Oil market & budget developments

After remaining stable through most of July, oil prices saw a major sell-off in early August as fears over renewed weakness in the global economy gathered momentum, triggered in part by S&P’s decision to strip US sovereign debt of its AAA status. The prices of most global oil benchmarks dropped by more than $15 per barrel (pb) in the first week in August. While the price of Brent – the main European crude – stood at around the $100 mark, West Texas Intermediate (WTI) fell to just $78, its lowest in 11 months. The heavy discount for WTI partly reflects oversupply issues at its storage point at Cushing in the US.

The price of KEC had fallen to $101 pb by August 9^th. Time-lags in the reporting process mean that the Kuwaiti blend had not by then seen the same magnitude of declines seen in other crudes.

Of the two events, signs of global economic weakness arguably have more scope than the US debt downgrade to do lasting damage to oil prices. The latter need not directly affect the demand for oil. And to the extent that the downgrade undermines the US dollar, it may boost demand for dollar-denominated commodities whose prices will fall in foreign currency terms. The overall impact might also depend on how the financial sector makes the technical adjustment to holding now lower-rated US government debt. The US authorities are likely to try to keep any such disruption to a minimum.  

While the sudden shift in sentiment has rekindled talk of a re-run of the collapse in prices seen in 2008, analysts are also pointing out the differences between now and then. These include the recent loss of Libyan output, which means that OPEC may find it easier to restrict output and defend a price floor; the lower likelihood of a major drop in global oil demand; and evidence from the last cycle that oil prices below $70-$80 pb are not sustainable, given the oil industry’s production costs and the need to finance new investment.

Oil Demand Outlook

Forecasters’ projections for growth in global oil demand had recently moderated, and the latest bout of pessimism could take them down further. The Centre for Global Energy Studies (CGES) sees incremental demand in 2011 of 0.9 million barrels per day (mbpd), or 1%, with a deceleration in 2H 2011 thanks to slowing economic growth and the impact of high oil prices. 2012 is expected to see a similarly mild increase. These forecasts are – for now at least – below the consensus. The International Energy Agency (IEA), for example, expects oil demand growth of 1.2 mbpd this year (1.4%) and 1.5 mbpd (1.7%) in 2012, with all of the increase coming from non-OECD countries. These forecasts may be subject to downward revisions in light of the latest global turmoil. However, it is worth noting that – if sustained – the latest fall in oil prices may itself provide some relief for the global economy, and by implication serve to moderate any further deterioration in oil demand.

Oil supply outlook

Latest data shows that crude production of the OPEC 11 (i.e. excluding Iraq) jumped by 492,000 bpd to 26.9 mbpd in June, as the organization moved decisively to replace the near 1.5 mbpd of Libyan output lost since the start of the year. The increase was entirely due to higher output from the three main Gulf producers – Saudi Arabia, Kuwait and the UAE – whose attempts to push through a formal increase in production quotas were rebuffed at OPEC’s acrimonious meeting in early June. Between them, the three Gulf producers have added 1.1 mbpd in output since January. But this is still not enough to compensate for the 1.5 mbpd lost from Libya.

Indeed, after accounting for more or less unchanged production in Iraq and other OPEC members, OPEC’s overall supply has shrunk by around 0.4 mbpd so far this year. Since Saudi Arabia’s current production level, at 9.4 mbpd, is still short of its believed capacity of 12.5 mbpd, it still has scope to increase its own output if needed. The latest sharp drop in oil prices, however, may have reduced its desire to do so. At current production rates, OPEC output in 2011 will be up 0.3 mbpd, or 1%, on its average for 2010.

Non-OPEC supplies this year have been given a boost by the IEA’s decision in June to release 60 million barrels of crude held in storage. This will add nearly 165,000 bpd to non-OPEC output in 2011, an increase of around 0.3% (though it will reverse in 2012). Including this, non-OPEC supplies are expected to rise by up to 1 mbpd this year, incorporating up to 0.5 mbpd in OPEC natural gas liquids, or NGLs, which are not affected by quotas. Early projections are for a similar-sized increase in non-OPEC output next year, again boosted by OPEC NGLs.

Price projections

The forecast changes in demand and supply in 2011 seem to be broadly offsetting. But after the stock drawdown in 2010, the market needed more oil this year to be brought back into balance. Nevertheless, from a quarterly perspective, the bulk of any market tightening might now be behind us: the global economy is weakening, falling post-summer energy demand should free-up more Saudi oil for export, while the recent rise in OPEC output may now be feeding through the supply chain. Notwithstanding the chance of a 2008-style crisis, therefore, our base case is for oil prices to slip from recent levels and into next year. The price of KEC edges down from its 2Q11 level of $109 pb, but remains above $100 through 1Q12. OPEC is expected to tolerate such a dip, trimming its output only at the margin.

Even if oil demand growth holds up, oil prices could still be pushed lower by stronger than expected supplies, coming either from more aggressive production increases by Saudi Arabia, or from a further release of strategic reserves by the IEA. An extra 0.3 mbpd of oil on the market by 4Q11 would push the price of KEC well below $100 by the end of this year, even if OPEC had already began to trim back its output.

If, on the other hand, global oil demand were to brush off the latest bout of financial market turbulence and turn out stronger than expected, oil market fundamentals could begin to tighten again. An extra 0.4 mbpd of demand in the final quarter of this year, for example, followed by a similar sized increase spread across 2012 would set prices on a firm upward trajectory from the beginning of next year. In this scenario, the price of KEC rises to $113 pb in 1Q12, and higher through the course of the year.

Budget projections

The recently-released government closing accounts for FY2010/11 reveal a budget surplus of KD 5.3 billion before allocations to the Reserve Fund for Future Generations (RFFG). This compares to a budgeted deficit of KD 6.4 billion. With oil prices averaging $82.5 for the year, government revenues reached KD 21.5 billion, more than double the budgeted figures. Total government spending jumped to KD 16.2 billion – a 44% increase on the previous year – thanks partly to the inclusion of an un-budgeted KD 1.1 billion in spending linked to February’s Amiri grant and a large intergovernmental social security transfer.

The three oil price scenarios described above would generate average oil prices of between $104 and $112 per barrel for FY2011/12, a 26%-35% increase on a year earlier. If, as we expect, spending comes in at 5-10% below the government’s forecast, the budget could see a surplus of between KD 7.3 billion and KD 11.4 billion before allocations to the RFFG. This would be Kuwait’s 13^th successive budget surplus.