The Supply of Oil

Eric Chaney and Richard Berner of Morgan Stanley pose this question: Why haven’t oil prices fallen more in recent months? Most forecasts made late in 2004 for oil prices had them falling in 2005 — Morgan Stanley’s forecast was for an average price of around $37/bbl — and yet they have remained stubbornly high, with Brent crude mostly stuck in the high $40s per bbl. As a result, forecasts for 2005 average oil prices by Morgan Stanley and other market watchers are being revised upward by $4 or $5 per bbl.

Unsurprisingly (at least to an economist), Chaney and Berner argue that there are two very familiar reasons that oil prices are higher than observers thought they would be just a few months ago: demand is higher, and supply is lower than expected.

The key reason for these forecast changes is that oil markets are today much tighter than we thought. New data from the February International Energy Agency (IEA) report show that global crude demand was 0.2 mb/d stronger than previously estimated in the last quarter of 2004 and that crude supply was slightly lower than prior data indicated. Nor is significant relief likely soon: the limited global economic slowdown we anticipate (with world GDP growth slowing from 4.6% in 2004 to a trend-like 3.6% in 2005) will not be sufficient to ease oil-market tensions significantly in 2005.

On the supply side… non-OPEC producers are operating at full capacity and output is stagnant. That has been a chronic issue for the past five years, and it has given OPEC market power as the swing producer. But the problem has lately intensified. For example, former Soviet Union (FSU) production was down 1% in January from a year ago, and we expect that Russian production growth will likely dwindle by half through 2007… [Also,] in hindsight, it appears that OPEC was literally operating at full capacity in the fourth quarter of last year, for the first time ever.

Naturally such talk makes one wonder if the world’s oil extraction is actually at or near its peak (often referred to as the Hubbert Peak), or if instead we’re currently just seeing a temporary pause in the expansion of the world’s production capacity, which will continue to grow once the oil development projects that have been launched in the past few years come to fruition. Given that demand will probably (barring a major economic setback to the world economy) keep growing at a steady rate in coming years, regardless of what happens to supply, the difference between these two scenarios could be quite dramatic.