KEC falls below $100 on softening market fundamentals and stronger dollar

KEC falls below $100 on softening market fundamentals and stronger dollar… but Kuwait still likely to see a record budget surplus
In its latest economic brief on the oil market and budget developments, NBK reports that bearish sentiment in global crude oil markets continued into September, with the price of Kuwait Export Crude (KEC) crashing back below the $100 per barrel mark to reach $98.0 by September 8th – including a record one-day fall of $9.6 on September 2nd. KEC is now down 28% from its peak of $136.2 on 4th July.
Just as tight fundamentals and financial market circumstances provided major support for crude prices in the first half of the year, both factors seem to be having the opposite effect now. Signs of weakening oil demand across OECD countries have coincided with rising crude production from OPEC and better news on US stock levels, while on the financial side, a rally in the US dollar has seen speculative funds exit the crude futures market and undermine oil’s attractiveness as an inflation hedge. Indeed, such has been the change in mood that market sensitivity to geopolitical flare-ups and natural disasters in oil producing regions appears to have ebbed: Russia’s military move into Georgia, for example - which forced BP to close pipelines carrying Azeri oil and gas - left crude prices largely unaffected, as did the passing of Hurricane Gustav through the Gulf of Mexico. In fact, it seems plausible that without these factors, the drop in crude prices could have been even steeper.
Global benchmark prices also beat a hefty retreat through August. The price of Brent crude fell to a low of $101.5 on September 8th, down 18% from the end of July and 30% from its all-time high of $145.7 reached on July 3rd. Other benchmarks recorded similar falls from July 3rd highs: West Texas Intermediate (WTI) reached a low of $106.2 on September 8th, down 27% from its high of $145.3, while the OPEC basket fell 28% to $101.2 from its high of $140.7. Despite signs that the drop in global crude prices had moderated in early September, the latest falls suggest that market sentiment remains weighted towards further weakness.
On the demand side, NBK says that evidence of a meaningful weakening in the growth of oil demand – at least in the OECD countries - has become increasingly visible. According to the US Energy Information Administration (EIA), the first half of 2008 saw a year-on-year fall in US oil consumption of 0.8 million barrels per day (mbpd), the largest half-year drop in 26 years. Indeed, the worsening economic news flow from developed markets is providing some vindication for those, such as the Center for Global Energy Studies (CGES), who have long been on the bearish side of the debate over the demand outlook. Most other market observers, however, still see global oil consumption remaining relatively solid over the next 18 months, supported by strong growth in China, other parts of Asia and the Middle East. The International Energy Agency (IEA), for example, sees growth in global oil demand of 0.8 mbpd (0.9%) in 2008 and 0.9 mbpd (1.1%) in 2009 – only a touch weaker than last year – the latter driven by growth of 3.7% outside the OECD.
Although less keenly reported, an improved supply-side situation has surely been at least as important in draining bullish sentiment from the market. Total crude production of the OPEC-12 (i.e. excluding Iraq) climbed above 30 mbpd for the first time this year in July, rising by 182,000 bpd in July alone largely thanks to an increase in production of 163,000 bpd from Saudi Arabia, which appears to be reasserting its authority as the cartel’s swing producer. Also significant has been the stabilization of Iraqi crude production at above 2.4 mbpd for the third consecutive month, reaching 2.5 mbpd in July, up 300,000 bpd from the start of the year. Meanwhile, Nigerian production, although still 200,000 bpd below its levels of the end of last year, registered its fourth successive monthly rise.
Despite the increases, however, NBK notes that the future direction of OPEC policy remains uncertain. Given the organization’s continuing assertion that its current output levels are “well above” expected demand for its crude, it seems likely to consider reining-in production at its next meeting in Vienna on September 9th. The decision could hinge upon any changes to its extremely optimistic forecast of a 1.2 mbpd rise in non-OPEC supply in 4Q08, which it believes risks flipping the market into a position of oversupply, thus triggering a price crash. Although tentative estimates suggest that non-OPEC supply may have improved in July, any downward revision is likely to leave the organization’s forecast still well above the consensus, making it difficult to justify a production cut without risking a new wave of speculation based upon market perceptions of a new price floor. Other observers expect non-OPEC supply to continue to stagnate this year, rather than stage a decisive rebound.
The interaction between OPEC and non-OPEC supply looks therefore set to assume an especially pivotal role in shaping the path of crude prices over the next 6-12 months and could place the cartel’s role in the price-setting process under increasing scrutiny. If the more bearish forecast of the CGES turns out to be correct, growth in global oil demand could turn out to be much weaker than the consensus view suggests at just 0.5 mbpd in 2008 and 0.4 mbpd in 2009. Even if non-OPEC supply were to disappoint, OPEC is likely to start reining-in output at the start of 2009 in an effort to keep crude prices above $100 pb, with cuts of 0.3 mbpd in 1Q09 and 0.5 mbpd in 2Q09. As global stock levels rebuild, crude prices would test $100 in 1Q09 before rising slightly in the middle of the year as the production cuts take hold. Accordingly, KEC would ease to $97 by 1Q09 but be back above $100 by 2Q09.
Bigger price falls would follow if non-OPEC supply growth turns out to be as vibrant as OPEC expects, though it is likely that the organization would respond to such a scenario with deeper production cuts – this time of 0.8 mbpd in 1Q09 and 0.4 mbpd in 2Q09. However, the comfort that a wider margin of excess production capacity would offer may make a floor of $100 difficult to maintain. We estimate that in this case, KEC would drop towards $80 in 1َQ09, and possibly below by the middle of 2009.
On the other hand, a more bullish scenario involves a combination of weak non-OPEC supply and surprisingly strong global oil demand of 1 mbpd in 2009, as growth in the non-OECD remains largely unaffected by ongoing economic weakness in the developed world. Saudi Arabia would likely lead efforts to accommodate stronger global oil demand, with OPEC output rising by 0.6 mbpd between 4Q08 and 2Q09. Under this scenario, crude prices begin a rapid climb in 4Q08 and KEC could touch $150 by 2Q09.
Under these three scenarios, KEC averages between $102 and $120 for FY08/09 - somewhat tamer than some of the projections of the past few months. Nevertheless, we are still well clear of the types of falls in prices that would put the government’s budgetary position – which would be in balance with an oil price of $75 - under any stress. Indeed, falling oil prices may help the government if it serves to condition expectations of a further big increase in public expenditure next year, which would only aggravate the inflation picture. As it is, if – as has occurred in the past – public expenditure comes in 5-10% below budget (except for the KD 5 billion exceptional transfer to cover potential future liabilities in the social security fund), the FY08/09 surplus would reach KD 6.8-13.3 billion before the allocation of 10% of revenues to the Reserve Fund for Future Generations (RFFG), with a fair chance of exceeding the record surplus of KD 9.3 billion set last year.