Oil Market Report: 12 August 2008

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Highlights

  • Crude prices had fallen $30/bbl from mid-July highs by early August on increased supplies, weaker OECD demand and as the first US Gulf hurricanes passed without causing damage.  Currently, neither the recent shut-down of the Baku-Tblisi-Ceyhan (BTC) pipeline, nor military clashes in the Caucasus have materially affected prices.
  • OECD oil stocks fell by 15.3 mb in June to 2,579 mb, confirming the near absence of the usual 0.9 mb/d 2Q stockbuild.  Weak demand kept OECD forward demand cover above average at 53.4 days.  Preliminary July data for the US, Japan and the EU-16 show a 30 mb stockbuild.
  • Global oil supply increased by 890 kb/d in July to 87.8 mb/d.  Norway, Canada, Argentina and Brazil underpinned non-OPEC growth of 520 kb/d, amid a lull in seasonal maintenance elsewhere.  Growth in non-OPEC output now averages 455 kb/d for 2008 and 665 kb/d for 2009, after 425 kb/d in 2007.
  • OPEC July crude supplies rose by 145 kb/d to 32.8 mb/d.  Nigeria, Saudi Arabia and Iran all saw higher output, although over 0.5 mb/d remains shuttered in Nigeria.  Effective OPEC spare capacity is 1.5 mb/d, but should rise by end-2008 and through 2009.
  • Global oil product demand for 2008 remains unchanged at 86.9 mb/d (+0.9% or 0.8 mb/d versus 2007).  Demand in 2009 is nudged up 70 kb/d to 87.8 mb/d (+1.1% or 0.9 mb/d versus 2008).  Growth is driven by projected non-OECD demand, largely unchanged at 38.3 mb/d in 2008 and 39.7 mb/d in 2009.
  • Global refinery crude throughput averaged 75.0 mb/d in July, 0.1 mb/d up versus June.  Lower OECD crude run estimates on still-weak US refining margins offset upward revisions to China, after its record June throughput.

Sea change, or just ebb and flow?

Crude futures have fallen 20% from early-July highs.  Any fall from recent peaks is welcome, but $115-$120/bbl remains high by any measure, sustaining inflationary concerns, not least in developing importer countries.  However, this report and the MTOMR have for some months pointed to a potential easing in fundamentals for 2H08 and into 2009, before a renewed tightening thereafter.  Minor adjustments to the fundamentals this month do not change that view.  The past month has seen renewed signs of weaker OECD economic performance and most forecasts see US and European growth edging lower in months to come.

Despite slightly stronger than expected US GDP growth in 1H08, oil demand data are coming in weaker on an underlying trend basis.  Annual US demand revisions for previous years, positive to the tune of 100-200 kb/d during 2004-2006, came in for 2007 at negligible levels.  This only reinforces the view that high prices are beginning to play a central role in determining demand, at least for the OECD countries.

On top of slowing demand, July OPEC crude supply of 32.8 mb/d was 1.0 mb/d above April levels. Moreover, there are encouraging signs for crude capacity, with summer field start-ups in Nigeria and Angola, and a reportedly imminent capacity boost in Saudi Arabia, which could raise OPEC spare capacity from July's very low level of 1.5 mb/d.  Middle distillate tightness (which we believe has been a key driver of crude prices) has begun to ease, and there is some prospect of higher natural gas availability unwinding a recent tightening in fuel oil fundamentals.  Weaker products markets after a post-maintenance increase in supply have now led OECD refiners to trim runs in the face of poorer margins, thus squeezing utilisation rates.  The dollar has staged something of a rally, NYMEX open interest has fallen sharply and net non-commercial positions have turned short.

Is this really the tipping point for the market that some pundits have identified?  We would hesitate before automatically extrapolating the recent price trend.  Our 'all other things being equal' forecast suggests easing fundamentals and potentially higher stocks in the months to come.  But July and early August have thrown up a number of warning signs which caution against complacency.  On the supply side, major outages have affected Nigerian and Azeri supplies these past two weeks.  The outage on the BTC pipeline and recent hostilities in the Caucasus highlight the potentially precarious nature of pipeline energy supplies from the region.  Hurricanes Bertha and Dolly, and Tropical Storm Edouard, did little damage to oil installations, but flagged a vigorous start to what could be an active autumn storm season.  Project delays abound, with suggestions that major projects in Brazil, Canada and Russia will now be late.  Political logjams could further derail Iraqi and Russian supply growth. OECD inventory remained worryingly flat in 2Q08 (versus a normal 0.9 mb/d build) and recent trends in Chinese crude runs suggest a possibility of stronger than expected demand, pre-Olympic stockpiling, or both.  While OECD demand could still surprise us on the downside, non-OECD prospects, particularly for China and the Middle East Gulf, could be subject to upside adjustment.  Add in customarily ever-changing sentiment over Iran, and it looks too early to cite definitively a sea change in the market.

Demand

Summary

  • Forecast global oil product demand remains virtually unchanged in 2008 at 86.9 mb/d, +0.9% or 0.8 mb/d versus 2007.  For 2009, the forecast has been nudged up by 70 kb/d to 87.8 mb/d (+1.1% or 0.9 mb/d versus 2008), mostly following a reassessment of the demand outlook in OECD Europe.
  • OECD oil product demand is expected to average 48.6 mb/d in 2008 (-1.3% or -0.6 mb/d versus 2007, and 16 kb/d lower than previously estimated).  In 2009, demand is expected to contract to 48.0 mb/d (-1.1% or -0.5 mb/d on a yearly basis, and 47 kb/d higher than in our last report).  This outlook incorporates annual revisions to historical OECD data (+100 kb/d on average between 2000 and 2007), as well as minor GDP revisions following the release of the IMF's World Economic Outlook Update and a marginal upward reassessment of German heating oil demand.


  • Forecast non-OECD oil product demand remains largely unchanged at 38.3 mb/d in 2008 and 39.7 mb/d in 2009, equivalent to annual growth of +3.8% or +1.4 mb/d in both years and roughly 20 kb/d higher than previously estimated.  In general terms, minor upward adjustments in Asia and the FSU exceeded slight downward revisions in Latin America.
  • In light of the Beijing Olympic Games, the short-term outlook for China's oil demand remains subject to considerable uncertainty.  On the one hand, the recent strength in crude and oil product imports may diminish after the Olympics, provided that stocks are ample.  However, demand will likely rebound as temporary measures to curb pollution are lifted.  On the other hand, ongoing power shortages could herald a spike in gasoil use, even though high prices may also deter small-scale power generation.  Finally, it is unclear whether the government may adopt policies that could potentially induce further changes to the supply and demand picture, notably regarding import taxes and end-user prices.

OECD

OECD inland deliveries (oil products supplied by refineries, pipelines and terminals) contracted by 1.4% year-on-year in June, according to preliminary data.  Losses in North America and Europe largely offset gains in the Pacific.  In OECD North America (which includes US Territories), oil product demand continued to shrink (-2.2% year-on-year) given the weakness of the US economy and restricted driving by US motorists, deterred by high oil prices.  In OECD Europe, demand fell by 2.3% given losses in the five biggest countries, most notably in Italy and Spain.  In OECD Pacific, by contrast, demand rose by 2.7%, supported by strong Japanese electricity needs and, to a lesser extent, by buoyant demand in Australia, partly boosted by the unexpected diesel spike that resulted from the Varanus natural gas outage.





It should be noted that this report incorporates the customary annual revisions to OECD figures, following data submissions from all member countries.  These adjustments are not uniform; for some countries, they go back to as far as 2000, as detailed in the table below.  OECD demand has thus turned out to be slightly higher than previously anticipated.  The 2007 revision (preliminary) has largely been carried through to the 2008 and 2009 forecast.





In addition, the outlook incorporates minor changes to GDP assumptions for several key countries following the July publication of the IMF's World Economic Outlook Update, as well as a marginal reassessment of heating oil prospects in Germany.  OECD demand is thus seen averaging almost 48.6 mb/d in 2008 (-1.3% or -0.6 mb/d over 2007, and 16 kb/d lower than estimated in our last report).  In 2009, demand is expected to contract by 1.1% on a yearly basis (roughly -0.5 mb/d) to 48.0 mb/d, some 47 kb/d higher than previously estimated.



North America

Oil product demand in North America (including US Territories) shrank by 2.2% year-on-year in June, according to preliminary data, mostly as a result of continued demand weakness in the US.  As in the previous month, deliveries for three product categories contracted conspicuously: high-sulphur gasoil (-29.5%, although this is related to US reclassification issues, since low-sulphur non-road, locomotive and marine gasoil are now counted as diesel), residual fuel oil (-15.7%), and 'other products' (-6.5%).  Only diesel deliveries registered gains (+9.4%), and as such total gasoil demand rose by a modest 1.2%.



The forecast has been marginally altered following the revision of the annual series and the incorporation of modified regional GDP growth assumptions.  Demand in OECD North America is expected to average 24.9 mb/d in 2008 (-2.6% or -660 kb/d when compared with 2007).  In 2009, the weakness in the US will continue to weigh down on the region, with demand seen at 24.5 mb/d, 1.5% or 370 kb/d lower than in 2008.

Adjusted preliminary data indicate that inland deliveries in the continental United States - a proxy of oil product demand - contracted by 2.3% year-on-year in June and by as much as 4.0% in July, with all product categories bar gasoil registering significant contractions.  Demand for gasoline and jet fuel/kerosene continues to fall on a yearly basis, providing further evidence of the effects of the ongoing economic slowdown and rising oil prices, which are prompting consumers to reduce road and air travel.



