Oil seems set to hit the $200 barrier

SERIOUS MONEY:Like it or not, the price of oil is marching relentlessly upwards towards $200 a barrel

BLACK GOLD continues to defy its sceptics and in March surpassed the inflation-adjusted all-time high registered in 1980 following the Iranian revolution.

Oil prices have since continued their seemingly relentless upward march and reached more than $135 a barrel a fortnight ago, an increase of more than 50 per cent from January's recent lows.

The frenzied trading activity during May sparked furious debate among market experts with Goldman Sachs suggesting that $200 oil was within reach while the venerable George Soros argued that the oil market was in the midst of a speculative bubble.

An examination of the dynamics behind the recent surge in oil prices is revealing. The increase has been accompanied by a sharp upward shift across the forward curve of futures prices, which saw the entire term structure flip.

Traditionally, futures prices are progressively lower the further away the delivery date - a situation which is known as backwardation.

Currently, prices of long-dated contracts through 2016 are trading at a price above short- dated contracts, a scenario known as contango.

What is unusual about the current development is that oil typically trades in backwardation and moves into contango through a fall in the price of near-dated contracts arising from an unplanned but temporary inventory build-up.

Recent trading activity saw contango emerge as the price of long-dated contracts appreciated by more than their near-dated brethren, which is unprecedented in the modern era, and suggests that long-term supply concerns are gathering momentum.

Careful analysis of supply fundamentals suggests that medium-term output concerns are legitimate.

World oil production has not responded to the doubling of prices over the past 2½ years and is barely higher than in 2005, a year that was characterised by the output shortfalls in the aftermath of hurricanes Katrina and Rita.

Annual supply estimates have been continually revised downwards in recent years and, although the International Energy Agency (IEA) recently cut its demand forecast for 2008 by more than one million barrels a day, this was accompanied by a comparable reduction in its supply estimate.

The evidence emanating from the supply data was largely ignored until recently as analysts focused almost exclusively on the emergence of China and India as the rationale for higher prices.

However, the complacency recently received one blow after another. Russia revealed that output dropped during the first quarter for the first time in a decade. This was followed by an admission from Lukoil's Leonid Fedun that his country's oil production had already reached a peak.

Worse was to follow when Saudi Arabia's energy minister confirmed that there would be no production increase beyond the current projected supply of 12.5 million barrels a day over the next year, which raised eyebrows as to the reliability of the official estimates that paint a picture of abundant oil for the foreseeable future.

Indeed, a former director of Saudi Aramco recently claimed that the kingdom's proven reserves were almost 50 per cent below official estimates.

The difficulties embracing the oil complex stem from its dependence on a small number of large oilfields, several of which have passed peak production and are now encountering high depletion rates.

Saudi Arabia's Ghawar, the world's largest oilfield accounting for 60 per cent of the kingdom's production, peaked two years ago and supply is currently dropping at a rate of 8 per cent per year.

Similarly, peak production estimates at Kuwait's Burgan field, the world's second largest, were lowered by 20 per cent in 2005.

The world's third largest field, Mexico's giant Cantarell, peaked in 2004 but its production decline is even more alarming at 15 per cent a year.

The output declines being experienced by some of the world's largest oilfields have contributed to one percentage point acceleration in the depletion rate from existing fields to 4 per cent in recent times.

The deterioration in the medium-term supply outlook has been aggravated by the increasing dependence on offshore fields for new production growth.

Deepwater fields, for example, exhibit depletion rates twice that of conventional fields. Steep declines have already been seen in the North Sea and, given that most of the world's new fields over the past decade have been offshore, the upward momentum in depletion rates can only accelerate.

This means that the oil complex will have to work ever harder just to stand still let alone meet the projected 1.5 to 2 per cent annual demand growth in the future.

Unconventional production is not sufficiently large to alleviate supply concerns and it remains to be seen whether the current enthusiasm for biofuels will be maintained in the face of rising food prices.

This means that the oil price must rise by enough to spur demand destruction. There is evidence that this is already happening in the developed world with airlines and automakers feeling the pinch.

Weaker demand may cause oil prices to drop in the short term but growing supply problems means that it is hard to argue against anything other than $200 a barrel oil on the horizon.

[ www.sequoia.ie ]