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Prices remain strong but oil markets face testing times

Brent has averaged $110.59 a barrel in the past three years. This is high by any historical measure. Even including the price run-up earlier this century, for example, the mean price in the 25 years till 2011 was just over $33/b

The consensus is that strong oil prices are here to stay. A Bloomberg survey of forecasters at the end of December, for example, found $105/b to be the average prediction for Brent in 2014. The US' Energy Information Administration, part of the Department of Energy, came up with the same number, while seeing a marginal fall in 2015, to $102/b.

This is happy news for crude producers and especially for suppliers of costlier new supplies, whether they come from the Gulf of Mexico, the Bakken or the oil sands. It's not such good news for net-oil-importing economies, which continue to pay through the nose for their most vital commodity. During periods of weakness in the euro against the dollar in the past three years, consumers in the beleaguered eurozone have been spending more for a barrel of oil than they did during the record-beating bull run of July 2008.

But the main pillars supporting the oil-price since 2011 are under threat. In 2014, we will find out how seriously, and we could also discover how resilient new tight oil output is to a falling market.

The first is China and the other fast-growing non-OECD countries. The International Energy Agency (IEA) says global oil demand this year will rise by 1.2 million barrels a day (b/d), to 92.4m b/d. Non-OECD countries will account for all of this, with demand rising by 1.4m b/d offsetting a drop in developed countries' consumption.

China accounts for just under a quarter of non-OECD consumption. But its economy is a worry. In mid-January, new GDP figures showed year-on-year expansion in the fourth quarter of 2013 of 7.7%; sparkling growth by Western standards, but the slowest pace in China in 14 years. The economy is likely to slow further this year, according to most forecasts.

Recent numbers from the government, moreover, show that oil consumption last year grew by just 150,000 b/d, or 1.6%, according to a recent Reuters assessment - well beneath the 3.8% forecast by the IEA. Some new refineries are due on stream this year, so buying should pick up. But the country's surging economy has been a key demand-side support for oil prices for the past decade. That no longer applies.

The second pillar has been the stimulus policies of Western economies, including quantitative easing from the Federal Reserve and the Bank of England and Japan's sharp devaluation of the yen. By helping major economies recover from the global recession, the stimulus has staunched some of the loss in OECD oil demand. Between 2010 and 2012, the OECD shed 1.1m b/d; between 2013 and 2014, the IEA expects just 200,000 b/d of contraction.

Western stimulus has also boosted emerging markets, as investors in the developed world sought higher-yielding assets elsewhere. "These increased investments, in turn, triggered a sharp rise in demand for commodities in the developing and emerging economies," noted Opec in January.

There is still plenty of stimulus to come. The Fed's announcement in December of lower monthly bond purchases - its easing method - only reduced the volume from $85bn to $75bn. Few major central banks plan yet to lift interest rates out of the basement, given that inflation has yet threaten the recovery.

But as the US economy improves, the Fed's appetite to taper its easing programme will, too. Quite what impact this will have on the oil market is unclear. Tapering will imply good news: that the US economy is healthy enough to come off the drip. But tapering will also take some hot money out of the system; and it should strengthen the dollar, which usually means a softening of dollar-denominated oil prices. It seems likely we will find out in 2014.

The last pillar is geopolitics. The uprisings in the Middle East, the threat of conflict with Iran, the disintegration of Iraq, oil theft in Nigeria and civil war in Libya have all put momentum behind oil prices since 2011. By some measures, 3m b/d of supply has been removed from the market. But the market has accounted for these problems now and several of them are easing. Notwithstanding Iraq's descent into more conflict, for example, oil exports from the south have already risen by 300,000 b/d this year. Iraq thinks it will add 1m b/d of output during all of 2014.

Negotiations with Iran have defused the prospect of that conflict, and a preliminary deal removed some sanctions in January. The Geneva deal "has not been the watershed moment some had hoped for", said the IEA in December, given that despite allowing petrochemicals exports, the sanctions relief does not yet open the floodgates for Iranian crude. But it is progress. If it continues, the crunch point on lifting oil sanctions should come in mid-2014. At that point, Iranian oil exports could begin a slow recovery - a deflationary force for oil prices if ever there was one.

Meanwhile, Libya's much-prized crude oil, pent up by strikes and the threat by some easterners to sell crude independently of Tripoli, is one agreement between faction leaders away from resumption again. It seems unlikely 2014 will pass without a resolution. 

The easing of those geopolitical tensions will soften oil prices. This will pose some other problems, and force a decision on Opec. Many of its members now depend on triple-digit oil prices to keep domestic budgets in the black. But the group's global market share is also falling thanks to more supply from the US. Would Opec cut to defend prices, when the consequence would be to shed more market share and justify further investment in marginal oil? And would Saudi Arabia, which would have to do the lion's share of the cutting, be happy to watch barrels from Iraq - still officially outside Opec's quota system - and Iran reach the market instead?

Any price drop would also test US shale oil output, where per-barrel costs are dangerously close to prevailing oil prices, according to some analysts. Opec and other shale sceptics think lower oil prices would curtail this marginal production. That seems unlikely. As a report from Citi last November pointed out, the collapse of natural gas prices in the US has made little difference to rig counts or production. The same may prove true for shale oil, as a fall in price forces greater efficiency in production and better recovery factors from individual wills. In other words, the big supply-side change of the past three years, rising shale oil production, may last the distance, even while the main forces supporting prices do not. 

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