In July the Energy Information Administration (EIA) revised 2007 demand data minimally (-17 kb/d).  (Preliminary monthly demand is derived from weekly data from the Weekly Petroleum Status Report, which are revised two months later in the Petroleum Supply Monthly and then finally adjusted in the Petroleum Supply Annual, usually in mid-year).  This annual revision bucked the trend observed in recent years, when demand had been typically - and often significantly - revised up.  Given that this report attempts to anticipate annual changes based on the monthly average revisions of previous years, our own 2007 revision was therefore greater (-110 kb/d).  For 2008, we are factoring in an annual correction of roughly +80 kb/d.



In its latest economic outlook, the IMF has markedly revised its economic outlook for the US, most notably for 2008 (the revisions to other countries, by contrast, were minor).  GDP is now expected to expand by 1.3% in 2008 and by 0.8% in 2009 (instead of 0.5% and 0.6%, respectively, as forecast last April).  At first glance this adjustment may seem surprising, but it actually reflects much stronger-than-expected 1H08 data and assumes that the US economy will contract in 2H08.  Indeed, most indicators suggest that the economy is rapidly weakening and most likely heading towards recession.  The credit crunch, falling house prices, and food and energy inflation will effectively continue to constrain consumer spending, as real incomes will at best remain stagnant (the fiscal effect of the tax rebate provided by the government was effectively largely wiped out by higher oil prices).

Moreover, the noticeable weakness in 1H08 oil demand despite resilient economic growth confirms that the negative effect of higher oil prices has been sizeable.  The ongoing woes of both the automotive and airline industries - seen in the sharp contraction of gasoline and jet fuel/kerosene demand - illustrate the degree to which US consumers are shunning travel and trying to save energy.  This trend is unlikely to be reversed in the short term - unless oil prices collapse, which seems a remote possibility despite their recent slide.  Therefore, US oil demand is expected to remain subdued, contracting by 3.1% in 2008, to 20.0 mb/d, and by 2.0% in 2009, to 19.6 mb/d.  It should be noted that the expected economic contraction in the second half of this year underlies our revisions in 3Q08 and 4Q08 (roughly -250 kb/d on average), which have been carried through to 2009.

Smaller Cars, Less Driving

The collapse of SUV and light truck sales in the US continues apace.  Total vehicle sales plummeted by almost 19% year-on-year to a 16-year low in July (12.6 million units), but the fall in sales by companies specialising in SUVs and light trucks was much more pronounced: Chrysler, General Motors, Ford and Toyota reported a 29%, 26%, 15% and 12% decline, respectively.  By contrast, manufacturers of smaller cars managed to contain the fall (Honda's sales dropped by only 2%) or even posted gains (Nissan's jumped by almost 9%).  This trend could well mean that US gasoline demand may have peaked in 2007; even if retail prices ease, it seems unlikely that motorists who have purchased smaller cars will revert to gas-guzzling vehicles, despite the numerous incentives offered by the automotive industry (ranging from rebates, zero percent financing and subsidised gasoline).  Nevertheless, the transition to a more fuel-efficient US fleet will take some time.  On the one hand, the SUV and light truck fleet is relatively young (7 years on average, compared with about 9 years for cars).  On the other hand, car manufacturers will need some time to reconfigure their factories to produce smaller cars.



Motorists are not only looking for more efficient vehicles but they are also driving much less, relying instead on public transportation, car-pooling or even bicycle riding.  As we noted in our previous report, the number of vehicle-miles travelled (VMT) compiled by the US Federal Highway Administration has actually declined since 2006, as prices began to bite.  Disaggregating the series into urban and rural driving provides an interesting insight.  Both urban and rural VMT are down year-on-year (-3.2% and -4.1%, in May, respectively).  However, urban VMT remain within their five-year range; rural VMT, by contrast, are now well below their range.  This may suggest that US motorists have sharply reduced leisure driving, a trend that appears to be supported by the so far lacklustre driving season.



Both Canada and Mexico posted large annual revisions to historical demand data.  Canadian revisions pertain essentially to residual fuel oil over 2005-2007, which has been lifted by roughly 25 kb/d on average.  Total demand is now expected to average 2.4 mb/d in both 2008 and 2009.  Meanwhile, Mexican revisions over 2006-2007 (almost +80 kb/d) relate to three product categories - LPG, residual fuel oil and 'other products' - as previously underestimated backflows have now been included.  Overall demand is now seen averaging slightly above 2.1 mb/d this year and the next.

Pricing Arbitrage:  The US-Mexico Border

The differential between retail gasoline prices in Mexico and the US is leading to renewed market distortions along the border between both countries.  Mexico's state-owned PEMEX has reportedly restricted gasoline deliveries to 556 service stations on the border area, particularly on the western edge (around the San Diego/Tijuana area) following similar curbs regarding diesel supplies a few weeks ago.  These moves have been prompted by concerns that US motorists and truckers are crossing over to Mexico to refill their tanks, since retail prices are much lower (gasoline, for example, costs about $0.70 per litre in Mexico, versus roughly $1.10 in the US) and despite worries about allegedly inferior Mexican fuel quality.  Understandably, the Mexican government is trying to limit the exorbitant cost of fuel subsidies, poised to exceed $20 billion in 2008 (four times more than last year), but such supply restrictions could lead to shortages.  Indeed, the strong growth in Mexican fuel demand observed in the past several years has been fuelled by domestic economic growth, not by additional demand from US consumers in the border area.

Moreover, this transnational arbitrage is not new.  A few years ago, the flow of traffic was actually in the opposite direction, as US prices were cheaper than in Mexico.  Successive Mexican governments have tried to close this arbitrage by setting differentiated prices between the border and the rest of the country.  The arbitrage, however, has never totally disappeared (excepting in the rare occasions when US prices have coincided with Mexican ones), while such price discrimination has created some resentment within Mexico, as consumers feel penalised on the grounds of their geographical location.  One solution would be to liberalise prices and adopt a similar tax regime to that in the US, so that prices in both countries converged, or at the very least to reduce subsidies.  However, given inflationary concerns and political constraints, this is unlikely to happen in the near future.

Europe

European oil product demand shrank by 2.3% year-on-year in June, according to preliminary inland delivery data, with all product categories bar LPG and naphtha registering losses.  The contraction in gasoline deliveries (-7.1%) was particularly marked.  Revisions to annual submissions, meanwhile, averaged some +35 kb/d over 2000-2007, largely driven by Belgium, which adjusted its naphtha demand upwards following some methodological changes.  Looking forward, these revisions, coupled with June's submissions, a marginal reappraisal of the demand outlook in Germany and minor changes to GDP growth assumptions in several European economies, suggest that demand in OECD Europe will average 15.2 mb/d in both 2008 and 2009, implying a year-on-year decline of 0.4% and 0.3%, respectively.



Inland deliveries in Germany fell by a modest 0.2% year-on-year in June, according to preliminary data.  The weakness observed in previous months continued with regards to gasoline (-6.6%), diesel (-0.6%) and residual fuel oil deliveries (-13.9%).  By contrast, heating oil demand showed some signs of revival, jumping by 5.6%, partly because German consumer stocks had reached historical lows.  Heating oil stocks averaged 45% of capacity by end-June, slightly above the levels registered a month earlier (44%) but well below the readings of June 2007 (55%).  On the basis of more normal patterns of refilling in 2009, we have slightly adjusted up our forecast of German heating oil demand, thus marginally lifting overall European oil demand.



Demand in France shrank by 2.0% year-on-year in June, dragged down by a sharp contraction in the deliveries of gasoline (-14.2%) and diesel (-7.8%).  This suggests that French motorists are finally reacting to high oil prices, by driving less or at reduced speed.  In fact, gasoline and diesel demand during 1H08 had been inordinately resilient.  Jet fuel/kerosene demand, by contrast, remains buoyant (+2.4% in June) and likely to remain so, reflecting the importance of Paris as a key European air flight hub.  Meanwhile, French fuel oil deliveries rose by 28.7% year-on-year in June as state-owned utility EDF reportedly proceeded to replenish its stocks.

France is not alone in recording plummeting demand for road fuels.  In Italy, gasoline and diesel contracted respectively by 10.1% and 2.6% year-on-year in June.  In Spain, the fall was 9.9% and 6.3%, respectively.  This is consistent with both economies being arguably the weakest in the Eurozone (Italy is being dragged down by a falling manufacturing competiveness and Spain by the bursting of its housing bubble).  In addition, in both countries natural gas continues to displace residual fuel oil for power generation.  In Italy, residual fuel oil deliveries plummeted for the fifth consecutive month (-30.2%); in Spain the fall was less sharp (-8.1%) but nonetheless significant.  Overall, total oil demand in both countries plunged in June (-8.4% in Italy and -7.8% in Spain).



