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Grappling with market uncertainties

Uncertainty over the global economic recovery threatens years of volatility in markets for oil and gas, says the IEA. Alex Forbes writes

OIL AND natural gas producers face years of uncertainty over demand for their output, according to the International Energy Agency (IEA). Its latest medium-term projections forecast that, by 2014, oil demand will range from a low of 84.9m barrels a day (b/d) – less than 2008's 85.8m b/d – to a high of 89.0m b/d, if global GDP recovers quickly from negative growth in 2009. Meanwhile, gas demand is projected to fall this year for the first time in half a century, just as a wave of new supply is reaching recession-battered markets.

"Both markets face enormous uncertainty surrounding the timing, pace and extent of any economic rebound, which affects all prognoses for oil and gas fundamentals over the next five years," said the agency's executive-director, Nobuo Tanaka, at the launch last month of two reports – the Medium-Term Oil Market Report 2009 (MTOMR) and the Natural Gas Market Report 2009 (NGMR).

One measure of how uncertain the outlook has become is how different this year's reports are to last year's. A year ago, oil and gas prices had reached record highs and there were few signs of imminent demand collapse. When the 2008 MTOMR was launched at the World Petroleum Congress in Madrid, in July 2008, the oil price was close to its peak of $147 a barrel; only months later, prices were almost at $30/b. "In the gas sector," said Tanaka, "we have moved from a tight supply and demand balance with extremely high gas prices to an easing one with plummeting prices."

Bullish or bearish?

This year's MTOMR describes two cases for the 2009-14 period: a relatively bullish one, which bases economic growth assumptions on the IMF's World Economic Outlook, published in April; and a more bearish one, which assumes a much lower rate of economic growth will prevail. The report observes that many commentators believe the bearish view to be a more likely outcome "so profound could be the fall-out from recent financial and economic market turmoil, amid concern over ballooning government deficits and the status of future credit markets".

In the higher-GDP case, global economic growth is assumed to recover from –1.4% a year in 2009 to close to 5% a year in 2012-14. Based on the crude-oil futures curve at the end of April, the real crude oil price, in 2008 dollars, is expected to rise from $49/b in 2009 (when the nominal price will be $51/b) to $61/b ($72/b nominal) in 2014 (see Table 1). The case projects that oil demand rises at an average of 1.4% a year, from 83.2m b/d this year to 89.0m b/d in 2014, while effective Opec spare capacity falls from 6.0m b/d in 2009 to 3.4m b/d by 2014.

"A spare capacity margin of only 3-4% by 2013-14 is narrow by any measure," says the IEA, "and represents a tightening, and potentially increasingly volatile, market once more."

In the lower-GDP case, economic growth reaches around 3% a year in 2012-14. Crude-price assumptions are the same as those in the higher-GDP case. Oil demand rises by an average of 0.4% a year to 84.9m b/d in 2014. Effective Opec spare capacity remains close to or above 6.0m b/d. "This," says the IEA, "is characteristic of a market that could potentially withstand unexpected supply shocks more easily than if spare capacity were to revert to the very low levels seen for much of the 2003-08 period."

The IEA suggests this "more balanced spare-capacity picture" could still occur even if GDP growth is close to that in the high-GDP prediction, but for different reasons – a greater willingness by oil-rich countries to make their resources available to private-sector investors, or the introduction of more effective energy-efficiency measures in oil-consuming countries.

The IEA lists six factors that could "significantly" affect the outlook for oil demand:

  • The timing, pace and strength of global economic recovery;
  • The evolution of commodity prices, notably oil;
  • The permanence or removal of administered-price regimes in non-OECD countries;
  • The prevalence of normal weather conditions;
  • Unexpectedly rapid development of energy efficiency and alternative supply sources; and
  • Revisions to baseline data resulting from greater transparency.

A significant change in the agency's view compared with last year is whether recent falls in demand are primarily short-term demand suppression or longer-term demand destruction. The report "tends to the view that significant demand destruction may already have occurred".

Meanwhile, the IEA says the industry's ability to expand supply – already constrained by years of "creeping resource nationalism, rising costs, industrial bottlenecks and chronic project delays" – will be further impeded by sharp reductions in upstream spending. It estimates that capital expenditure in 2009 will be 20% lower than in 2008. "For now, as producers negotiate contract cost reductions and await global demand recovery, upstream project deferrals and delays have intensified."

The MTOMR projects that oil-supply growth during 2008-14 will be 4.0m b/d, around 1.5m b/d lower than in last year's projection, with most of the growth coming from Opec crude capacity, Opec natural gas liquids and biofuels (see Figure 1). "Spending curbs and endemic new project slippage see total non-Opec supply levelling off at 50-51m b/d during the projection period," says the IEA. Supply could be lower still if spending curbs extend beyond this year.

The report reiterates the agency's view that oil-price volatility is explained primarily by market fundamentals rather than by the actions of speculators. Countering claims that fundamental forces could not account for such wild price swings, the IEA points to the low price elasticity of both oil demand and supply – "a clear recipe for high volatility of market-clearing prices". It adds that studies by the US Commodity Futures Trading Commission and the IMF have found little evidence to support the speculation view.

The IEA argues that: "Any future legislation needs to avoid the risk of destroying market liquidity and price discovery, something that could exacerbate market volatility rather than remove it."

Meanwhile, NGMR says gas demand is set to drop for the first time in 50 years. Moreover, unlike in the oil sector, where demand falls are being met with cuts in supply, gas-demand decline has collided with a sharp rise in supply. This helps explain why gas prices in contracts not indexed to oil remain extremely low, while oil prices have rebounded strongly.

Prices in the US and the UK have fallen to $3.50-4.00/m Btu, a third of the price of crude oil on an energy-equivalent basis. Oil-based prices in Japan and continental Europe, with their built-in time lags, continued to rise through most of 2008, but are expected to decline during 2009 (see Figure 2). The IEA says European oil-based gas prices should average $7-8/m Btu this year.

An "astonishing" amount of incremental gas-supply capacity will come from LNG projects, from this year, says the IEA. Capacity will rise by at least 370bn cubic metres (cm) a year over the next three years, it forecasts. Supply from Norway is also on the rise. In 2008, the country produced almost 100bn cm, a year-on-year rise of 10%. "Growth will continue into 2009, and is set to rise to beyond 120bn cm in coming years, making Norway the largest IEA gas exporter," says the IEA.

Unconventional gas supplies in the US constitute a third important source of incremental supply. In 2008, production rose by 8%, compared with an annual decline rate of around 2% earlier in the decade. Partly reflecting the increase in domestic output, US LNG imports in 2008, at under 10bn cm, were less than half those in 2007, leaving large volumes seeking alternative markets.

However, unconventional gas is relatively expensive to produce and it remains to be seen how low prices will affect output. The rig count in April 2009 was half the level of April 2008 and the IEA says it is inevitable that output growth will slow down. Nevertheless, it describes the evolution of US gas output as "one of the main uncertainties in global gas markets".

Lack of investment

Yet despite expectations of a short-to-medium-term gas glut, the IEA is concerned about the adequacy of gas-supply investment. "The combination of weak demand and lower prices could undermine investments," says the agency. "Despite the expected relief on engineering, procurement and construction costs, project sponsors face both financing problems and increasing uncertainty about when and at what pace the economy and, therefore, gas demand will recover."

Although gas-liquefaction capacity will see an unprecedented growth of 50% between 2009 and 2013, a lack of new capacity additions beyond 2013 could quickly see the market tighten.

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