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Demand growth weak and production on the rise

Geopolitics has lost its impact on the market and the fundamentals are bearish

Global oil demand growth has weakened and supplies continue to rise. Contango in the forward curve is persuading traders to buy now, too, pushing inventories higher. These are bearish fundamentals and the market has responded. Brent, trading at around $96 a barrel as Petroleum Economist went to press, is now $20 cheaper than it was in June. Sentiment in the market, not least sharp cut in long positions by speculators, suggests it could fall further.

That old stalwart of the bulls, geopolitics - code for war in the Middle East - has lost its market force. Despite the terrorism plaguing northern Iraq, and renewed Western military engagement to repel it, exports from the big southern oilfields remain resilient. The same, for now, is true in Libya, where oil production continues even as the country disintegrates. The market has factored in the risks, and still oil prices have fallen.

On the supply side, soaring US tight-oil production has neutralised the impact of lost output in politically troubled Opec countries. In the 12 months to June, says the International Energy Agency (IEA), the US added a staggering 1.3 million barrels a day (b/d) of supply, roughly equivalent to pre-war Libyan output. A recent report from Citi, a bank, showed that since January 2011 supply disruptions have seen Opec shed about 3m b/d. Non-Opec supply growth has more than matched that. This is a colossal problem for Opec. In effect, internal failures within the group have simply gifted market share to rivals. The situation is getting worse, too: last month, Opec revised down the forecast demand for its crude this year, by 200,000 b/d to 29.5m b/d. It will fall again next year, to 29.2m b/d, it said.

On the demand side the signals are not good either. Opec expects consumption to rise this year by 1.05m b/d. Next year, it sees growth of 1.19m b/d. The IEA predicts global demand will grow by 900,000 b/d this year and 1.2m b/d in 2015.

Those forecasts are both well below the kinds of annual growth figures seen in the first decade of this century. Both may be trimmed back yet again this year. Some market players say global demand growth in 2014 may come in at closer to 500,000 b/d. Much will depend on the fourth quarter, when seasonal demand is supposed to pick up.

Look closely at the IEA’s demand projections, however, and things are even more bearish than their latest cut in consumption forecasts suggests. Consider that last year, global demand between the first and second quarters rose by 600,000 b/d. In the same period this year, there was no growth at all. Between the second and fourth quarters of 2013, demand rose by 1.6m b/d. Yet the agency’s forecast for this year - despite a “notable downgrading” of Chinese oil demand; the flatlining of the eurozone economy; and expectations of a downwards revision to IMF global economic growth forecasts – is for demand to rise between the second and fourth quarters by an incredible 2.3m b/d. Something is deeply awry with those figures.
Either way, the matter should come to a head in the fourth quarter. If demand doesn’t rise as quickly as the IEA expects between now and the end of the year -- helping to drain some of the oil storage - the market could lose balance, putting more pressure on prices. Indeed, Opec believes non-Opec supply alone will rise by 560,000 b/d in the fourth quarter.

The problem for Opec is that it can do little about this. Tight oil is already cutting into the group’s customer base, backing out West African crudes from the US market and forcing Gulf producers to concentrate supplies on their Asian client base. But Asian consumption growth is not what it was. The IEA says it will struggle to get above 2% this year in China. In Japan, consumption in July was down by 10% compared with last year.

Another bearish signal is coming from Saudi Arabia. To place its barrels in Asia, where rising output from Iran and Iraq are direct competitors, the kingdom has begun discounting its oil - and even with those discounts, supply in August was down by 330,000 b/d in response to lower demand from customers. That suggests Saudi Arabia is in a mood to defend market share, not price. The kingdom could stomach a softening of Brent to $85/b before it acted, says Bill Farren-Price, head of Petroleum Policy Intelligence, a consultancy. Even at that point, it would need persuading to act. Its reluctance is understandable, because any action to defend prices now would bring another problem to the fore. The relentless rise of tight oil as a competitor means that any Opec cut would simply hand more of the market to rival producers. Assuming it helped support prices, a cut would at the same time simply buoy investors in North America’s unconventional oil sector.

Saudi Arabia also knows that any responsibility for cuts would fall on its shoulders, with a little help from other Gulf producers. None of the other members can afford either a prolonged drop in the price of oil - or a cut in output to prop up the price. The longer that situation lasts, the better for non-Opec and the more obvious this shift in the market’s dynamics will become. Citi expects that between 2013 and 2019 the US alone will have added almost 3m b/d to supply. Don’t forget Canada, either. By 2018, another 1.1m b/d of oil sands crude should begin arriving in the Atlantic basin through a new pipeline, backing out yet more West African oil and encroaching on Opec customers in Europe and Asia.

Strong demand growth would account for those increments. But an era of high oil prices has put paid to that. Fuel switching from oil to natural gas, rising fuel economy in cars, and secular changes in oil-consumption behaviour are now in play.

Relentless non-Opec supply growth, in other words, is flowing into a market that is eagerly seeking alternatives to high-priced oil. Geopolitics may have been a defining word for crude markets in recent years. But another one is cropping up more frequently among market watchers too. Unless something gives, world oil is facing a glut. 

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