Administering Diesel Demand:  France's Incentives Scheme

In early 2008, France introduced a fiscal policy aimed ostensibly at discouraging the purchase of large cars on environmental grounds.  Under the so called bonus-malus system, the price of vehicles emitting more than 160 grams of CO2 per kilometre is increased by as much as €2,600 according to a sliding scale.  By the same token, cars emitting less than 120 g/km benefit from a discount that can be as high as €1,000.233



In practice, this new system has helped support the sales of diesel-powered cars.  On the basis of equivalent horse-power, a gasoline engine will typically emit more CO2 than a diesel one.  In the case of small engines, this can translate into a significant cost difference: for example, a 90 HP diesel engine emitting 120 g/km will benefit from a €200 discount, whereas an equivalent gasoline engine will emit 150 g/km - within the emissions range where no discount can be applied.169

Although diesel vehicles are about a third more efficient than gasoline cars, they are also generally more expensive, both in terms of their purchase price and maintenance costs.  As such, the drive towards the dieselisation of Europe's vehicle fleet over the past decade was primarily related to the fact that, until recently, diesel was much cheaper than gasoline.  A consumer purchasing a diesel-powered vehicle could thus expect to rapidly amortise the price differential vis-à-vis gasoline engines, even if driving relatively little.

With the sharp increase in oil and distillates prices over the past few years, diesel and gasoline prices have tended to converge in most countries (in some cases, retail diesel has even become more expensive).  As such, diesel cars have become less attractive for the average consumer; only motorists driving very long distances may still find diesel advantageous from a cost perspective.  More interestingly, this could augur a renewed interest in gasoline engines, thus partly reversing Europe's dieselisation trend - unless other countries emulate France's policy.

Oil product demand in the UK contracted by 10.0% year-on-year in May (the last month for which official data are available), dragged down by very weak deliveries of transportation fuels (gasoline contracted by 11.5%, jet fuel/kerosene by 15.3% and diesel by 5.2%) and residual fuel oil (-34.8%).  This appears to confirm the dampening effect of high oil prices and the ongoing slowdown of the British economy.  As such, in mid-July the UK government announced it will postpone a planned increase in the country's fuel duty.  The two-pence (US$0.04) per litre rise was scheduled to take effect in October, but implementation will now wait at least until April 2009.  The rise had already been pushed back from April 2008 given soaring prices and loud protests from motorists and businesses over the past few months.  This delay, however, runs counter the government's public commitment to enhance energy efficiency and combat climate change via market-based policies.





Pacific

Preliminary data indicate that oil product demand in the Pacific rose by 2.7% year-on-year in June, largely driven by buoyant growth in Japan and, to a lesser extent, Australia.  Japanese demand, which represents two-thirds of the regional total, jumped by 4.6%, as it continues to be supported by strong demand for residual fuel oil and direct crude use for power generation given the ongoing nuclear outages.



Australian demand, meanwhile, surged by an estimated 7.6% year-on-year in June following the spike in diesel demand that resulted from the June outage at Apache Energy's Varanus Island natural gas production hub.  According to recent reports, production in the facility is being gradually restored, and should be fully back by the end of the year or perhaps even earlier.

Given that annual revisions turned out to be relatively minor - essentially a combined average upward adjustment of 23 kb/d to Japanese jet fuel/kerosene and residual fuel demand - projections of OECD Pacific oil demand are virtually unchanged compared with the last report.  It is expected to average 8.4 mb/d in 2008 (+1.1% or +90 kb/d on a yearly basis) and 8.3 mb/d in 2009 (-1.2% or -100 kb/d) as oil demand in Japan resumes its structural decline.



Non-OECD

China

In June, according to preliminary data, China's apparent demand (refinery output plus net oil product imports, adjusted for fuel oil and direct crude burning and stock changes) jumped by an estimated 6.2% year-on-year.  The rise was supported by strong deliveries of transportation fuels (gasoline, gasoil and jet fuel/kerosene soared by 22.2%, 15.1% and 23.8%, respectively).  These largely offset the sustained weakness in residual fuel oil demand - the feedstock of choice for 'teapot' refineries - which contracted by 33.7% and the contraction in LPG demand (-7.5%), which is not subject to price caps.  Overall, demand surpassed the highly symbolic 8-mb/d mark for the first time ever in June, reaching 8.3 mb/d.



As in recent months, demand growth was met by strong oil product imports and higher refinery output (+11.3% from May).  However, the fact both net crude imports and net oil product imports, albeit high (respectively 3.4 mb/d and 677 kb/d in June), were well below the highs recorded in May (3.8 mb/d and 872 kb/d), suggests that the state-owned majors, PetroChina and Sinopec, decided to draw down stocks rather than pay ever-rising prices.  It should be noted, in particular, that net fuel oil imports almost halved to 233 kb/d in June, compared with the previous month.  This arguably implies that the economics of teapot refineries running fuel oil as a feedstock have not improved despite the retail fuel price hike in early June.  It could also indicate, as pointed out in our last report, that the rumours regarding the government's alleged intention to cut the fuel oil import tax from 3% to 1% have indeed prompted refiners to delay feedstock imports as long as possible.



We have kept our forecast of China's total oil demand essentially unchanged versus our last report, at 8.0 mb/d in 2008 (+5.6% year-on-year) and 8.4 mb/d in 2009 (+5.7%).  There is, though, considerable uncertainty regarding this outlook in the months ahead, as discussed below.

Other Non-OECD

According to Indian preliminary data, oil product sales - a proxy of demand - rose by 0.1% year-on-year in June.  This weak rate of growth mostly reflects the fact that retailers had reportedly built ample stocks in May in anticipation of June's widely publicised increase to gasoline, gasoil and LPG retail prices.



Interestingly, despite such a stockbuild, only gasoline sales registered a contraction (-5.9% year-on-year in June).  Both LPG and, more importantly, gasoil sales, which account for over a third of total oil product sales, posted relatively brisk increases (+2.2% and +3.3%, respectively).  This would confirm, as we had anticipated, that the price hike merely slowed down the pace of oil demand growth, rather than fostering a contraction in absolute levels.  Therefore, our demand forecast remains virtually unchanged at 3.1 mb/d in 2008 (+4.6% over 2007) and 3.2 mb/d in 2009 (+4.5%).

China's Demand Outlook Has Not Become Any Clearer

Several months ago (Oil Market Report, 11 April 2008) we argued that assessing short-term Chinese oil demand was a particularly difficult exercise, notably for the period through 3Q08.  At present, despite having gone through half the year, China's demand trends remain remarkably opaque, posing a considerable risk to the demand forecast for 2H08.

  • Some commentators argue that demand growth will ease markedly after the Olympics, citing lower scheduled purchases by Sinopec for August.  This could well be the case - as long as stocks are ample.  Given the lack of data on Chinese inventories, it is unclear whether the high levels of imports recorded over the past four months were prompted by any (or a combination) of the following issues: a) the government's attempts to stockpile ahead of the Games, when demand should spike; b) the need to replace the substantial production loss from teapot refineries, whose production was restrained by high feedstock prices; or c) buoyant demand growth fuelled by breakneck economic growth and low retail prices, despite recent hikes (in November 2007 and June 2008).
  • The need to reduce Beijing's air pollution levels during the two-week Olympic Games has led to the closure of several close-by industrial facilities (such as refineries, steel plants and coal-fired power plants), notably in the western suburbs, and to the removal of some one million cars off the city's roads.  This will likely reduce oil demand in the Beijing area from early July to mid-September - but the extent of such a reduction is difficult to estimate at this point.  In any case, by end-September local demand should be back to its pre-Games levels.
  • The power shortages affecting several provinces are evolving into a full-blown crisis.  Nation-wide shortages could be as high as 15 MW during the summer, given a) tight coal supplies and low inventories following the weather disruptions earlier this year and the closure of small mines; b) the shutting down of small generators; c) rising coal prices (despite an official cap); and d) frozen retail prices, which discourage producers.  However, this coal-fired power tightness may not necessarily prompt a surge in gasoil use as during the massive shortages of 2004, when many manufacturers, notably in coastal areas, resorted to small gasoil generators to maintain operations.  (Over 80% of the country's power generation capacity is coal fired, and industry accounts for almost 70% of total electricity demand.)  A major difference is that gasoil has now become much more expensive, implying an additional - and significant - financial burden for a manufacturing sector that is already facing higher input costs (notably labour), an appreciating currency and contracting export markets.  Therefore, the potential spike may be limited (many of the less competitive manufacturers, notably in coastal areas, have reportedly gone out of business over the past few months).
  • There could be important policy changes that might alter the oil supply and demand picture:
  • a.   The government has still not officially renewed the value-added tax (VAT) rebate on monthly crude, gasoline and gasoil imports, which expired at the end of June.  The rebate had been decreed in April in an effort to boost imports and offset the refining losses of state-owned oil companies Sinopec and PetroChina (the government refunded both firms' 17% VAT on product imports and 75% of their 17% VAT on crude imports).  The government and the state-owned companies are reportedly negotiating to extend the rebate at least to July's import bill (or possibly all of 3Q08).  Afterwards, however, refiners could well cut imports sharply to minimise their losses and thus foster a fresh round of shortages, unless they are assured of some other form of financial compensation (either higher direct subsidies or a reduction of the windfall tax on crude production) or if international oil prices continue to fall.

    b.   In the same vein, as noted above, the government may cut the fuel oil import tax from 3% to 1% in an attempt to coax teapot refineries into increasing production.

    c.     The government may adjust end-user prices once again just after the end of the Olympic Games, either by raising the so-called 'guidance' (ex-refinery) prices or by introducing a fuel tax.  Such rumours, however, are recurrent and often unsubstantiated (the latest suggested that another price increase would take place in July, which did not occur).  In fact, if international oil prices fall further the government could well decide to leave retail prices unchanged if inflation fails to abate.  Nevertheless, faced with the need to address China's macroeconomic imbalances, it appears that the government is leaning towards an adjustment via higher energy prices rather than through a further appreciation of the yuan, seen in some quarters as eroding the country's key competitive advantage.  The political risks of higher inflation may be perceived to be lower than those associated with stagnating economic growth.

