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In its November outlook, the International Energy Agency (IEA) warned that there were strong indications that high prices were depressing demand. In addition, the IEA noted that higher output was evident. The comments were in many ways prescient. While talk of 100 dollar oil continued, the market had different ideas of vulnerability. Values have fallen in short order from a high of 99.20 to a low under 88.00, a decline of over 10 percent.

If you cannot view the Weekly Crude Oil Continuation chart, go here.

The weakness was caused not only by the reassessment of supply/demand fundamentals, but also by a reallocation of assets from commodities back into equities. For now it appears that central banks in concert with sovereign funds, fearing a much wider contagion, are attempting to inject some stability into financial markets. The crude market, whose fortunes are intertwined with the world economy, is likely to be tested in the New Year. High prices have started to have an impact on supply/demand relationships. How quick and to what extent the adjustments occur will be critical in determining the outlook for crude oil prices in 2008.

Key considerations include:

• Economic growth, particularly in non OECD areas, and how the credit crisis impacts these areas and ultimately energy usage.
• Movement toward low sulfur distillates and lower carbon emission and its impact on prospective demand. 
• Expansion in refining capacity amidst limitations on crude supplies and the corresponding impact on refining margins.
• OPEC’s ability and willingness to make additional supplies available to the market. 
• Weather. 
• Future repercussions over the availability of supplies due to the Iranian impasse over nuclear weapons, Nigerian civil unrest and the Iraq war.
• Impact on supply availability of rising nationalism in Venezuela and Russia.
• Environmental activism and its impact on energy usage and the adoption of alternatives to petroleum products.

The list is far from all-encompassing but includes areas that are likely to provide shocks to values, both up and down. With what appears to be stagnant growth in crude supply, strains will quickly become apparent on sudden shortfalls or if demand growth accelerates. Given the relatively tight supply/demand situation there is little room for unexpected surprises.

2008 Supply and Demand prospects

If you cannot view the World Oil Supply and Demand chart, go here.

World oil demand in 2008 is currently expected to reach 87.7 mb/d. Due to interfuel substitution toward natural gas and only a modest increase in transportation use, demand from OECD countries will show a modest increase of .6 mb/d to 49.8 mb/d. Further revisions downward might be in the offering if the winter proves milder than normal in Europe or the U.S., and economic growth, particularly in the U.S., weakens further from current forecasts.

The highlight of the demand side is expected to come from non-OECD countries, where and increase to 37.9 mb/d in 2008 from 36.5 mb/d this year is expected. However, with retail prices being allowed to move up domestically in China and other non-OECD areas beginning to pass on the higher crude price despite prevailing subsidies, the actual level might fall short of forecast and be closer to 37.7 mb/d. Efficiencies through conservation and uncertainty associated with the global economic outlook might necessitate additional adjustments.

The world supply situation is also offering some uncertainty following pronouncements that production is too low. Ongoing entreaties for additional production heard recently by OECD countries might not be necessary as production begins to surge. For October, it was estimated that production totaled 86.4 mb/d, 1.8 mb/d above that reached in August as OPEC and Russia took advantage of a favorable price environment.

OPEC production reached 36.2 mb/d in October, 1.0 mb/d above August. The majority of OPEC increases were in Saudi Arabia (.25 mb/d), Iraq (.4 mb/d) and new member Angola (.1 mb/d). The latter two are currently exempt from quotas although Angola will lose this exemption at the beginning of 2008.

An overview of these areas suggests:

• Iraq has seen the benefits of an improvement in security and could become one of the potential growth areas over the next few years.
• Angola’s production is likely to level out given that their quota for 2008 will be assigned based on 2007 production levels.
• Saudi Arabia will remain the swing producer, exerting pressure on all members of OPEC. However their influence is limited to there excess reserves and sustainable capacity.
• Other OPEC members are showing limited gains and some, such as Indonesia and Venezuela, are witnessing declining output levels.

As we move through the OPEC meeting on December 5, 2007, we look for the Saudis to favor the status quo and maintain current production levels while allowing marginal non-compliance by some members. In the near term, the impact might not be as bullish as one might think given the uncertainty due to weather and the economy as we move into 2008. In addition, the expansion in production from non-OPEC countries could be seen as a near term threat to prices.

Non-OPEC supplies are anticipated to expand in 2008 to 51.2 mb/d from the relatively low rate of 50.14 mb/d in 2007. Production gains in the former FSU will account for as much as .5 mb/d in increased output. The rising market share of Russia will provide increased leverage in international economics and relations as the FSU and Russia exert their new found economic might upon Europe.

Despite the relatively favorable outlook, supplies will still fall short of anticipated demand. Although the supply demand situation has improved since the summer and fall, the stability and near term pressure on values could be short-lived. Given the tight situation, any production shortfalls or stronger than expected demand could have an inordinate impact on values. For now, valuations are reflecting disappointment that the supply/demand situation will not be as tight as previously forecast. Despite the improvement, the world will still need to see further deterioration in demand to avoid a repetition in 2008 of the tightness that we saw this year.

If you cannot view the
World Crude Oil Supply and Demand chart, go here.

Price Outlook: Short term risks on downside but longer term bullish bias

In the near term, the potential for further downward revisions in demand coupled with the possibility that supply availability will improve into the first half of the year should help restrain values on the upside. Given the overextended nature of the market, the depth of the decline may be substantial. Prices have the potential to test the 80.00 area, particularly if crude stocks begin to build at Cushing. Only on a retracement back up through the 95.30 area basis January would the continuation of a weak trend be called into doubt for the intermediate term.

If you cannot view the January Crude Oil chart, go here.

We suspect that the deferred months will attract better support given the appearance that demand could hold up late in 2008 if values were to weaken now. We see the impact of lower prices now as the foundation for a renewed uptrend in the coming year. December 08 crude should present a buying opportunity in the 77.50-78.00 area, risking 73.00, with an objective of 105-110. At current levels, demand will not be rationed enough to come in line with supplies. Only with sharply higher prices can demand be stifled sufficiently to impede the prospective stock drawdown forecast currently for 2008 and into 2009.

The information and comments contained herein are provided as general commentary of market conditions and are not and should not be interpreted as trading advice or recommendation. The information and comments contained herein are not and should not be interpreted to be predictive of any future market event or condition. The information and comments contained herein is provided by ADM Investor Services, Inc. and not Archer Daniels Midland Company. Copyright © ADM Investor Services, Inc.

Charts Courtesy of DTN