Crude oil prices remain elevated because of a tight
supply-demand balance. Let's look at the supply and demand sides of
Some investors still ask me why oil prices remain high even
though demand is weak. This question assumes that sluggish growth
in the US and other developed economies necessarily vitiates oil
In 2010 the world consumed about 88.2 million barrels of oil per
day--2.7 million barrels per day more than in 2009. Whether you
look at the incremental increase in demand or the percentage gain,
oil demand in 2010 increased at the second-fastest pace in 30
years. Much of this rebound stemmed from the snap-back in
consumption that followed the severe 2008-09 recession. But the
magnitude of this recovery took many analysts and industry
participants by surprise.
Investors should also remember that although US oil demand
remains well under its 2004-05 high, global oil demand hit a new
peak in 2010. Demand growth in 2011 won't match up with last year's
resurgence. However, the International Energy Agency's (IEA)
forecast still calls for global oil demand to grow by more than 1
million barrels per day to 89.3 million barrels per day. This
uptick in consumption hardly qualifies as weak; oil demand has
grown at an average annual rate of 1.05 million barrels per day
The IEA has raised its estimate of 2011 crude oil demand sharply
higher since July 2010. Although the agency has trimmed its
projection by about 300,000 barrels per day since August, these
estimates remain far higher than they were six months ago.
(Click charts to expand)
International Energy Agency
The IEA first published its estimate of 2012 global oil demand
in July and has steadily reduced this projection by roughly 500,000
barrels per day. Even with these revisions, global oil demand is
expected to expand by 1.3 million barrels per day. If this scenario
pans out, global oil demand would exceed 90 million barrels per day
for the first time in history.
Of course, accurately forecasting global oil demand is at best
an inexact science that inherently entails multiple revisions.
Signs of economic weakness in the US
and emerging markets have prompted IEA economists to lower their
estimates of 2011 and 2012 oil demand.
Oil prices also factor into the IEA's revisions. When oil prices
are elevated, demand growth invariably slows.
Since the US and other developed economies
hit a soft patch in spring
, the risk to global economic growth skewed to the downside. At the
same time, oil prices remained elevated. These factors prompted me
to call for crude oil prices to drop from sky-high levels in the
April issue of the
Recent developments [unrest in the Middle East and North Africa]
suggest that oil prices will easily average more than $100 per
barrel in 2011. Investors also shouldn't rule out a move to $140
per barrel at some point this year--a price point I had expected in
2012. I see a 50-50 chance that oil breaches $140 per barrel in
2011. As before, Brent crude oil will lead any rallies; WTI should
continue to trade at a discount to Brent for the foreseeable
future. But don't expect Brent crude oil to remain above $120 per
barrel for a prolonged period, as demand growth would suffer.
Contrary to popular belief, sky-high oil prices aren't welcome
news for energy producers, oil services companies and other stocks
in the energy patch. Although profits may jump in the short term,
inordinately high oil prices tend to erode global demand and set
the stage for a correction. Producers would prefer that oil prices
hover around $100 per barrel, a sustainable level that generates
solid profits and encourages drilling activity. Fears of demand
destruction are one of the main reasons energy stocks fall or rally
only slightly when oil prices jump.
This view has largely proved correct. Brent crude oil topped out
near $130 per barrel and WTI had continued to trade at a
historically high discount to its counterparts. The price of Brent
crude also pulled back over the summer, though the benchmark never
breached $100 per barrel. Oil prices should average north of $100
per barrel this year.
Don't expect another run-up in Brent crude oil prices this year:
Economic growth remains sluggish in developed nations, and oil
prices are still high enough to generate some meaningful demand
By the same token, I don't foresee much additional downside for
oil prices in early 2012 because economic risks have receded. As I
The Case of Adding Risk
, US gross domestic product likely grew at the fastest pace in the
third quarter since the second half of 2010.
China's economic growth has decelerated to a 9.1 percent
annualized pace, a sustainable rate which suggests that
policymakers successfully curbed speculation and inflationary
pressures. Look for Beijing to stop tightening monetary policy and
to start taking steps to promote growth by early 2012.
International Energy Agency
I break down the outlook for oil demand in the Americas and
emerging markets in the mid-October issue of
The Energy Strategist
Now that we've gotten the demand view, let's examine the outlook
for oil supply.
The IEA has slashed its estimate of non-OPEC oil production at
an even faster pace than reduced its forecast for oil demand.
International Energy Agency
This graph shows the IEA's estimates of non-OPEC oil output for
2011 and 2012. The agency issues its initial estimate for the
following year in July and revises this projection as
Since May, the IEA has lowered its forecast of 2011 non-OPEC
production by 900,000 barrels of oil per day to 52.8 million
barrels per day. This projection implies year-over-year non-OPEC
production growth of only 200,000 barrels of oil per day.
If global oil demand expands by forecast 1 million barrels per
day in 2011, non-OPEC production will satisfy only 20 percent; OPEC
will need to ramp up production or countries will need to dip into
Global oil inventories have declined relative to 2010 levels,
but these reserves won't fill the gap. This imbalance--exacerbated
by the loss of Libya's 1.5 million barrels per day of light, sweet
crude oil for six months--forced OPEC to tap into spare productive
capacity to cap prices and limit demand destruction.
Investors should pay close attention to OPEC's spare capacity
when divining oil prices. In general, oil prices tend to rise when
OPEC's spare capacity declines.
At the end of 2010, effective OPEC's spare capacity stood at 5.6
million barrels of oil per day. Today, sluggish non-OPEC output
growth, rising demand, and supply disruptions have reduced the
cabal's spare capacity to 3.25 million barrels of oil per day. This
single statistic tells you a lot about why oil prices have been
resilient this year.
Spare capacity should remain tight. Libya's oil production may
recover to between 200,000 and 300,000 barrels per day by early
2012 But the Libyan government has admitted that production won't
return to pre-conflict levels before early 2013.
Meanwhile, the IEA has lowered its estimate of 2012 non-OPEC
production by 400,000 barrels of oil per day. Expect OPEC's spare
capacity to dwindle throughout 2012.
I foresee more downside risk to the IEA's non-OPEC supply
estimates than I do for global oil demand. Producers increasingly
have to target complex, expensive-to-exploit fields in the
deepwater and other remote areas to generate incremental output
growth. Drilling activity has also increased in unconventional
plays such as North America's shale oil and gas fields and Canada's
T he balance between global oil demand, supply and spare capacity
remains tight. Higher oil prices are necessary to incentivize the
development of complex fields. Higher prices are also the only way
for the global oil market to effectively limit demand; if
consumption growth in 2012 matched the IEA's estimate for 2011
demand growth, the world's spare capacity would be effectively
Based on this outlook, I continue to favor oil services names
like Weatherford International (NYSE:
) and Schlumberger (NYSE:
), which have pulled back because of the recent growth scare and EU
sovereign-debt crisis--not the realities of the global oil market.
I profiled Weatherford International in an August 2011, article for