Supply

Summary

  • Global oil supply increased by 890 kb/d in July to average 87.8 mb/d.  The Americas and Norway are thought to have underpinned the 520 kb/d of non-OPEC growth, amid a lull in seasonal maintenance elsewhere.  OPEC crude gained 145 kb/d with the balance coming from higher gas liquids supply.  Just as in June, July global supply stood 2.3 mb/d above levels of a year ago.
  • Non-OPEC supply is revised up by 0.1 mb/d historically and for 2008/2009.  It averages 50.1 mb/d in 2008 and 50.8 mb/d in 2009.  FSU processing gains are included after April's methodology change and a review of refinery yields.  US and North Sea projections combined are now 0.1 mb/d higher for 2008 and 2009.  The US sees higher NGL and ethanol output, while stronger May and June crude supply affects the UK and Norway.  Non-OECD projections are cut by 130 kb/d for 2008 and by 80 kb/d for 2009, with lower output from Malaysia, Brunei, Brazil, Russia and Kazakhstan.  Forecast Azerbaijan output is also cut by 235 kb/d for 3Q08 and 55 kb/d for the year after the BTC pipeline outage.
  • Growth in non-OPEC output averages 455 kb/d for 2008 and 665 kb/d for 2009, after 425 kb/d in 2007.  Rising supply from US, Canada, Australia and New Zealand help offset declines elsewhere in the OECD.  Brazil, Azerbaijan, China and Kazakhstan drive non-OECD growth, with contributions also from Malaysia and Vietnam in 2009.  Russian supply is seen levelling off.  Subject to on-schedule project completion, OPEC NGL output rises from 4.8 mb/d in 2007 to 5.1 mb/d in 2008 and 5.9 mb/d in 2009, with Saudi Arabia, Qatar, the UAE, Nigeria and Iran all showing strong growth.
  • OPEC crude supply in July rose by 145kb/d to 32.8 mb/d. Nigeria, Saudi Arabia and Iran all saw higher output, although over 0.5 mb/d of Nigerian output remains shuttered in the Niger Delta.  Maintenance work cut Libyan and Angolan production, and a combination of lower Ceyhan exports and weaker crude runs cut observed Iraqi supply by 100 kb/d to 2.4 mb/d.  Effective OPEC spare capacity stands at some 1.5 mb/d, although installed capacity is seen rising by end-2008 and through 2009.


  • The 'call on OPEC crude and stock change' for 2008 is revised down by 0.1 mb/d to 31.6 mb/d but remains unchanged at 31.1 mb/d for 2009.  The downward trend in the 'call' going forward is dependent upon a strong rebound in non-OPEC supplies in late 2008/early 2009.  While any further weakening in OECD demand could reinforce this trend, upside potential for the call also exists if non-OECD demand growth comes in stronger than anticipated.

All world oil supply figures for July discussed in this report are IEA estimates.  Estimates for OPEC countries, Alaska and Russia are supported by preliminary July supply data.

Note:  Random events present downside risk to the non-OPEC production forecast contained in this report.  These events can include accidents, unplanned or unannounced maintenance, technical problems, labour strikes, political unrest, guerrilla activity, wars and weather-related supply losses.  Specific allowance has been made in the forecast for scheduled maintenance in all regions and for typical seasonal supply outages (including hurricane-related stoppages) in North America.  In addition, from July 2007, a nationally allocated (but not field-specific) reliability adjustment has also been applied for the non-OPEC forecast to reflect a historical tendency for unexpected events to reduce actual supply compared with the initial forecast.  This totals ?410 kb/d for non-OPEC as a whole, with downward adjustments focused in the OECD.

OPEC

OPEC crude supply in July rose by 145 kb/d to 32.8 mb/d. The June total was revised up by 215 kb/d to 32.6 mb/d on indications of higher crude runs and exports for both Iran and Iraq.  In July, Nigeria, Saudi Arabia and Iran all saw higher output, although over 0.5 mb/d of Nigerian output remains shuttered due to attacks on pipelines and other oil installations in the Niger Delta.  Field outages and maintenance work cut Libyan and Angolan production, and a combination of lower Ceyhan exports and weaker crude runs cut observed Iraqi supply by 100 kb/d to 2.4 mb/d.



Effective OPEC spare capacity stood at 1.5 mb/d in July, although installed capacity is seen rising by nearly 900 kb/d by end-2008 to 36 mb/d and further through 2009.  Net capacity increases over the balance of this year are likely to come from Saudi Arabia, Angola and from offshore deep-water Nigeria.

OPEC ministers will meet in Vienna on 9 September.  While Iranian sources have suggested that observance of quotas might be on the meeting's agenda, OPEC President Chakib Khelil was quoted as saying that prices close to $120/bbl were not indicative of a pressing need to curb output. A further, extraordinary meeting has been called for Oran in Algeria on 17 December.

Saudi Arabian supply is estimated to have increased by around 100 kb/d to 9.55 mb/d.  Preliminary Middle East Gulf tanker sailings data do not support a sharper rise towards publicly-flagged 9.7 mb/d levels, nor reportedly were refiners over-enthusiastic about pricing terms.  Saudi pronouncements of an ability to boost to 9.7 mb/d in July were in any case subject to incremental crude demand, which may have proved elusive, at least in the case of OECD refiners.  However, indications for the most recent month are patchy at best, and could be subject to revision later on.  Meanwhile price formulae announced for September term sales generally narrowed spreads between light and heavy grades, reflecting strengthening fuel oil markets.

Our capacity estimates for Saudi Arabia (which attempt to exclude condensates and Bahrain's 50% share of Abu Safah crude production) brush 11 mb/d by end-2008 and 11.8 mb/d by end-2009.  We continue to assume that the 500 kb/d AFK/Khursaniyah project enters service later in 3Q08.



Iraqi crude supply for July is assessed at 2.4 mb/d, down by 100 kb/d from an upward revised June total.  The June revision sprang from higher-than-expected domestic crude throughput (our Iraqi proxy for production comprises exports plus domestic crude use in refineries and for power generation). June domestic crude use was reported at a recent high of 565 kb/d, although we believe refinery maintenance may have seen this slip to some 450 kb/d in July.  Crude exports from southern ports gained 100 kb/d in July to 1.57 mb/d, but were offset by a similar magnitude fall in northern exports to 390 kb/d.  Nonetheless, the story of 2008 so far has been of remarkably steady northern exports averaging 400 kb/d.  This compares to minimal and sporadic levels prior to the installation of a security zone around the Kirkuk-Baiji stretch of pipeline last summer.

Indeed, many analysts now see political and regulatory bottlenecks becoming more of an impediment to Iraqi supply growth prospects than security risks.  While it is premature to write off the real security issues that persist in Iraq, nonetheless slow progress in agreeing an election law and the regulatory framework for foreign company oil company investment look to be taking on greater prominence.  Our MTOMR projections of expanding capacity from late 2008 may need to be revisited if technical service contracts aimed at adding some 0.5 mb/d of new capacity within two years remain unsigned for much longer.  There is a risk that with the government shortening their duration, companies may wait instead until longer-term contracts under the first licensing round are awarded in 2009.

Despite regular reports of field and pipeline outages through July, Nigerian supply is believed to have increased by 135 kb/d to 1.97 mb/d.  2Q08 supply levels were revised lower by an average 70 kb/d on evidence of lower-than-expected domestic crude runs, resulting in a new June supply figure of 1.83 mb/d.  Ministerial statements in early August tend to back up our own estimate, citing current production at just below 2.0 mb/d.  July began on an optimistic note, with the resumption on 9 July of full Bonga field output.  Earlier restrictions on Escravos and Bonny Light exports were also lifted in mid-July, while both Qua Iboe and Pennington output levels are thought to have increased in July.  That said, renewed attacks on the Tebida flow station and Nembe pipeline later in the month again curbed Brass River and Bonny Light supplies respectively.  Force majeure on Bonny Light exports remains in force for August and September liftings.  Current production outages lie in a 500-600 kb/d range.

On 31 July, Chevron started production from the deepwater Agbami field, although it may be early 2009 before volumes rise in excess of 100 kb/d and approach capacity 200 kb/d.  ExxonMobil also started up output from the East Area NGL expansion, which should ultimately generate 40 kb/d of gas liquids. These developments illustrate once again the dichotomy between disruption-prone onshore and Niger Delta production on the one hand and ongoing offshore expansion on the other (notwithstanding the earlier attack on Bonga).

We have markedly revised up Iranian June supply to take account of what now look like higher exports and domestic refinery crude runs.  June supply is revised up to 3.95 mb/d from 3.8 mb/d in last month's report.  A further increase of 75 kb/d is estimated for July, taking output to 4.02 mb/d.  Reports through July and early August suggest gradual draw-down of crude previously held in floating storage offshore Kharg Island.  On 5 August, state company NIOC suggested the remaining 6 mb of crude in storage would be processed at the newly expanded Bandar Abbas refinery.

Iranian sources discussed a potential expansion of some 60 kb/d in production by September deriving from the onshore Azadegan and Darkhovin fields, and from Hendijan and Hengam offshore.  Revolutionary Guard sources also restated threats in July that any attack on Iran over its nuclear programme would inevitably lead to disrupted shipping movements via the Straits of Hormuz.

