The Hindu Business Line : Capacity constraints keep crude prices high

DESPITE supply well above demand, the lack of spare production capacity to take care of any demand spikes or supply disruptions continues to keep oil prices high. Prices are likely to stay strong in the short term because neither OPEC or non-OPEC countries have the wherewithal to build capacity immediately nor is the "fear premium" likely to subside in the near future.

Crude oil prices are ruling a shade below the $47-per-barrel mark amid fresh turmoil in Venezuela, the world's No.4 oil exporter, intense fighting in Iraq and a legal battle between the Russian Government and Yukos Oil Co., Russia's biggest oil exporter.

Fear premium

Crude prices are likely to stay in the $40 range in the near future because of lingering uncertainty.

In Iraq, insurgents loyal to Shiite cleric Moqtada al-Sadr threatened to sabotage southern oil facilities if the US military attacked the holy city of Najaf threatening all of Iraq's 1.7 million b/d of exports. Russia's problems with Yukos, which pumps around 1.7 million b/d, continue on the issue of unpaid taxes. Analysts say that the high prices are not fully justified by market fundamentals, and that a "fear premium" has vaulted prices as much as $15/bl or nearly 50 per cent above where basic supply and demand rules suggest they should be.

Two key factors are driving and keeping oil prices high — a fear premium and a strong concern that there is inadequate spare production capacity available worldwide to meet any sudden spike in demand or possible disruptions in supply.

In addition, demand for petroleum products continues to remain strong with China accounting for nearly 40 per cent of last years global growth in oil demand.

Opec running out of spare capacity

Oil shocks since the early 1970s were always driven by fears of supply disruptions rather than actual shortages of supply. Some analysts say that recent prices are justified because Opec is producing virtually flat out, and any glitch in world supply would have a large impact on the market.

The Opec President, Mr Purnomo Yusgiantoro, said recently that Opec had no spare capacity left and the International Energy Agency and US' Energy Information Agency said that Opec spare capacity had dwindled to 670,000 b/d or 500,000 b/d, respectively.

Though the Saudi Oil Minister, Mr Ali Naimi, said recently that the kingdom has been producing 9.3 million b/d over the past three months and that it has "more than" 1.3 million b/d of spare capacity that is "immediately" available to meet demand, the fact that the capacity is concentrated in a country witnessing attacks by Al Qaeda is spooking markets further.

Moreover Opec's clout to dictate prices has shrunk since the 1970s and non-Opec producers have their own share of problems. Opec is unable to bring down oil prices to the $22-$28 range. Free market forces and capacity constraints has reduced Opec to a spectator in a tight market giving rise to fears that the global economy is now very vulnerable to price shocks arising from any supply disruptions.

The fear premium is not purely driven by the war in Iraq or concerns on supply disruptions from terror attacks on Iraqi or Saudi oil installations. It has more to do with the changing geopolitics in Middle East and the accompanying uncertainties. Otherwise, as seen in the aftermath of the 1991, Gulf war oil prices should have dipped sharply post US invasion of Iraq.

It is not so. Uncertainty this time around is likely to continue longer because of the emergence of the Al Qaeda as a potent force with a capability to disrupt oil production in Iraq and Saudi Arabia and the United States continues to rattle sabres at Iran with a view to change the entire political landscape in West Asia.

Supply still higher than demand

Meanwhile, global demand is strong but still below supply. The IEA has estimated consumption in 2005 at 84 million barrels per day, and expects oil demand to grow at around 3 per cent this year. But global supply still exceeded demand by more than 2 million b/d in the second quarter this year after about matching demand in the first quarter. Global demand of 80.9 million b/d in June was more than matched by supply of 82.7 million b/d.

Some say that one way to tame crude prices is an expansion of production capacity by Saudi Arabia. Saudi Aramco was reluctant to add capacity earlier because it would be saddled with costs of maintaining excess capacity. Aramco now has a detailed plan to increase production capacity by 1 million barrels per day within a 12-month period.

A new study from Energy Intelligence Research (EIR) concludes that in the longer term production capacity growth to 2010 will be enough to meet increases in demand. It also reveals that non-Opec supply will plateau between 2005 and 2010 and that the world's reliance on Opec oil, now at around 29 million b/d, is set to rise dramatically as early as 2005.

Total Opec surplus capacity is now around 1.5 million b/d, including Saudi Arabia. Remaining spare capacity is confined to small volumes from Iran, Kuwait, Abu Dhabi, Qatar and Nigeria. For 2005, the Opec Secretariat projects a rise in the group's capacity of 1 million b/d, with small gains from Saudi Arabia, Nigeria, Abu Dhabi, Libya, Iran and Algeria.

Non-Opec production will expand, too, but much more slowly than this year's expected rate of 1.4 million b/d. Much of this increase is confined to Russia and the Caspian region, which are equally prone to uncertainty.

(The author is analyst with Energy Intelligence Group, US.)