abare.gov.au - Australian commodities – June quarter . volume 15 . number 2 2008

Oil and gas

Sharp increase in prices

The West Texas Intermediate (WTI) oil price increased by more than 25 per cent during the June quarter 2008 and reached a high of $US139 a barrel in early June, before a partial reversal to $US132 a barrel in mid-June.

The surge and volatility in oil prices reflect a combination of factors. These include a tightly balanced demand-supply situation and the existence of a substantial risk premium driven by perceptions of significant potential for supply disruptions as a result of weather events and geopolitical tensions in key producing regions, notably the Middle East. In a global environment of limited spare oil production capacity, prices have become highly sensitive to the possibility of future supply shortages. Further, there is some suggestion that rising prices in the short-term have been partially underpinned by financial market drivers, with hedge funds investing in oil in expectation of future price rises. The interplay between the fundamental market forces affecting oil markets, the unpredictable effects of the geopolitical situation and the increase in the financial or ‘speculative’ elements in the market, has made short-term oil price forecasting challenging in recent times (see box 1).

Demand outpacing supply

Fundamentally, the oil market has been characterised in recent times by robust demand growth, particularly in emerging markets, and a sluggish supply response.

While oil demand growth in OECD countries, primarily the United States, is showing early signs of slowing in response to higher oil prices, oil consumption in non-OECD countries, such as China and India, has continued to increase strongly. This reflects, partly, strong economic growth, but also the effect of government fuel subsidies put in place in these countries to reduce the effect of high oil prices on consumers.

In contrast, supply has lagged behind, with relatively weak growth in non-OPEC production and a significant decline in OPEC spare production capacity.

In particular, oil production has been declining in Mexico and the North Sea. The expected startup of a number of new oil projects has been adversely affected by worldwide shortages of skilled labour and equipment.

In addition, uncertainty attached to the sustainability of current price levels over the medium to longer term, and an emerging trend of resource nationalisation in a number of countries, have added to the perceived risks associated with investment in oil projects.

In May, OPEC’s effective spare production capacity fell to 1.95 million barrels a day, compared with 2.9 million barrels a day a year earlier.

More than 75 per cent of this capacity is located in Saudi Arabia, where a signific ant proportion is sour crude oil that is difficult and relatively expensive to refine into low-sulfur distillates typically consumed by OECD countries.

This situation has limited the ability of production to respond quickly to unanticipated supply disruptions arising from geopolitical upheavals, natural disasters, and labour disputes, thereby underscoring the sensitivity of prices to actual or potential supply disruptions.

Oil and gas outlook

2006

2007

2008-09

% change

Production

mbd

85.6

86.8

88.1

1.5

Consumption

mbd

85.8

86.8

88.1

1.5

Trade weighted crude oil

price

US$/bbl

68.31

115.53

113.45

– 1.8

West Texas Intermediate crude

oil price

US$/bbl

72.18

121.54

119.40

– 1.8

Australia

2006

2007

2008-09

% change

Crude oil and condensate

Production

28 555

25 247

27 618

9.4

Exports

15 965

15 710

16 709

6.4

– value

A$m

8 317

10 526

15 328

45.6

Imports

25 345

26 955

28 155

4.5

Natural gas

Production

Gm3

43.6

43.7

45.9

5.0

LNG exports

15.20

14.75

16.90

14.6

– value

A$m

5 222

6 352

10 632

67.4

LPG

Production

4 550

4 276

4 400

2.9

Exports

2 824

2 863

2 728

– 4.7

– value

A$m

1 038

1 385

1 720

24.2

f ABARE forecast. s ABARE estimate.

box 1

Challenges of forecasting oil prices

Market fundamentals have clearly played a key role in sustaining high oil prices in the past few months. The sharp rise in oil prices reflects a sustained period of strong growth in demand, particularly in non-OECD countries, combined with weak growth in supply from non-OPEC countries and OPEC’s unwillingness to increase production from the limited spare capacity that it has available.