Non-OPEC Overview

Non-OPEC July supply is estimated at 49.9 mb/d, up by 520 kb/d from June.  We think that Canada, Argentina, Brazil, Malaysia and China saw July growth, although this is based on preliminary indications only.  As important as month-to-month changes, however, is the observation that July followed May and June in showing growth in non-OPEC output compared with the same month in 2007, after a preceding six months of annual declines.  July supply stood 265 kb/d above July 2007 levels.  Our ceteris paribus, working forecast envisages non-OPEC growth accelerating markedly in 2H08 and into early 2009.

This month's report sees non-OPEC supply revised up by 0.1 mb/d historically (back to 1986) and for 2008/2009.  Supply averages 50.1 mb/d in 2008 and 50.75 mb/d next year, after averaging 49.6 mb/d (excluding Angola and Ecuador) in 2007.  FSU refinery processing gains (themselves estimated at around 0.1 mb/d) are now included in the processing gains aggregate in our global balance.  This follows April's FSU demand methodology change and a subsequent review of FSU refinery yields.

Elsewhere, US and North Sea oil output projections combined are now 0.1 mb/d higher for 2008 and 2009.  The US adjustment comes from higher gas liquids and ethanol output, while stronger May and June crude supply affects the UK and Norway.  In contrast, non-OECD projections are trimmed by 130 kb/d for 2008 and by 80 kb/d for 2009, with lower output now expected from Malaysia, Brunei, Brazil, Russia and Kazakhstan.  Forecast Azerbaijan output has also been cut by 235 kb/d for 3Q08 and 55 kb/d for the year following this month's BTC pipeline outage.



Growth in non-OPEC output now averages 455kb/d for 2008 and 655 kb/d for 2009, after 425 kb/d in 2007.  Rising supply from the US, Canada, Australia and New Zealand help offset declines elsewhere in the OECD.  Brazil, Azerbaijan, China and Kazakhstan drive non-OECD growth, with contributions also from Malaysia and Vietnam in 2009.  Russian supply is seen levelling off at close to 10.0 mb/d.  OPEC NGL output rises from 4.8 mb/d in 2007 to 5.1 mb/d in 2008 and potentially to as high as 5.9 mb/d in 2009.  Saudi Arabia, Qatar, the UAE, Nigeria and Iran all show strong gas liquids increases although, as we note below, attaining project completion close to latest available schedules will be critical to this impressive level of growth being realised.  That said, the impetus to boost natural gas output to quench local thirst for industrial, petrochemical, power generation and oilfield reinjection purposes, or for exports, is clear.

Our non-OPEC supply and OPEC NGL projections show resurgent growth from now onwards through 2009.  On the surface, there are ample new projects approaching completion which can offset decline - in the short term at least. This marks a potential reversal of the trend evident in the period since mid-2007, when non-OPEC supply has consistently lagged levels of a year ago.  But we readily acknowledge there are substantial risks surrounding this forecast, deriving from unscheduled production stoppages, cost inflation and new field delays, and political, fiscal and regulatory uncertainty.  One look at the past couple of months' slate of news illustrates the point:  a major explosion on the BTC pipeline in Turkey; uncertainties over pipeline supplies transiting Georgia; specific project delays announced for Russia, Kazakhstan, Canada, Australia and the Philippines; a mooted windfall profits tax in the UK and contractual uncertainty surrounding Brazil and Russia.



OECD

North America

US - July Alaska actual, others estimated:  Revised 2007 data from the EIA cut US crude estimates by 40 kb/d (to 5.06 mb/d), largely based on marginally lower US GOM output.  Our aggressive hurricane outage assumptions for 2H08 (based on the rolling five-year average) constrain US GOM supply for the remainder of this year to around 1.4 mb/d.  July saw three major storms transit the region, causing precautionary oil and gas installation shut-ins, but with only minor volumetric impact and scant damage recorded.  Nonetheless, forecasters envisage an active storm season this year, albeit less so than in 2005.  However, even allowing for potential storm outages, new field start-ups push expected total GOM supply to 1.56 mb/d for 2009, up nearly 200 kb/d from this year's average.



Total US oil production in 2008 is now forecast at 7.65 mb/d, with stronger baseline NGL and ethanol supplies adding a combined 65 kb/d to last month's forecast.  As we note elsewhere in the report, surging US natural gas production has pushed gas prices lower, but is also generating substantial extra gas liquids volumes. Next year's supply rises by some 200 kb/d to 7.85 mb/d (5.1 mb/d crude oil) as gains of around 180 kb/d each from GOM and ethanol supply are partially offset by lower crude supply from other areas of the US.

Canada - Newfoundland June, others May:  Our Canadian oil production forecast is trimmed by 10 kb/d for 2008 and by 40 kb/d for 2009, centred on lower expected Alberta in-situ bitumen output.  Although data through May point to slightly higher-than-expected production, we have cut the outlook for supply based on recent announcements from producer group CAPP.  They have cited typical project delays for oil sands projects now amounting to two years.  Moreover, the group has trimmed its expectation for 2008 oil sands production from 1.4 mb/d to 1.3 mb/d, something we have mirrored in our own projections.  All told, Canadian oil production is expected to average 3.3 mb/d in 2008 (unchanged from 2007) and 3.4 mb/d in 2009.  Conventional crude (net of NGL and mining output) averages 1.9 mb/d both years.


Mexico - June actual:  Mexican projections are revised up modestly this month, by around 10-20 kb/d for the forecast period.  Nonetheless, crude production is expected to drop by nearly 200 kb/d in both 2008 and 2009, averaging 2.85 mb/d and 2.67 mb/d respectively.  While we retain an assumption of near-25% decline from the offshore Cantarell field, other areas, notably the south eastern offshore region, are performing better than we anticipated.  State oil company Pemex recently reduced its forecast for 2008 crude production to 2.8-2.85 mb/d, close to our own expectation.  Natural gas liquids output is seen levelling off close to 375 kb/d in this report's forecast.

North Sea

Norway - May actual, June provisional:  Some 20 kb/d is added to the forecast of Norwegian oil production for 2008 and 2009, with May data showing stronger Heidrun field supply.  Also, 1 August saw start-up of StatoilHydro's Vilje field, two months later than our original forecast, but with plateau output now seen at 35 kb/d compared with our earlier estimate of 25 kb/d.  Latest crude loading schedules for the main North Sea export streams reinforce our prevailing view that June and August would be Norway's peak maintenance period.  All in all, maintenance cuts Norwegian crude supply by 300 kb/d from spring output levels in those two months, although output could recover to around 1.8 mb/d again by end-year.  Total crude output for 2008 averages 1.84 mb/d and 1.66 mb/d in 2009.  Crude thus drops by around 200 kb/d on an annual trend basis.  Gas liquids production could prove more resilient, averaging around 560 kb/d both years, compared with 500 kb/d in 2007.



UK - May actual:  UK offshore production is expected to decline by around 150 kb/d in both 2008 and 2009, after stabilising at 1.4 mb/d in 2007.  May production came in nearly 260 kb/d above expectation, with both scheduled maintenance and the impact of the Grangemouth/Forties system outage proving less than we originally estimated.  This, however, is a one-off adjustment and a more modest upward revision of 10 kb/d from revised field-by-field detail through April is all that is carried through the forecast.

August appears to be the peak month for UK offshore maintenance, with a dip of around 140 kb/d expected for loadings of the key export streams. Regarding new field start-ups, condensate from the Brodgar and Callanish satellites of the Britannia gas field started up around 25 July, nearly one month ahead of our assumption.  Earlier caution on our part regarding start-up at Nexen's Ettrick field seems to have been well placed, with the company now expecting output to begin in 4Q08 (our forecast already assumed December).

Producer group UK Oil and Gas stated that new projects in the North Sea now require $60-80/bbl prices in order to obtain the same returns as generated by $20-30/bbl five years ago.  Unconfirmed press reports suggested that a windfall profits tax on energy companies is being considered by the UK Treasury.

Former Soviet Union (FSU)

Russia - June actual, July provisional:  Forecast Russian production has been trimmed by 25 kb/d for both 2008 and 2009, now averaging 10.1 mb/d and 10.0 mb/d respectively (and including around 470 kb/d of NGL and condensate).  Weaker than expected June and July output accrued from TNK-BP, Gazpromneft, Surgutneftegaz and Gazprom.  Production from Lukoil and from smaller operators came in ahead of our previous outlook.  July production from the three production sharing agreements (PSAs) came in 60 kb/d below expectation.  This was due to a delayed start-up of summer season production from the Sakhalin 2 project, and therefore this adjustment is not carried through the forecast.  This is important, since our expectation of stronger Russian supply in 2H08 is based largely on higher Sakalin 2 production alongside some gains from Lukoil. The neighbouring Sakhalin 1 project faces weakening production in the short term, and an announcement that the related Odoptu field development will not after all start in 2009 was widely anticipated (our MTOMR assumed a 2012 start). Fiscal and regulatory uncertainty continues to surround Russian hydrocarbon prospects, despite an initial package of tax relief measures due to be enacted in 2009.  During July there were signs of a deepening rift between TNK-BP shareholders, Lukoil warned of a need for further tax reform to avoid falling production and Russian audit authorities cautioned PSA operators over unrealised 2007 production targets.



