Incremental oil demand, non-OPEC supplies and the need for additional OPEC oil

CGES | MARCH 2006 | SOURCE: Global Oil Insight

One of the key factors influencing the price of oil is the degree of ease, or difficulty for that matter, with which OPEC — the world’s marginal supplier — is able to meet the demand for its oil.

The high oil prices prevailing at present are largely due to the low level of existing spare oil capacity in OPEC [under 3% of global oil demand], which places the spotlight firmly on the tension between the need for OPEC oil versus the Organisation’s ability to meet the demand for its oil.

Since OPEC is the world’s residual oil supplier, it seems but a simple task to calculate the need for OPEC oil. All we have to do is to estimate world oil demand, subtract expected non-OPEC supplies and OPEC’s NGLs (for we are primarily interested in crude oil), and we have the call on OPEC’s oil.

We then compare this call with the Organisation’s ability to produce oil and express the difference as a percentage of world oil demand. Low levels of spare capacity imply a tight market and — other things being equal — lead to higher oil prices.

However, this task is more problematical than appears at first sight. First of all, there is the matter of oil inventories. The call on OPEC oil described above does not take into account changes in oil inventories (desired or otherwise), yielding instead a need for OPEC oil that would leave oil inventories unchanged should OPEC actually provide the amount of oil required — the so-called zero stock-change call on OPEC. What if the oil market wants to build inventories, or conversely reduce the amount of oil held in stock? Surely, this would affect the amount of OPEC oil the market wanted.

Secondly, there is the data question. Since the call on OPEC oil in level terms (e.g., ‘X’ million barrels per day) is calculated as the difference between two large numbers, it matters greatly what the two numbers are based on. Any definitional discrepancies regarding world oil demand, non-OPEC supplies and OPEC NGL production could result in significantly different calls on OPEC. Projections based on BP or Argus

Fundamentals numbers, as opposed to International Energy Agency (IEA) statistics, lead invariably to quite different projections of the call on OPEC.

Incremental demand, supply and call on OPEC

A good way of circumventing the problem of differing definitions of oil demand and supply is to derive the call on OPEC oil in incremental terms. When only the increments of demand and supply are considered, the differences of the levels of these variables between sources diminish in importance. It is easier to understand, compare and contrast rates of change of oil demand and oil supply than to cope with different definitions and representations of these variables.

The IEA’s projection of the incremental world oil demand in 2006 can be compared relatively easily with the CGES’ prediction, or with the number to be found in Argus Fundamentals, without having to worry too much about whether the processing gain — for example — is included in the CGES’ definition and not in Argus’.

Provided each prediction of incremental quantities is internally consistent, the precise definition of each variable to which the increment applies is of lesser importance.

To obtain the demand for additional oil from OPEC we start from the incremental world oil demand and then subtract incremental non-OPEC supplies, having incorporated the changes in OPEC NGL production in these incremental supplies (see Table 1). However, the need for additional OPEC oil that results from this operation (item 1 in Table 1) does not take into account any inventory changes that may have occurred in the previous year.

This omission is significant, because in calculating the requirement for additional OPEC oil we need to know whether the base period from which we calculate each increment (in this the case the previous year) was one in which oil inventories stayed the same or not.

If inventories in the previous year happened to have increased then the call on OPEC in the current year has to be adjusted downwards by the amount of this inventory rise to reflect a lower need for OPEC oil than otherwise would have been the case.

Adjusting the incremental call on OPEC oil by the previous year’s change in world oil inventories yields the so-called zero-stock-change need for additional OPEC supplies (item 2 in Table 1).

Taking the year 2004 as an example, on subtracting a 1.3-mbpd non-OPEC supply boost from surging incremental world oil demand of 3 mbpd we obtain a notional need for an OPEC output increase in that year of 1.7 mbpd, which is cut back to 1.4 mbpd on taking into account the 300,000-bpd actual increase in inventories that occurred in 2003.

In 2004, OPEC’s output increased by 1.9 mbpd over 2003, whereas the zero-stock-change need for additional OPEC supplies amounted to only 1.4 mbpd. OPEC oil supplies surplus to requirements went into stock and boosted global inventories by 0.5 mbpd (the difference between 1.9 mbpd and 1.4 mbpd).

Last year incremental oil demand was down to a third of the 2004 figure, but non-OPEC oil supplies also fell, yielding a zero-stock-change incremental call on OPEC of a mere 0.3 mbpd after taking into account inventory changes in the previous year.

Since OPEC’s oil production rose in 2005 by 0.9 mbpd against a 0.3-mbpd zero-stock-change rise in the need for oil from OPEC, the global stock-change figure for 2005 was 0.7 mbpd (with rounding), a second year of substantial global stock-building.

The incremental need for OPEC oil plus stocks

Thus far we have concentrated on the need for additional oil from OPEC based on unchanging inventories, but this assumption is unrealistic. For a start, as the oil market grows from one year to the next there is a need to hold additional oil reserves  in order to keep inventory cover constant. One could call this particular need for extra inventories the ‘transactions motive for holding additional stocks’.

To maintain global inventory cover (including government held or controlled stocks) at 75 days’ worth of forward consumption — that is, at the current level of cover — the oil industry needs an additional 200,000 bpd from OPEC in 2006.

Then there is the precautionary need for extra oil and, since OPEC is the only source of marginal supplies, it is to OPEC that the market tends to look for additional oil should it become worried about the ability of the oil industry to meet demand.

A precautionary stock requirement of two days’ worth of consumption in 2006 is equivalent to 400,000 bpd. Adding these two inventory-related requirements for more OPEC oil (based on the transactions and precautionary motives) to the zero-stock-change need for extra OPEC oil in our base case (-0.6 mbpd in Scenario A as shown in Table 2) obviates the need for more OPEC oil in 2006 (item 3 in table 2). However, what if oil demand grows at a faster pace in 2006 than the CGES predicts?

Taking the IEA’s figure of 1.5 mbpd for incremental oil demand this year and leaving the other increments unchanged leads to a need for 300,000 bpd of additional oil from OPEC (scenario B in Table 2).

Finally, a combination of 1.5 mbpd of extra oil demand (the IEA view) and only 0.8 mbpd of additional non-OPEC supplies (Scenario C) generates a need for 600,000 bpd more oil from OPEC this year — quite a difference in comparison with Scenario A!

As we have seen, the need for additional oil from OPEC depends on the particular assumptions made about incremental oil demand and non-OPEC supplies, and on the transactions and precautionary requirements for more inventories. Moreover, expressing the factors that determine the call on OPEC oil in incremental terms allows us to circumvent definitional problems associated with the levels of the relevant variables.

Finally, isolating the zero-stock-change need for additional OPEC oil from inventory considerations enables us to identify clearly how much extra oil is required from OPEC to leave stocks unchanged and how much is needed to satisfy the oil market’s desire to hold more inventories.

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