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With oil prices reaching levels unfathomable only a few months ago and concerns developing over the adequacy of supplies, the market focus appears to have shifted to the longer term supply demand scenario and heightened commodity price pressures, of which oil is a key input.

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

Prospects for price weakness linked to a decrease in US demand have quickly given way to the appearance that demand has held up relatively well in major growth areas such as Asia and the Middle East. Fears are building over the long-term supply prospects once again, as demand for the deferred months picks up on concerns over the limited excess sustainable capacity of OPEC and fears that they have lost control over the pricing mechanism. Given that oil is a key component of price inflation either directly as an input, or indirectly as resources are turned away from food to the production of ethanol and biodiesel, it is no wonder their has been heightened investor interest. The inflow of funds from speculative investors has been pronounced with estimates of as much as 30 bln dollars so far this year into the energy complex. The better buying interest has helped push prices beyond $125 per barrel in the face of what would have been seen in the past as a weak fundamental environment of growing inventories. How long the price strength will persist and how high prices will go is not only contingent on the near term supply demand setup but also the longer-term prospects as well. Key to the outlook will be how quickly demand is reigned in consistent with longer-term supply considerations which are being dynamically shaped by globalization, geopolitical risks and perceived capital investment risks.

Demand Outlook 2008

World demand estimates have weakened in line with economic growth prospects, particularly in the US, but they still point to overall growth in world demand to 86.8 mb/d compared to 85.8 mb/d in 2007, an increase of 1.2 percent. Despite an absolute decline forecast for the US and Europe, growth continues to be evident in countries that have been the drivers of global economic growth such as India and China, along with areas that have been beneficiaries of the commodity boom such as Brazil, Canada and Mexico. To a large extent the weakness in the US and European economies have delinked from major consumption areas of the Mid East and Asia. These areas, which provide varying degrees of subsidies to domestic energy, are proving to be the greatest growth areas for crude and products and are no longer dependent on economic prospects in the main industrialized countries as economic diversification stimulates growing internal domestic demand for energy and other goods.

In the US, it is becoming clear that demand is beginning to contract. Weak economic growth and high retail prices have forced a more conservative mindset upon consumers. More active use of public transportation, more efficient use of miles driven and a preference for energy efficient vehicles is becoming more common. In Mexico and Canada, no notable contraction has occurred. Strong internal demand and high earnings from commodity industries maintains growth in these areas and softens the impact from the slowing US economy. Overall, North American demand is expected to decline by .3 mb/d to 25.2 mb/d in 2008 with the entire decline attributed to the US.

In the OECD countries of Europe, demand has held up better than expected. Germany has shown the best gains reflecting rather strong transportation growth and demand for heating oil. Other areas where economic activity is slowing such as the UK and Italy are sluggish at best. Overall, demand is expected to be rather flat at 15.35 mb/d. In Japan, demand is maintaining a stable rate as nuclear power outages continue to increase fuel oil demand for power generation.

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

Non-OECD demand continues to be the main driver behind growth in global energy demand. In China there have been some disruptions due to the rising gap between domestic and international prices, as the government continues to subsidize the price differential with price caps. Although the caps have led to some shortages, the overall impact has been supportive to demand by limiting the impact of the run up in international oil prices. With spring plantings and the upcoming Olympics, demand is expected to expand further by 5.3 percent to 7.9 mb/d. In India, capped prices are also supporting demand, although government support is limited and some retail outlets are closing as a result of recurring losses. The subsidizing of oil purchases by national governments is seen as a way of avoiding social unrest and stimulating industrial growth. However, the failure to reflect international prices causes distortions which ultimately forces greater adjustments than would occur in those countries where world prices are reflected more fully.

Global Supply Outlook

The Global Supply outlook continues to be marked by the appearance that global reserve replacement has stalled and that the world is entering an era in which recoverable reserves will steadily be depleted. This depletion has been most evident in OECD countries where production has been in a state of decline leading to growing reliance on imports. Areas where potential for supply increases exist include Russia, Asia and South America. OPEC will remain a key swing producer but there ability to meet growing demand is being questioned as limits on sustainable production capacity are being reached.

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

Assuming that OPEC production levels will generally remain stable through the year at 32.0 mb/d, global supplies including natural gas liquids and biofuels are expected to total 87.6 mb/d. In the absence of a major production disruption, supplies should be adequate particularly through September.

If you cannot view the OPEC Crude Production, Target and Capacity chart, go here.

Of utmost importance will be the ability of OPEC and particularly Saudi Arabia to direct the market. So far the Saudis have used their market influence judiciously. They have helped maintain supply availability at a time when the situation looked bleak and members were calling for cutbacks. Although the market looks far from orderly, it does appear they have moderated price spikes which could have forced sharper declines in consumption. Nevertheless, sustainable excess spare capacity among OPEC members is near 3 mb/d with Saudi Arabia accounting for over half at 1.8 mb. Most of this crude is heavier grades rather than the more desirable light crudes. In any case, Saudi Arabia will exert heavy influence on the market and likely continue to be the ultimate decision maker at future OPEC meetings. Already they have shown a propensity to accept higher prices than what had been thought desirable and with little indication that longer term demand prospects have been inordinately damaged, they will be hard pressed to use their pricing power to ease the pain on the developed countries from high oil prices amidst existing supply concerns.

Conclusion

With calls daily for OPEC to take action against the sharp price rise by increasing production, the idea that the market is adequately supplied raises the question as to what the longer term benefits of increasing production levels might be. If anything, it would forestall the demand adjustments that are necessary over the longer term. In addition, it would hinder the shift to other alternative energy resources by posing additional risks to investment. Heightened concerns also might develop as OPEC inches closer to their sustainable capacity limits and further limiting their perceived control over prices.

With demand adjustments, particularly in emerging markets, slow to develop, there is no indication as of yet that the uptrend has reversed. However, demand will ultimately adjust, providing the basis for a sharp correction that could eventually carry values back down to the 110 level. As long as the world economy continues to grow, price moves much below that level will be dependent upon OPEC actions. In the back months, the discount to the nearby's might dissipate as a tighter situation moving forward continues to be apparent.

For more information about this article, please contact Steve Platt at 1.877.377.7931 or via email at Stephen.Platt@archerfinancials.com.

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

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