Kazakhstan - June actual:  July and August maintenance at the Tengiz oilfield is now expected to remove higher volumes of production than previously expected. This underpins downward adjustments of 15 kb/d for 2008 production and, replicating a similar maintenance profile next year, 5 kb/d for 2009. Growth in Kazakh production now averages 45 kb/d in 2008 and 110 kb/d in 2009, taking total production to 1.43 mb/d this year and 1.54 mb/d next year (some 270 kb/d of this is gas condensate).  Growth derives largely from the Tengiz project, with operator TCO citing target 500 kb/d production for 2H08.  This report retains a more cautious build-up to 500 kb/d in 2009, partly on uncertainty about transport infrastructure.

Damage to the Baku-Tblisi-Ceyhan Pipeline

An explosion on a block valve of the Turkish section of the Baku-Tblisi-Ceyhan (BTC) crude oil pipeline early on 6 August has led to the pipeline's complete shutdown. Kurdish insurgents of the PKK have claimed responsibility, although Turkish authorities cite a technical problem.  Turkish pipeline authority Botas has responsibility for this section of the pipeline.  The fire was reportedly extinguished early on Monday 11 August, but as yet there is no definitive assessment of the extent of the damage, although some sources have suggested a likely pipeline outage of at least one to two weeks.  Tanker loadings of Azeri crude from the Turkish port of Ceyhan ceased on 7 August after storage at Ceyhan ran dry and force majeure on exports has been declared.  Oil market reaction to the incident, together with the outbreak of hostilities involving Russia and Georgia, has been relatively muted, but these developments appear to have placed a floor under recent crude price falls.



BTC has a capacity of 1.0 mb/d, and is to be expanded to 1.2 mb/d during 2008.  Some 910 kb/d of Azeri Light crude was scheduled to be pumped along the line during August, compared with 775 kb/d in July.  At the time of the outage, production from the BP-operated Azeri-Chirag-Guneshli (ACG) fields offshore Azerbaijan, which form the bulk of BTC throughput, was running at between 850-900 kb/d.  BP has scaled back production from the ACG complex on a precautionary basis, with press reports citing weekend output at between 250-450 kb/d.  It was reported on 7 August that the 2 mb of crude storage capacity at the Azeri end of the pipeline was almost full.  ACG production has been expanding recently with new supplies from the Guneshli deep formation potentially expected to take production to around 1.0 mb/d by late 2008.

Azeri Light is high quality, 35°API/0.2% sulphur crude, similar to Nigeria's Bonny Light, exports of which are also under force majeure presently.  It has a high yield of middle distillates, unlike more gasoline-rich grades from neighbouring Kazakhstan.  Some 55% of Azeri export volumes in 2007 were destined for Europe, 21% to Asia, 14% to North America and 12% to other destinations.

Producers have been investigating alternative export routes for ACG crude.  These comprise the 150 kb/d Baku to Supsa pipeline and the 100 kb/d Baku-Novorossiysk line, while some 50 kb/d of ACG crude can also be railed to the port of Batumi.  All of the alternative routes involve crude transiting the Black Sea, although winter tanker delays which at other times mitigate against the use of these routes are clearly less of an issue in August.  Normally exporters of ACG have shied away from using Baku-Novorossiysk as this effectively downgrades ACG quality as it is mixed with poorer quality Russian Urals crude.  However, with reports that shipments from Georgian ports are disrupted, the Novorossiysk route may be the sole viable pipeline outlet for ACG crude while BTC repairs are carried out.  Although it is too early to make a definitive judgement on potential lost supplies, we have scaled back our forecast of Azerbaijan production by 260 kb/d for 3Q08 and by 65 kb/d for 2008 as a whole, on the assumption that BTC remains offline for August but gradually re-enters service in September.

Risks to Energy Transit Facilities as Military Action Escalates in Georgia

A recent escalation in military engagement between Russia and Georgia poses a threat to certain key oil and gas pipelines which transit Georgia.  With negligible domestic oil production (unlike some of its Caspian neighbours), Georgia's significance to global oil and gas markets is as a transit corridor:

  • The BTC (Baku-Tblisi-Ceyhan) pipeline which carries up to 1 mb/d of mostly Azeri crude to the Turkish port of Ceyhan passes through Georgia (for 250 km) and near to its capital Tblisi.  Although temporarily closed in early August after an explosion on the eastern Turkish section of the line (claimed to have been carried out by Kurdish separatists), renewed flows through Georgia (expected from September) could be further delayed if the line is damaged during the Russia-Georgia conflict.
  • Along the same corridor runs the South Caucasus gas pipeline which carries up to 8.8 bcm per year of Azeri natural gas to Georgia and Turkey.  A branch of this pipeline continues through to the Russian port of Tuapse, transiting the region of Abkhazia, another Georgian area affected by separatist action where Russian troops are reportedly also being mobilised.
  • The Black Sea ports of Batumi, Supsa and Poti (and the newly reopened port of Kulevi) are also important export terminals.  Up to 150 kb/d of crude from Azerbaijan plus some products are pumped via pipeline to the ports.  These are then either exported via tanker in crude parcels (most commonly to Southern Europe), exported directly as product from Batumi or Poti, or crude may be refined at the Batumi refinery and then exported as product.  Some rail exports of crude and products follow the same route from Azerbaijan and augment the volumes leaving these ports, notably up to 50 kb/d via Batumi.  Total product exports leaving Georgian ports typically average 50-70 kb/d, with middle distillates taking the largest share.  Latest reports suggest that oil exports from Poti have ceased, while only partial operations are currently possible from Supsa and Batumi.

While the threat of an attack on the BTC pipeline poses the bigger risk to oil markets, it is clear that more generally, Georgia is a key energy transit hub in the Caucasus region and a country of significant strategic importance to energy markets.  With the BTC currently closed, disruption to Georgian energy infrastructure further limits the possibility of getting Caspian oil and gas to markets.

FSU net oil exports fell to 8.83 mb/d in June, according to preliminary data.  This was a modest reduction from May exports of 8.90 mb/d, when crude exports hit a record-high of 6.52 mb/d, including 940 kb/d via the BTC pipeline.  In June, BTC transits dropped to 700 kb/d and there was an increase in Russian export duties (to around $54/bbl for crude).  Total June crude exports for the FSU consequently declined to an average of 6.05 mb/d, with volumes of Russian crude passing through the Druzhba pipeline reduced to an extremely low level of 960 kb/d.  Preliminary data indicate that FSU product exports rose to 2.82 mb/d after a sharp drop to 2.4 mb/d in May.

FSU exports could drop further in July and August.  Field maintenance in Kazakhstan apparently constrained July transits via CPC, while loading schedules suggest that Russian crude and product exports were also down.  Druhzba shipments may also have been affected by temporarily curtailed Russian exports to the Czech Republic.  An explosion on the Turkish section of the BTC pipeline in early August (see Damage to the Baku-Tblisi-Ceyhan Pipeline on page 25) has for now halted crude flows to Ceyhan.  Combined with a further rise in Russian export duties from 1 August, lower FSU exports are anticipated henceforth, despite indications of higher CPC transits and reports that 10 ppm diesel exports are due to start imminently from Baltic terminals.



Other Non-OPEC

Brazil - May actual:  Brazilian crude production should rise steadily through 2008, before stabilising close to 2.1 mb/d for 2009.  Annual average crude output reaches 1.9 mb/d in 2008 (from 1.75 mb/d last year) and 2.1 mb/d in 2009.  NGL supply averages close to 90 kb/d, while fuel ethanol production is expected to increase from 310 kb/d in 2007 to 360 kb/d in 2008 and 415 kb/d in 2009.  Crude forecasts have been cut by 55 kb/d for 3Q08 (including the impact of now-resolved strike action affecting state producer Petrobras) and by 10 kb/d for 2009.  We have also deferred start-up to 1Q09 and slowed the ramp-up of production from Chevron's Frade field in our forecast, from an earlier start assumption of late 2008.

Petrobras has suggested that its huge Tupi find in the Santos Basin will begin test production in 1Q09, attaining 100 kb/d by end-2010 and an ultimate 1.0 mb/d.  However, our projections exclude Tupi for 2009, after reports that Brazilian construction yards are struggling to meet Petrobras' demand for new rigs.  Uncertainty over whether Brazil will change its oil law to stop offering concession arrangements, and replace these with PSAs, also casts doubt over the time lines for Tupi and adjacent field developments.

OECD stocks

Summary

  • OECD oil stocks fell by 15.3 mb in June to close at 2,579 mb.  This confirmed the almost total absence of the seasonal second-quarter stockbuild this year.  In fact, 2Q08 stocks were essentially flat, increasing by just 3.8 mb, compared with the usual 2Q build of 81.3 mb (0.9 mb/d).  Slow stockbuilding in each of the three OECD regions combined to make this the lowest total OECD 2Q stock change for over 25 years.  Still, weak demand means that OECD stock cover, in days of forward demand, remains above average at 53.4 days.
  • June's OECD stock draw was driven by decreases of 5.7 mb and 10.2 mb in North American and European crude inventories, respectively.  A post-maintenance rise in refinery throughputs alongside lower crude imports contributed to draws in both regions.  Gas liquids stocks in the OECD fell counter-seasonally by 4.2 mb in June.
  • OECD distillate stocks rose by 7.8 mb in June, albeit from a downwardly revised May base.  North American distillate inventories built by a healthy 7.8 mb, while European stocks were flat, resisting the usual June dip of 0.4 mb.  However, Pacific distillate stocks remain very low in forward demand cover as well as absolute terms, as they are in all other Pacific product categories bar fuel oil.
  • Preliminary July data show a seasonal upturn in OECD stocks, with a strong recovery in crude inventories of 13.5 mb (led by Europe), alongside a mild product build of 16 mb (mainly US).  This would equate to total OECD oil stock cover of 54.0 days of forward demand at end-July, an increase of 0.7 days from June's closing level.