In such a finely balanced demand-supply situation, unanticipated supply disruptions, have had discrete and significant effects on prices, as illustrated in figure a. Disruptions have included attacks on oil production facilities in Nigeria throughout the first half of 2008. Also, the Forties pipeline system which connects the North Sea oil fields to the United Kingdom has been temporarily shutdown as a result of industrial action at a Scottish oil refinery. The difficulty in foreseeing the nature and timing of these types of events explains, in part, the divergence between forecasts of oil prices and actual prices.

Overlaying the set of market fundamentals placing upward pressure on prices, have been financial market factors leading to an increase in speculative trading on oil futures. While the size of financial flows coming into the oil market has not been fully assessed, there are indications to suggest that investment demand for oil futures by hedge funds may be a factor behind rising oil prices in the short-term.

Evidence of very tight demand-supply balance can be found in the movement of prices on the spot and futures markets. In most cases, it is expected futures prices will be higher than spot prices, reflecting largely the cost of storing oil. When this occurs, the market is said to be in ‘contango’. However, for much of the June quarter 2008, the market has been in ‘backwardation’. That is, futures prices were lower than spot prices, reflecting market preferences to purchase oil now. These expectations are linked to some extent to market fundamentals – which reflect an already tight oil market that is highly vulnerable to supply disruptions.

The dynamics of these interrelated factors over the past few years have increased the complexity of forecasting oil prices. Since 2004, a large number of oil price forecasters, including ABARE, have consistently underestimated the increase in world oil prices. While the majority of forecasters have been projecting a decline, world oil prices have risen to historical highs, both in nominal and real US dollar terms (figures b and c).

It is also noteworthy that past expectations of participants in the oil futures market significantly understated actual movements in oil prices. As demonstrated in figure d, participants in the oil futures markets also expected oil prices would decline, consistent with oil price projections released by the majority of forecasters.

Market to remain tight

With little change expected in market fundamentals or in the risks to supply in the short-term, oil prices will continue to be volatile on a daily basis and to remain high on average.
In late June, the WTI price was around US$133 a barrel, compared with an estimated US$111 a barrel in the first half of 2008. The oil price is forecast to decline moderately toward the end of 2008 under the assumption that demand, particularly in OECD countries, is unlikely to grow, and that non-OPEC production is expected to rise gradually with a number of projects completed recently. The WTI price is forecast to average around US$122 a barrel in 2008.

Oil prices are forecast to average about US$119 a barrel in 2009. This assumes a further moderate increase in non-OPEC production and lower demand growth in non-OECD countries. Geopolitical issues, particularly in the Middle East, and their effects on supply risks, can be expected to continue to keep prices high.

A demand response is emerging slowly

OECD oil consumption is forecast to decline slightly by 1 per cent to 48.7 million barrels a day in 2008. The reduction in consumption reflects weaker economic growth, especially in the United States and western Europe, and the effect of higher prices on oil consumption. In the United States, oil consumption is forecast to fall by around 2 per cent.

To the extent the recent instability in US financial markets and the associated effect on economic activity could have a flow-on effect to economic activity in economies in western Europe and in Japan, oil consumption in these economies could also be lower than expected.

In contrast, non-OECD oil consumption is forecast to increase by 4 per cent in 2008 to around 38 million barrels a day. In 2009, this growth rate is forecast to slow to 2 per cent, reflecting lower economic growth in China, Latin America and the Russian Federation. In addition, retail petrol prices in a number of Asian economies, including China, Indonesia, India, Malaysia, Pakistan, Sri Lanka and Chinese Taipei, are expected to increase as governments attempt to reduce the rising fiscal burden imposed by fuel subsidies.

It is estimated that in 2008, fuel subsidies in Indonesia, for example, could reach as high as 3 per cent of gross domestic product. In response to the sharp increase in oil prices, the Indonesian Government decreased the retail fuel subsidy in May 2008, causing prices to rise by around 30 per cent. Other economies with domestic fuel subsidies are expected to consider similar moves in an attempt to reduce the size of subsidy payments.

China’s oil consumption is forecast to increase by around 5 per cent in 2008 to 7.9 million barrels a day, compared with growth of 9 per cent in 2007 and 6 per cent in 2006. This expected slower growth in oil consumption mainly reflects the assumed easing of China’s economic growth in the short-term, and the Chinese Government’s plan to increase domestic gasoline and diesel prices, announced in June. However, there remains considerable uncertainty about the extent to which China’s central government will continue to move toward a domestic oil pricing system that is more directly linked to international prices.

