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The Energy World's Perspective - A Review & Forecasts, With Focus On The ME.

The Middle East is the heart of the energy world. Apart from being the leader of OPEC, i.e., leader of the world of conventional petroleum, the Middle East is the centre of gravity for global politics and global economics. This is because the world's biggest economy and the leader of world politics, the US, is as much a part of the Middle East as this region is part of what will make or break the US as the globe's sole super-power.

The oil world has two separate markets. One is a futures market trading in paper oil in which psychology is the key. The other is a far smaller market for physical oil in which the fundamentals of supply and demand are the rule.

Squeezed between the two, OPEC - which supplies 40% of the world's physical crude oils - has kept its official 27.25m b/d production ceiling unchanged until its oil ministers meet on Feb. 1, 2008.

The oil world, however, has a third logic which should make us all cautious about the future: dependence on oil supplies from the Middle East is getting increasingly critical while, at the same time, there is uncertainty about the security of future demand for oil from this region. The third logic also means hesitation about investment in E&P in the Middle East beyond 2009/10 (see omt24-OPEC-EnergyPersp-Dec10-07).

Oil, however, is part of a much wider world of energy; and a quick review of this is necessary to perceive what may lie ahead for all concerned. The main driver in the energy world is paper oil, the price of which sets the market value for each of the various sources of physical energy - both conventional petroleum and its alternatives.

The main price taker in the energy world is the speculator in paper energy, the value of which is set in futures markets such as NYMEX in New York or ICE in London. The main factors to driving prices for paper energy - hence for physical sources of energy - since late 2002 have been, and for the near future will continue to be, in this order of importance:

Capacity shortages across the whole chain of energy businesses worldwide, a problem aggravated by the third logic - uncertainty about the future for any physical source of energy which is more vulnerable to competition than the other sources. This part of the third logic, as mentioned above, is to become a serious problem.

Geo-politics in both the producing and consuming parts of the energy world - for paper energy as well as for the physical sources of energy - including political violence in the Middle East, Africa and other parts of the world (see news26-Rev&ProspDec24-31-07). This problem is aggravated by a combination better energy economics and protectionism in the consuming world - such as energy efficiency, conservation, fuel substitution, investment in alternative sources of physical energy, etc. - and resource nationalism in the producing world.

In turn, this problem is aggravated by both an increasing lack of confidence between producers and consumers (i.e., lack of demand security being countered by lack of supply security from the producers' side) and a four- or five-fold rise in project costs as well as a 40% fall in the value of the US dollar since late 2002. The latter is aggravated by a steady rise in global inflation in the more recent years, which seems to be rising at a more rapid pace in the coming years.

The weather, which is the shortest-term factor pushing or pulling prices of paper energy (led by paper WTI at NYMEX) in at least two cycles within every year. International oil companies (IOCs) have been investing less in storage of physical crudes and fuels which used to be a good buffer against the strong demand months, while from the supply side the national oil companies (NOCs) have been spending less on the use of VLCCs and ULCCs as floating reserves which used to sail close to the markets to meet any surge in demand.

Aggravating this - some call it a problem for physical oil, others use it as a profit opportunity for investors in paper oil - has been a steady fall in the levels of commercial fuel inventories. This has been caused mainly by quick-profit considerations among the IOCs and other energy corporations and by steadily rising storage and shipping costs.

The Fear Factor: Thus WTI at NYMEX moved close to $100/b in November, driven by a collapsing US dollar, a tense Middle East and worries over a winter fuel supply crunch. Speculators then said it was only a matter of time before WTI hit triple digits, with tightening stocks adding to the fear factor.

On Dec. 3, however, the fear factor lost much momentum as a US National Intelligence Assessment (NIE) report said Iran had stopped its nuclear weapons development in the autumn of 2003 (see news24-GCC-IranDec10-07).

Now this fear factor is dependent on winter demand, stock levels, the current Turkish incursions into northern Iraq's Kurdistan against PKK rebels (see ood6-IraqTurkeyDec31-07), and the possibility of a terrorist attack somewhere in the Middle East.

On the other hand, the Dec. 3 NIE report contained two road-maps as far as Iran was concerned. One is a road-map for peace based on political deal between the US and Iran over security in Iraq, to be followed by more difficult negotiations for a deal over Tehran's nuclear and regional ambitions. The second is a road-map for war, a road-map through which Israel seems confident it will be better placed to navigate than the Bush administration, which will be busy with presidential electioneering in 2008, or the next US administration beyond January 2009.

The question for now is whether the Bush's Republican strategists - particularly the military - have confidence in the capabilities of the current government in Israel under a weak Prime Minister, Ehud Olmert, whose poor handling of the July/August 2006 war with Hizbullah in Lebanon has raised many questions in the Pentagon (see news26-Rev&ProspDec24-31-07). Yet much will depend on the first road-map (see this week's rim6-IraqShi'iteSplitDec24-07 and ood6-IraqTurkeyDec31-07).

However, forecasts that a war with Iran and/or a blockade of the Strait of Hormuz by Iran or the US would caused the WTI price to double - with Venezuelan President Hugo Chavez having repeatedly predicted a $200/b price in such a case - are countered by a completely different price scenario. Such an event would mean a non-commercial state of emergency in which case WTI will fall drastically, perhaps below $50/b, because the US and the other IEA member state would immediately release their strategic oil stockpiles.

Related to the third logic - uncertainty about the Middle East meeting world oil demand beyond 2010 - is the rise in costs from food to construction and skilled work forces. This says the current oil price is way under the inflation-adjusted peak of $109/b WTI hit in late 1979, when Khomeinist students seized the US Embassy in Tehran.

In the physical market, there is no shortage of crude oils - an argument OPEC ministers have kept repeating for months in 2007 - which means the real price of physical WTI should be less than $50/b. But the fear factor has migrated from the paper market, pushing the value of physical oil closer to the peak reached in late 1979. This is also what is happening to the energy world.
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Publication:APS Review Oil Market Trends
Date:Dec 24, 2007
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