Crude prices rise on weak dollar, stronger oil demand... Kuwait could see another budget surplus in FY10/11

NBK’s latest Oil brief stated: After starting the month weakly, crude oil prices crept slowly upward through July, reversing most of their earlier losses. The price of Kuwait Export Crude (KEC) finished July at USD 73 per barrel (pb) after dipping below $68 at the start of the month. Nevertheless, this is still some way off the near 2-year high of USD 84 recorded in early May. Despite a certain amount of volatility, prices have been fluctuating near the USD 70-80 pb range for the past 9 months, leaving USD 70 looking like a floor for prices at present.

Crude’s solid performance through July came despite fears of a softening global recovery may be softening, including data showing that US GDP growth decelerated in 2Q 2010 and that Chinese manufacturing activity slowed to a 17 months low. But there have been two important offsetting forces. First, despite macroeconomic concerns, demand for oil seems to be holding up relatively well. The latest release from the Joint Oil Data Initiative (JODI) – an international body set up to improve oil sector data and timeliness – showed OECD oil demand rising at its strongest for more than seven years in May. Second, crude prices were supported by a weaker dollar, which fell 4% in trade weighted terms in July and by 6% against the Euro. In Euro terms, crude was more or less unchanged at around EUR 56 pb through the month.

Prices of most global benchmarks breeched the USD 80 pb mark in early August. The price of West Texas Intermediate (WTI) reached USD 81 on August 2^nd, some USD 9 above its low in early July. Meanwhile, WTI’s main European equivalent, Brent, increased nearly USD 11 from its low to USD 82. Futures contracts for both crudes have also climbed strongly, with prices now expected to reach almost USD 88 by the end of 2012.

In support of this outlook for prices, analysts expect two years of strong growth in oil demand for 2010 and 2011. Few appear worried about a ‘double-dip’ scenario for the world economy. In most projections, emerging markets will continue to account for the bulk of the increase in oil demand, but the share contributed by richer markets will rise. The Centre for Global Energy Studies (CGES), for example, sees global oil demand expanding by 1.5 million barrels per day (mbpd) this year (1.8%) and 1.6 mbpd (1.8%) next. Countries outside of the OECD account for all of the increase this year, but just over 80% in 2011. The International Energy Agency (IEA), meanwhile, expects growth of 1.8 mbpd (2.1%) this year and 1.4 mbpd (1.6%) next. But – unlike other forecasters, it sees demand in the OECD resuming a gentle decline in 2011. This would come as a combination of efficiency gains and of substitution towards other types of fuels which would more than offset the impact of faster growth on oil demand.

Note that OPEC continues to offer a more pessimistic view. It sees demand growing by a cumulative 1.1 mbpd less over 2010 and 2011 than the IEA, for example. This helps to justify the cartel’s cautiousness over any future increases in its own crude production.

According to data published by OPEC, crude output of the OPEC-11 (i.e. excluding Iraq) rose by 64,000 bpd in June to 26.86 mbpd – its second largest monthly jump this year. Overall production is more than 2 mbpd above its official quota levels, an effective compliance rate of around 50% with the output quotas of December 2008. Most of the increase in June came from Saudi Arabia, which saw its output rise by 44,000 bpd. Since the Kingdom is usually one of the organization’s most disciplined members, the rise could signal a softening of OPEC’s hawkish stance, particularly in light of the growing external consensus over the robust outlook for oil demand. Nevertheless, an official change in policy stance is still considered unlikely before the cartel’s next meeting in October. The organization remains wary of the potential for natural gas liquids and non-OPEC crude to add as much as 1.3 mbpd to global oil supplies this year, thus shifting the market balance. But as time passes by and prices remain high, such concerns may be fading.

The potential for sizeable increases in both oil demand and supply over the coming year leaves scope for substantial uncertainty in the outlook for crude prices. The broad consensus over the likely strength of oil demand comes in spite of the uncertainty surrounding the world economy. Assuming that oil demand grows by a healthy 1.5 mbpd in 2010 – albeit with the pace of growth slackening this year - and non-OPEC supplies rise by around 1 mbpd, prices seem likely to drift lower into 2011. The price of KEC might dip from USD 76 in 2Q10 to below USD 70 in 1Q11.

Worse than expected global growth could trigger a much weaker scenario for oil prices, however. This might come about, for example, as a result of a loss of momentum in the world economic recovery, the implementation of government austerity measures or a more sudden crisis triggered by concerns over sovereign debt. In this case, demand rises by just 1.2 mbpd in 2010 sending the price of KEC to below USD 60 by the start of 2011. The degree to which such a fall occurs might be dependent upon OPEC’s willingness and ability to implement production cuts amidst declining oil revenues.

Stronger world economic growth, on the other hand, could see global oil demand rise by an amount more in line with the IEA’s prediction of 1.8 mbpd this year. To avoid prices escalating too far, OPEC might relax their quotas, adding around 0.4 mbpd to its output by early 2011 compared to the scenarios above. Under these conditions, the price of KEC could reach mid-USD 80 levels by 1Q11.

The NBK report concluded: The above scenarios leave the price of KEC in the USD 67.3 to 79.9 pb range for this fiscal year. This is well above the USD 43 projection used by the government in its current budget. Under the government’s projection, the fiscal deficit would reach KD 6.4 billion this year. In fact, if, as we assume, government spending comes in at 5-10% below budget levels, our oil price scenarios could generate a fiscal surplus of between KD 0.9 and 5.7 billion this year, before allocations to the RFFG. This comes despite an increase in budgeted spending of some 33% this year, and would see the budget record its 12^th consecutive annual surplus following a surplus of KD 6.4 billion in FY2009/10.