OECD Inventory Position at End-June and Revisions to Preliminary Data

Total OECD industry stocks closed at 2,579 mb in June.  This was 81 mb below the mid-year closing stock level in 2007 and trailed the 2003-07 end-June average by 21 mb.  In light of the June stock draw of 15.3 mb, OECD stock cover fell by 0.4 days of forward demand to 53.4 days, its third consecutive decrease.  Still, cover remains above the five-year average of 53.1 days due to upward revisions to the base including a +7.2 mb adjustment to May stocks and a weaker OECD demand estimation.

Preliminary June data suggest that the second-quarter stockbuild amounted to a lowly 3.8 mb (or 42 kb/d).  As mentioned in last month's report, an unusual draw in US crude stocks was a key limiting factor, while the erosion of the winter overhang in US gasoline was also instrumental.  Even so, the absence of the seasonal stockbuild was shared fairly equally across the regions, with European and Pacific distillates also failing to rebound as expected.  Admittedly, individual OECD regions have seen even slower rises in April-June oil inventories as recently as 2005 (in Europe).  However, taking the OECD as a whole, our latest data show 2Q08 as the lowest second-quarter build for at least 25 years.



Looking beyond the simple aggregates, crude stocks in the US and OECD Europe were at their lowest end-June level for five years.  In the OECD Pacific, they were only 1.5 mb above their lowest ever level (at April's close).  In fact, end-June OECD Pacific stock cover was at the bottom or below the five-year range for all product categories except gas liquids and residual fuel.  Total OECD distillate stock cover also remained at the low end of the 2003-07 range at 28.7 days, well below the five-year average of 29.9 days.

It is not all negative news for OECD inventories, though.  Firstly, the weak 2Q stockbuild must be taken in context: it followed a milder-than-average first-quarter stock draw (-4.7 mb or -50 kb/d vs. the five-year average of -36.7 mb or -406 kb/d) and comes at a time of weak OECD demand.  Consequently, stock cover is still above average as 2008 hits its mid-point.  Secondly, there was a clear improvement in distillate stock cover in June, its shortfall versus the five-year average narrowing by 0.4 days, albeit from a downwardly revised May base.  Preliminary data for July suggest that the distillate recovery (including a notable rise in jet fuel stocks) continued in OECD commercial inventories, as well as in independent product tankage in ARA and Singapore, while crude stocks rebounded ahead of July norms.  More generally, our balances suggest that global oil stocks could build from this summer as new supplies are expected online.  Of course, it should be remembered that non-OECD stock changes remain a critical unknown in the equation.



Revisions to OECD stock data totalled +7.2 mb for May and +3.0 mb for April.  For May, the most significant revisions were seen for 'other oils' (essentially gas liquids), corrected up by 15.1 mb in total including 6.7 mb and 8.8 mb in North America and Europe respectively.  Otherwise, North American crude stocks for April and May were adjusted upwards by 3.6 mb and 9.4 mb respectively.  Corresponding European product stocks were corrected down by 3.5 mb and 12.6 mb, with the majority of the revisions in distillates.  As presaged in last month's report, Japanese May crude stocks were reassessed lower by 5.3 mb.

OECD Industry Stock Changes in June 2008

OECD North America

Commercial oil stocks in OECD North American countries rose by 8.8 mb in June, as a total product build of 17 mb outpaced a combined reduction in crude and gas liquids stocks of 8.2 mb.  Within the seasonal product build, there were healthy June increases in all product categories in the US, and notable rises of 8.7 mb and 2.0 mb in US distillates and gasoline inventories, respectively.  US gasoline stocks were boosted by weak demand, while higher distillate inventory was a result of refiners' increasing their distillate yields in the face of a massive premium of distillate prices over gasoline.  EIA weekly data indicate that distillate (and jet) stocks continued to rise throughout July, while gasoline stocks likely peaked before a late-July draw as demand stabilised.  Elsewhere, a June drop in Mexican refinery activity of 170 kb/d contributed to a sizeable 1.1 mb dip in product inventory, including 0.9 mb in middle distillates.



US crude stocks were off by 9.1 mb in June.  As discussed in recent reports, this follows weaker imports (notably from Mexico) but could be a continued push by refiners to hold less inventory in the face of lower demand and high prices.  This would release much-needed capital at a time of low refining profitability.  An unseasonal June fall of 2.5 mb in US gas liquids was also observed.  Weekly July data show a counter-seasonal rebound in US crude stocks, a trend which may continue with higher OPEC volumes expected to arrive in the coming weeks.  The dip in Mexican throughputs afforded a crude build of 3.4 mb in June while latest Canadian data showed an upward revision to May crude stocks to a new record high of 121.6 mb, now 21 mb higher than one year ago.  Accordingly, trade data show that US imports of Canadian crude and gas liquids (combined) decreased by 170 kb/d in May, compared with April.

OECD Europe



In OECD Europe, a large crude stock draw of 10.2 mb combined with a mild product draw of 5.3 mb to prompt a typical June decrease of 16.4 mb in total oil inventories.  Most notable within the crude stock change were draws of 5.7 mb, 3.0 mb and 2.2 mb in France, Italy and the UK respectively.  Rising refinery throughputs account for some of the dent in European crude stocks, as spring maintenance continued to wind down, alongside evidence from tanker data of lower crude imports in June.

European distillate stocks remained flat in June, a month when they often fall.  This slightly narrowed their deficit to the five-year average in both cover and absolute terms, after May levels were revised down by 5.0 mb.  Higher refinery throughputs contributed to distillate builds of 2.6 mb in France and, preliminarily, of 1.1 mb in Denmark.  ARA independent stocks, a useful indicator of marginal product trade or stock changes in the region, showed pronounced builds in gasoil and jet kerosene throughout June and July, although Euroilstock data shows a mild 2.5 mb July build.  Regional motor gasoline stocks decreased in line with seasonal expectations in June, with notable draws in the UK (-1.7 mb) and Germany (-0.8 mb), possibly related to a reduction in gasoline yields allied to faltering gasoline prices.  In partial offset, French gasoline stocks rose for the second month in a row, this time by 0.3 mb, to top the five-year average for the first time in over 10 years.  Preliminary July data from Euroilstock reflects a sharp 8.7 mb fall in EU-16 gasoline stocks.  With signs of unfavourable export economics to the US, this likely reflects a further lowering of regional gasoline production.

OECD Pacific

OECD Pacific oil stocks fell by 7.7 mb in June, a month when they are usually building towards a late summer peak.  Counter-seasonal stock draws were observed in crude, distillates and 'other products', three of the four largest regional stock categories (alongside gas liquids).  Crude stocks fell counter-seasonally by 1.6 mb in June from a May base which was itself revised downwards by 5.3 mb.  The May revision included a -4.7 mb correction in Japanese crude stocks, the potential for which was flagged in last month's report and the submission of new data from Australia and New Zealand, which in both cases recorded unseasonal May crude draws.  In June, Japanese crude imports fell sharply, by almost 600 kb/d, which overshadowed a dip of 160 kb/d in refinery throughputs, prompting a draw in crude stocks of 4.6 mb (provisionally).  OECD Pacific refinery throughputs generally hit their low point for the year in June and, accordingly, Korean crude runs were down by 240 kb/d on the month.  A 200 kb/d drop in June crude imports contributed to a build of 3.0 mb in Korean crude inventories.  More positively, weekly Japanese data indicate a 5.1 mb build in crude stocks in July, despite a sharp seasonal uptick in refinery throughputs.



OECD Pacific product stocks decreased counter-seasonally by 5.3 mb in June to 164.4 mb, or almost 16 mb below the five-year average.  Pacific product stocks usually build in the second quarter as post-winter demand drops.  However, a very marginal June build of 0.4 mb mean that distillate stocks were basically flat between end-February and end-June at around 58 mb.  Meanwhile, June drops in both motor gasoline and 'other products' inventories eroded a large part of the stockbuilds seen in these categories earlier in the year.  Rising naphtha prices in June may have curbed imports and hence contributed to a monthly stock draw of 2.3 mb in 'other products', with petrochemical throughputs reportedly strengthening.  May data for Australia showed a 0.9 mb dip in distillate stocks, confirming the shortages they had at the time, due to a natural gas plant outage.

Recent Developments in Singapore Stocks

In July, there was a 1.6 mb increase in middle distillate stocks held independently in Singapore.  This followed higher Pacific refinery throughputs, including extremely high Chinese runs and a recovery from peak maintenance in Japan, potentially boosting regional light product supplies.  Residual fuel oil inventories fell by 2.4 mb following a tightening in local fuel oil markets and higher freight costs possibly acting as a constraint on long-haul imports.



