.0 mb/d by the end of the 2008‐14 outlook period compared with growth of 5.5 mb/d in our last outlook. From a revised base of 89.4 mb/d in 2008, total supply capacity, including non‐OPEC, biofuels, OPEC NGLs and OPEC crude, is expected to reach 93.4 mb/d in 2014. The bulk of the growth will come from OPEC crude capacity additions, augmented by increases in OPEC NGLs and global biofuels.'

IEA (Optimistically) Concludes That Prices Will Remain Stable

The IEA expects a rapid recovery in world GDP growth...without a corresponding increase in oil prices. Given the production shortfalls, this seems unlikely.

IEA: 'Global oil product demand is expected to grow by 0.6% per year on average between 2008 and 2014, from 85.8 mb/d to 89.0 mb/d, representing an average volumetric increase of 540 kb/d per year.

The foundation of this projection is the economic outlook offered by the International Monetary Fund in its latest World Economic Outlook (April 2009), which sees global economic activity gradually rebounding to almost 5% per year by the end of the period, from 1.4% in 2009. The oil price assumption, meanwhile, is derived from forward price curves as of late April, which indicated a smooth rise to roughly $61/bbl in real terms by 2014 (around $72/bbl in nominal terms).'

Emerging Nations Getting Thirsty

Where will the demand come from? Emerging economies. Developed nations' demand for oil is actually falling.

By 2014, the IEA thinks demand for oil will be evenly split between the two groups.

US Oil Demand Destruction I: Peak Gasoline

Why is demand declining in the developed world? Right now, the recession. But longer term, the IEA thinks four factors will combine to permanently reduce demand in the US.

The first factor? For four reasons, the IEA thinks gas demand has probably peaked:

--The companies that made big gas guzzlers are going under.

--Changes in behaviour during the recession--car sharing, public transit, etc.--may become entrenched.

--Anecdotal evidence suggests that suburban sprawl is losing its appeal.

--Car efficiency is actually improving.

U.S. Demand Destruction II: Jet Fuel

The second factor leading to permanent demand destruction in the US (in the IEA's opinion) is reduced used of oil-based jet fuel.

The theory: New, more efficient aircraft engines replacing old aircraft and an expansion of the synthetic fuels.

U.S. Demand Destruction III: Reduced Use Of Fuel Oil

The IEA says fuel oil 'is poised to become an increasingly marginal source for power generation.' This is because natural gas is taking over.

Demand Destruction IV: Efficiency

The fourth factor that IEA says will lead to permanent demand destruction in developed countries is increased efficiency.

IEA says efficiency gains in both OECD and non-OECD will continue in the future.

And Now For The Problems... Declines In Expected Production Growth

Production in non-OPEC countries will grow, but not as fast as expected.

Non-OPEC Production: Old Forecast vs New Forecast

The recession has drastically changed the picture for non-OPEC oil supply.

Meanwhile, OPEC Production Growth Is Down, Too

Wild price swings are causing havoc for OPEC nations. Capacity growth is much slower than previously thought, and varies from nation to nation.

Production In Some Countries Is Actually Decreasing

Iran, Ecuador, Nigeria, and Venezuala are projected to have decreases in the next 6 years.

Iraq Production Forecasts Were Also Too Optimistic

IEA cuts the outlook for Iraq, too.

And Where Is All That Oil Going? Mostly Transportation

This is why there's a race around the world to develop more fuel efficient cars. Transportation is the primary source of demand for oil.

Also, Forget The Idea That Speculators Caused The Price Spike

The IEA says 'only inconclusive evidence to suggest that speculative activities had caused the spot price to climb up to the level it did last summer.'

Full explanation based on a CFTC study: 'The explanatory powers of crude oil market fundamentals, namely the strength of world demand for industrial commodities and capacity constraints affecting crude oil production, as well as the level of open positions of specific kinds of traders are tested statistically, with market activity and exogenous liquidity shocks held equal.Without delving too deeply into thetechnical part of the modelling exercise, the final conclusion did not establish a price making role of the noncommercials in the oil market, even though it did find that market activities of hedge funds and other financial institutions as well as swap dealers help to explain the cointegration of spot and futures prices. Simultaneously, however, market fundamentals were also shown to be strong indicators of price cointegration. It provides, therefore, only inconclusive evidence to suggest that speculative activities had caused the spot price to climb up to the level it did last summer.'

But The Weakness Of The Dollar Is Contributing To The Recent Spike

The dollar and the price of oil are tied. Many investors fearing inflation hedge with oil.

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