Markets have shown very little reaction to OPEC's announcement of a 2 million barrels a day increase in output. Instead they remain focused on the possible impact of Hurricane Rita.
There are a number of reasons for this lack of interest in OPEC. At the most general level, markets are sceptical that the announcement makes much difference, since most of the cartel is already pumping as much crude as it can. Any additional crude output would come from Saudi Arabia, in the heavy sour grades which are not currently in great demand.
The bigger picture is that markets are gradually adjusting to the growing importance of refining capacity rather than extraction capacity. Until recently, the conventional wisdom was that higher gasoline prices should result in higher crude prices, as crude producers took their slice of the enlarged pie. For example, both gasoline and crude oil prices rose following news of the accidents at BP's Texas City refinery in March and July this year.
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However, the effects of Hurricane Katrina may undermine this conventional wisdom. Current estimates suggest that Katrina caused greater loss of refining capacity than of crude extraction capacity. Four refineries remain shut down. This makes it more likely that refining capacity will be seen as the biggest constraint. But if there really is greater supply of crude than ability to refine it, then the industry literally has more crude than it can use. Markets haven't yet taken this thinking to its logical conclusion - that if refining capacity is scarce then crude oil is plentiful, and should be expected to fall in price.
A production chain can typically have only one choke point' which is the binding constraint on overall supply. The processes which are upstream from this point are in danger of over-supplying in comparison. Oil is no different. The more that refining capacity limits overall consumption, the more that crude oil slips into over-supply. The bottom line is that no-one should have any interest in buying crude that they cannot refine.
We have been getting steadily closer to a point where lack of refining capacity is the binding constraint at a global level. Global oil demand has been increasing over recent years, but crude oil supply has responded. Refining capacity has been less responsive. The US has famously not built a new refinery since the 1970s. The amount of spare refining capacity has narrowed, and is likely to have shrunk further during 2005.
These estimates can never be entirely reliable, since it is not clear how close to its theoretical full capacity the global refining industry can actually get in practice. The measures suggested in the US since Katrina (eg. suspension of regular refinery maintenance) are an indication of the degree of concern on this issue. The relative lack of demand for crude can also be seen in the fact that only 11m barrels has been bought from the US strategic reserve (of the 30m barrels on offer).
However, the best evidence of the scarcity of refining capacity is in the crack spread (the differential between the prices of crude and refined product). This had already risen from around $5 to $10 per barrel over the past two years as refining capacity became tighter. It leapt sharply higher as the damage done by Katrina became apparent.
More generally, crude oil supply is tight, but not as tight as is generally supposed. Even after the initial Katrina-related fall, crude oil stocks are higher than is usual at this time of year. These high stocks are unlikely to be a coincidence, since fears of future shortages have given every incentive for stockbuilding. This stockbuilding is often interpreted as a response to the contango in futures markets (higher prices in the longer futures contracts), but the bigger picture is that the contango is itself likely to have been the result of pervasive fears of future supply shortages. This could all now change.
Our forecast of falling crude oil prices has up to now been based on a number of factors: that crude oil supply was increasing in response to higher prices, stocks were already high, and demand growth would soften (indeed, the International Energy Agency has repeatedly revised down its estimate for current oil demand as higher prices start to bite).
The damage inflicted by Katrina on US refineries has nudged us further towards a situation in which crude oil prices may fall even if underlying demand for oil products were to remain strong. Crude oil output is likely to continue rising faster than refinery capacity, and so lack of refining capacity is increasingly likely to undermine demand for crude. This would see gasoline prices rise further, but crude oil prices could fall sharply in this high growth scenario as well as in the low growth scenario.
The increasing shortage of refining capacity supports our view that Brent crude is likely to fall back below $50 per barrel before the end of the year. Indeed, with OPEC confirming that it wants to keep prices above $40, we could soon see renewed talk of future OPEC output cuts.
By Simon Hayley, Senior International Economist at Capital Economic
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