Oil demand in the Middle East is forecast to grow strongly in 2008 as a result of strong economic growth associated with revenues from high oil prices. Oil consumption in this region averaged 6.6 million barrels a day in 2007 and is forecast to increase by 5 per cent in 2008 to 6.9 million barrels a day.

Supply response remains weak in non-OPEC countries

Over the period between 2004 and 2007, non-OPEC oil supply remained around 50 million barrels a day. In the first quarter of 2008, OECD oil supply averaged 19.7 million barrels a day, a year on year decrease of 2 per cent. Higher production from the United States was offset by falling production in Mexico and the North Sea.

The limited increases in non-OPEC supply, in response to high oil prices, are also underpinned by a number of factors affecting the investment outlook for oil. Importantly, the uncertainty associated with the sustainability of current prices over the medium to longer term means there may not be an increase in investment in oil projects and alternative fuels and technologies such as oil sands and coal to liquids. These risks are also being reinforced by the potential implications of future climate change response policies on the energy sector generally.

Rising construction and input costs are providing a further disincentive to investment. While the continuation of high prices in recent years has, to some extent, encouraged an increase in investment in new crude oil production capacity, many of those projects have been delayed by shortages of equipment and labour, driven by capacity constraints globally.

Nonetheless, a number of recently completed projects are expected to increase oil supply from non-OPEC countries. A significant proportion of this increase is forecast to come from the Russian Federation, the Caspian republics and Brazil. Russian oil production capacity will increase following the commencement of production from the Vankorskoye field and the first phase of the Timan Pechora field in the second half of 2008. In addition, output from the Sakhalin 2 project is forecast to increase in 2009. Higher oil production in 2008 and 2009 is also forecast from Azerbaijan (development of the Guneshli field) and Kazakhstan (expansion of the Tengiz field).

Oil production in Brazil is also forecast to increase by 9 per cent in 2008 and 8 per cent in 2009. Higher crude oil production will be supported by the recent commencement of production from deepwater fields, including Roncador, Polvo and Golfinho. In addition, production of ethanol from sugar cane is forecast to increase by around 15 per cent to average 360 000 barrels a day.

There are a number of other projects that could contribute to an increase in crude oil production by the end of 2009. For example, in the Gulf of Mexico, a number of projects are expected to commence production in the second half of 2008 or in 2009, which will support increased production. These include Blind Faith, Thunder Horse, Neptune and Tahiti.
The completion of all the projects listed in the table below, according to their planned schedule, would add a total of 1.1 million barrels a day of new oil production capacity by the end of 2009. This is equivalent to approximately 2 per cent of total non-OPEC oil production. However, this gross addition to capacity is expected to be offset to some extent by declining production from existing mature oil fields in the North Sea and Mexico.

In addition to the potential increase in the production of crude oil, Canada’s production of oil sands is expected to grow by 150 000 barrels a day during the remainder of 2008, reflecting the commencement of production from the Surmont project and the expansion of the Foster Creek project.

OPEC production increases only gradually

In the first quarter of 2008, OPEC crude oil production averaged 32.3 million barrels a day, an increase of 6.7 per cent year on year. Around one-third of this increase is attributable to higher production quotas agreed by OPEC in September 2007. In addition, Angola became an OPEC member in December 2007, contributing an additional 500 000 barrels a day of crude oil production.

For 2008 as a whole, OPEC crude oil production is forecast to average around 31.3 million barrels a day, an increase of 2 per cent compared with 2007. Production capacity in Saudi Arabia is expected to increase in the second half of 2008 following the startup of production from the 500 000 barrel a day Khursaniyah project.

In Iraq, steady progress is being made to increase crude oil production. In the first quarter of 2008, crude oil production averaged 2.4 million barrels a day, a 20 per cent increase from the March quarter in 2007. The Iraqi Government and Kurdish authorities have reached agreement regarding production from two fields, Tawke and Taq Taq. It is estimated production from the Tawke field could increase toward its capacity of 90 000 barrels a day, from current production of 10 000 barrels a day. Production from the Taq Taq field is scheduled to commence in late 2008, also at a rate of 10 000 barrels a day, however ultimate capacity is estimated to be 200 000 barrels a day.

