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Fri 25 Sep 2009 04:00 AM

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The only way is up?

Oil has risen 59% in 2009 but with supply outpacing demand amid the global downturn, pressure on prices will remain.

The only way is up?
The only way is up?
China, Asia’s biggest energy consumer saw net imports of oil jump 18 percent in August this year.
The only way is up?
The only way is up?
OPEC boss Abdulla El Badri feels that further oil production cuts may hurt economic rebound.

Oil has risen 59 percent since the start of this year on tentative signs of a global recovery, but with supply outpacing demand as the West licks its wounds from the downturn, pressure on prices will remain.

You could be forgiven for thinking that Abdulla El Badri, the OPEC secretary general, was advising a novice tightrope walker this month when he warned: "The road is not that wide. You have to walk very, very carefully at this time."

In fact, the boss of the 12-nation Organisation of Petroleum Exporting Countries (OPEC) was summing up the difficult decisions he faces in keeping oil at a non-destructive price through the current economic storm. Further cuts in production, which OPEC voted against this month, could hurt the economic recovery, he says. "We don't want to take action that will jeopardise the recovery," was how he put it.

Speculation that worldwide fuel demand will pick up when global economies emerge from the recession has been a key driver of this year's 60 percent oil price rise, from lows of around $30 in December to around $70 now. But inventories, or stockpiles of the fuel are at record highs - and analysts see this huge supply surplus pegging back any major increases in price over the next few years.

"High inventories show the weakness in demand because it not going into the refineries. It shows that the economy is not moving, particularly if you are looking at US stocks," says Kate Dourian of energy information firm Platts.

Prices are also under pressure, says Platts, because of uncertainty over the global stock market rally in recent months - did it constitute a genuine economic revival or a death rattle?

"You wonder why oil is not lower at the moment because of weak demand and because there is so much in storage. Plus, no one knows whether this is an economic recovery. Is it ‘green shoots', is it a U-shaped recovery?"

Currently, global demand for oil appears to be picking up in emerging markets but remains weak in the West. The latest figures from the International Energy Agency (IEA) for Western inventory levels (not including the US) certainly bear this out. According to the IEA, oil stocks rose 1.4 percent in Q1 but only by 0.4 percent in Q2 in the West.

Equally, data coming out of the US, the world's largest energy consumer, shows demand is yet to return.

By contrast, China, Asia's biggest energy consumer, saw net imports of oil jump 18 percent in August to 17.92m tonnes - the second highest level on record. However, analysts indicated that actual demand is not as strong as it appears, with the country importing more oil than it needs to hedge against a weakening dollar.

"Just recently there has been data out of China showing that their exports of refined products are rising strongly, which suggests that domestic demand is not as strong as it might be," says Caroline Bain, senior commodities analyst at the Economist Intelligence Unit (EIU) in London.

"Imports [of oil to China] are rising but so are its exports of refined products. The oil is going into the refinery and then they are exporting much more."

OPEC is acutely aware of the weak fundamentals that belie the oil market. "While there are signs that economic recovery is under way, there remains great concern about the magnitude and pace of this recovery," OPEC said in its communiqué earlier this month when it decided to keep its output unchanged.

With the price hovering at around $70 a barrel, OPEC is faced with a quandary. Cutting output further and raising the price of oil could damage any global economic resurgence, while the reverse would discourage companies from investing in new infrastructure projects.The latter scenario is already being played out in the UAE. Lower oil prices are hampering Abu Dhabi's push to increase its production capacity.

International oil companies such as Shell, BP and France's Total are unwilling "to invest in further idle capacity expansion at a time when they cannot sell what they produce", US investment bank Morgan Stanley said in a report this month.

Bain at the EIU, who predicts $75 oil for 2010 and $70 for 2011, says it would be seen as "bad taste" if OPEC were to cut output.

"It would be difficult for them to justify less production at a time when the global economy is showing tentative signs of recovery," she says.

Analysts agree that OPEC is comfortable with oil at around $70.

"They don't want to tip it over the edge. They figure we are not suffering, the market is bobbing along, why fix it when it ain't broke," says Dourian at Platts.

Gas prices are also under renewed pressure on a cold winter outlook in the US. Natural gas prices have suffered in recent months from high storage levels and poor demand due to the financial downturn. The number of gas drilling rigs have plunged by half over the last year as producers scaled back output.

Ivor Pether, an energy analyst at UK-based fund manager Royal London Asset Management says that OPEC's keenness for oil to remain at around $70 or higher, means the downside risks to the price are limited.

"If you ask, ‘is the price likely to fall back to $50?', I can't see what is going to drive it down," he says.

He is more bullish, and insists demand is improving and inventories are high but stable. The key issue, he says is how high OPEC will allow oil to go. Last summer the commodity hit a record $147 a barrel.

"At $140 there was genuine demand destruction," he says. "You can't keep pushing the price up and up."

Pether predicts that oil will average around $85 a barrel in 2010 but rules out oil reaching 2008 levels anytime soon.

"There isn't the level of demand around," he says, before adding that regulatory reform in the US to limit speculation among traders would help prevent $140 oil in the near future.

The IEA forecast world oil demand will shrink 2.2 percent this year, a less pessimistic prediction than the EIU's 3.2 percent. The agency says global consumption will grow by 1.3m barrels a day in 2010, after a fall of 1.9m barrels a day last year.

While demand may be edging up, the daily fluctuations in the oil price have as much to do with performance of equity markets as any long term drivers, explains Dourian.

"Oil prices are being affected by equity markets as well, so the price is being affected by short term economic indicators," she points out.

"It's a kneejerk reaction: the dollar goes up, the oil price goes down. Equities perform one day, commodities follow and they underperform the next day. It seems to be more of a knee jerk reaction as opposed to a sustained move up or down."

For now, though, experts see a sharp rise in oil as unlikely.

"Supply is not going to be a problem. OPEC has the capacity to increase production considerably - this is quite a big cushion against a spike in demand," says Bain at the EIU.

"Even if you have 20 percent growth in Chinese demand there is no way your spare capacity won't be able to meet that," agrees Dourian.

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