Nigeria’s crude oil production in the first quarter of 2008 was 10 per cent lower than a year earlier, as a result of maintenance, sabotage and industrial unrest. An estimated 500 000 barrels a day of production remains unrealised because of security concerns and this situation is not expected to improve over the outlook period.

Major oil projects in non-OPEC countries

major oil fields

capacity b/d

location

year

Neptune

50 000

United States

2008

Thunder horse

250 000

United States

2008

Blind Faith

45 000

United States

2008

Horizon

110 000

Canada

2008

Vincent

100 000

Australia

2008

Angel

50 000

Australia

2008

Vankor

150 000

Russia

2008

Shenzi

100 000

United States

2009

Thunder Hawke

60 000

United States

2009

Tahiti

125 000

United States

2009

Frade

90 000

Brazil

2009

OPEC spare production capacity falling

In May 2008, OPEC’s effective spare production capacity fell to 1.95 million barrels a day, compared with 2.9 million barrels a day a year earlier. This excludes spare capacity in Indonesia, Iraq, Nigeria and Venezuela, where it is not considered feasible to increase production in the short-term. OPEC spare capacity is expected to fall even further in the remainder of 2008 because in mid-June Saudi Arabia agreed to increase crude oil production by 200 000 barrels a day.

In 2009, OPEC spare production capacity is not expected to increase significantly. The process of developing oil projects in OPEC is being challenged in the same way as in non-OPEC countries and the global mining industry in general — a shortage of labour and equipment and higher construction costs.

Australian production and exports

Australian oil production in 2007-08 is estimated to have declined by 12 per cent to 25.2 gigalitres (435 000 barrels a day). This estimated lower production is mainly a result of technical difficulties at a number of fields, including Mutineer–Exeter and Corallina off the northern Australian coast, where production in the first half of 2008 was significantly lower than in the first half of 2007.

In 2008-09, Australian oil production is forecast to increase by 9 per cent to 27.6 gigalitres (476 000 barrels a day). Additions to production capacity in 2008 include the Angel, Skua/Swift and Vincent oil fields. In addition, higher output is expected from Stybarrow field as it increases toward full capacity following commencement in late 2007. In 2008-09, these four projects, which are all located off the coast of north-west Australia, are anticipated to operate at full capacity, which is estimated at a total of more than 220 000 barrels a day (12.7 gigalitres a year), accounting for almost half of Australian production.

Reflecting the growing production from north-western Australia, exports are also forecast to increase. With close proximity to Asian refining markets, it is assumed that oil production within the Bonaparte and Carnarvon Basins, including the Stybarrow and Puffin oil fields, will be exported.

Australian exports of crude oil are forecast to increase by 6 per cent in 2008-09 to 16.7 gigalitres. The value of crude oil exports is forecast to increase by 46 per cent to $15.3 billion, reflecting the sharply higher oil prices forecast for the year.

Australian LNG exports to grow

Australia’s LNG exports in 2007-08 are estimated to have been 14.8 million tonnes, a decrease of 7 per cent from the previous year. The estimated fall reflects planned shutdowns of facilities at the North West Shelf project and Darwin for maintenance in 2007. LNG exports are not expected to be affected by the fire which damaged the Varanus Island gas plant in May, as the plant supplies gas exclusively into the Western Australian domestic market.

In 2008-09, Australian LNG exports are forecast to increase by 15 per cent to 16.9 million tonnes. This forecast increase is expected to be supported by the startup of the fifth train at the North West Shelf in late 2008, expanding its capacity by 4.2 million tonnes to 16.9 million tonnes a year. The other operating LNG project in Australia is located in Darwin, with an annual capacity of 3 million tonnes.

Reflecting higher LNG prices (which are linked to oil prices) and increased export shipments, the value of Australia’s LNG exports is forecast to increase by 67 per cent to $10.6 billion in 2008–09.