Prices

Summary

  • Oil prices fell sharply in the latter half of July and early August on easing fundamentals and against the background of a general downturn in many other commodities, including natural gas.  Crude futures were down around $30/bbl or 20% since all-time highs reached in early July, as OPEC increased supply, demand in the OECD weakened and the first seasonal US Gulf hurricanes passed without anything more than precautionary shut-ins.
  • Spot crude prices fell on below-average OECD throughputs, as refining margins remained weak.  Light/heavy differentials narrowed on fuel oil's relative gains.  At the time of writing, neither the shut-in of the Baku-Tblisi-Ceyhan (BTC) pipeline, nor military clashes in the Caucasus had affected prices.
  • Refining margins were mostly down in July, with cracking and coking margins weakened by already-low gasoline and falling distillate cracks respectively.  Hydroskimming margins in simple refineries, however, benefited from fuel oil's recovery, but remain negative.
  • Product prices mostly fell in absolute terms in July and early August, as did crack spreads.  Fuel oil discounts narrowed, but were more than offset by lower distillate and still-weak gasoline cracks.  Long-time fuel oil weakness has forced refineries to invest in upgrading which, in combination with reduced Middle Eastern exports on lower local demand, is tightening fundamentals.
  • West African Suezmax rates joined Middle East Gulf VLCC rates at historically high levels in mid-July, as higher OPEC exports boosted dirty vessel demand.  However, crude tanker rates corrected down dramatically in the final week of the month on reports of improved vessel supply.  Weak US gasoline demand undermined transatlantic clean tanker rates in July, while Asian clean rates rose on more attractive eastbound naphtha trade economics.


Overview

Oil prices fell from a mid-July peak to three-month lows in early August as fundamentals eased.  Crude futures dipped below $115/bbl in early August, after hitting $147 in trading on 11 July, a fall of around 20% or more than $30/bbl.  Higher OPEC production, weak OECD demand, a rise in stocks and - so far - the absence of any substantial weather-related shut-ins in the US Gulf have contributed to bring down crude.  Moreover, peak summer refinery throughputs, a shift in yields towards distillate maximisation and slower demand in key areas have combined to ease the previously very tight distillate market.  Lastly, the decline in oil prices comes against a background of weaker energy and commodity prices in general (see Gas and Crude Prices - Correlation or Causality?).

As foreseen in previous reports and in the Medium-Term Oil Market Report, fundamentals have eased.  While it may be too early to identify a sea change (see page 4), commodity markets in general appear to be reacting to high prices and many price indices are down.  Besides oil and gas, other commodities such as corn, wheat, copper and gold have all fallen in recent weeks.  These declines have also come at the same time as a strengthening of the dollar.  While the Jefferies/Reuters CRB index lost 10% in July, its sharpest fall since March 1980, total open interest in WTI on the NYMEX has continued its decline, while non-commercials have recently gone net-short for the first time since February last year.



In terms of oil fundamentals, crude and product supply tightness has eased.  OPEC pumped an additional 145 kb/d in July, with Saudi Arabia seemingly following up on earlier pledges to raise supply.  After total OECD stocks failed to match their usual build in the second quarter, preliminary data for July show a higher-than-normal build of around 30 mb.  In product markets, the distillate tightness that has been a pillar of support of high oil prices this year has now begun to loosen, as demand from key sources weakens and the global refinery system has ramped up output.  Conversely, fuel oil cracks have recovered strongly due to tighter fundamentals, which may however, if sustained, have the positive effect of strengthening refining margins, thus encouraging higher throughputs and greater product availability.



On the demand side, the slowdown in demand related to the general economic downturn and high oil prices is becoming increasingly evident - at least in the OECD and predominantly in the US.  Consumers clearly are reacting by a change in behaviour as evidenced by less driving, shorter and more local holidays, different consumption patterns, etc.  For instance, the US Federal Highway Administration reported in late July nearly 38 billion fewer vehicle-miles travelled (VMT) in May year-on-year, the third-largest monthly drop ever.  May is considered the start of the peak summer driving season, when traffic rises due to the Memorial Day holiday and the subsequent holiday period.

Gas and Crude Prices - Correlation or Causality?

Oil prices' decline since early July may be seen against the background of a wider energy and commodity downturn.  Indeed, US NYMEX natural gas futures have fallen by around 35% since 4 July, to around $8.5/MBtu currently.  WTI and gas had tracked each other since the beginning of the year, but since early July gas started declining earlier and more steeply than oil (on an energy basis, gas remains considerably cheaper).  While most would argue that oil and gas prices are linked in some way, this begs the question whether the decline in oil prices in this case was partly caused by gas.

US gas prices have arguably fallen on a significant increase in domestic gas production.  Production in the US Lower-48 started to rise in 2007, culminating in a surge in output at the beginning of this year.  Year-to-date, production has increased nearly 9% year-on-year, to over 1,800 bcf.  This rebound - stimulated in part by high oil and gas prices - followed a long period of stagnation since the turn of the decade.  In addition, production is forecast to continue to grow if demand and high oil prices are sustained, albeit not at the same pace.

Moreover, gas prices fell despite an increase in demand for air conditioning in the US and the precautionary, but temporary shutdown of the Independence Hub in the US Gulf due to Hurricane Dolly, the latter taking about 25 mcm/day of production off the market.  In addition, total US Lower-48 gas in storage is very much in line with its five-year average level.



The most obvious physical link between oil and gas prices is in the realm of competition as feedstock for power generation.  An increasing number of power stations, especially in the US, have the ability to choose between the two, depending upon price and logistics (fuel substitution).  The growth in volumes in the liquefied natural gas (LNG) market and gas's increasing physical liquidity mean that for the first time, a quasi-global market for gas is emerging.  Already, some Atlantic Basin and Middle Eastern producers can choose between sending cargoes to the US, Europe or East Asia - or even change direction mid-journey if the economics make sense.

But increasing volumes of gas on the global market would - according to this logic - imply weaker fuel oil prices, which is not what we are seeing (albeit many power stations increasingly prefer to run distillates as an alternative to gas).  Quite the opposite; since early July, fuel oil prices have to some extent bucked the downward trend compared with crude and light and middle distillates, though for low-sulphur product this is less true in the US than in other markets.

Thus the link between oil and gas appears tenuous in this case.  There may be a time lag: when any excess LNG volumes get redirected towards Asia - arguably now the tightest market in terms of fuel oil - we may begin to see a widening of fuel oil discounts again.  While record price falls suggest more correlation than causality, further work and data visibility is needed to understand substitution trends.

This feature benefited from input by the IEA's Energy Diversification Division.  For more background and analysis, see the forthcoming IEA Natural Gas Market Review 2008, to be published in September.

A flurry of geopolitical and weather-related news may have lent some support to oil prices, but could not prevent the broad downward slide.  On 5 August, the 1 mb/d Baku-Tblisi-Ceyhan (BTC) pipeline was set on fire - reportedly by Kurdish insurgents - which led to its complete shutdown (see Damage to the Baku-Tblisi-Ceyhan Pipeline on page 25).  At the time of writing, it was unclear how long repairs might take, but reportedly, loadings of Azeri Light crude from the Turkish port of Ceyhan had stopped completely.  In addition, a flare-up in fighting in Georgia raised concerned about Caspian export supplies (see Risks to Energy Transit Facilities as Military Action Escalates in Georgia on page 26).  In early August, Tropical Storm Edouard briefly forced the shut-in of some US Gulf oil facilities, but ultimately had little impact on operations and prices.  However, it and previous Hurricanes Bertha and Dolly were a reminder that the autumn hurricane season's peak is yet to come.  The US National Oceanic and Atmospheric Administration (NOAA) recently predicted a more active 2008 season than previously envisaged, now forecasting seven to 10 hurricanes, of which three to six may be classified as 'major'.



In other geopolitical developments, Nigerian infrastructure experienced further attacks, but nonetheless actually increased production slightly in July.  The partial curtailment of Russian Druzhba supplies to the Czech Republic looked to be short-lived, with flows assumed to return to normal in August.  Meanwhile, Libyan threats to halt crude exports to Switzerland have apparently not resulted in reduced flows.  A strike by Petrobras workers in Brazil briefly shut-in some production, but a larger industrial action threatened for August was avoided.  The crisis over Iran's alleged nuclear activities is however ongoing and more sanctions against it are being considered.

Spot Crude Oil Prices

Spot crudes declined in line with futures, with supplies slightly higher and below-average OECD refinery throughputs crimping crude demand.  Total OECD crude stocks fell further in June, remaining below their five-year average, but preliminary numbers for July saw a crude build of around 13.5 mb.  Meanwhile, distillates' relative price decline, even as fuel oil discounts contract, is narrowing light/heavy differentials by boosting fuel oil-rich crude grades.



In the US, where cracking margins are especially weak, light sweet crudes came under particular pressure given lower gasoline and distillate crack spreads.  Hence, Gulf Coast sour benchmark Mars improved against LLS and, to a lesser extent, against WTI.  Heavy sour Maya also moved from a strong discount to WTI to - unusually - a brief premium, though this is also related to lower Maya production in Mexico.  US refiners appear to have shown less interest in West African and other Atlantic Basin crudes, with arbitrage spreads a disincentive.  Stellar dirty freight rates also contributed, limiting the transatlantic flow.

In Europe, Dated Brent moved to a premium to WTI in mid-July, though this was short-lived and possibly more related to the unusual, counter-seasonal distillate premium and thus relatively stronger interest in Brent (while, as argued above, US refiners currently prefer medium and heavy sours).  At the time of writing, the BTC pipeline outage had not noticeably affected the price of Azeri Light despite the reported halt to exports from Ceyhan.  But medium-sour Urals had seen its discount to Brent narrow to the lowest in the past year, shored up by stronger fuel oil.  Additional support came from lower Kirkuk availability in the Mediterranean and lower Forties output in the North Sea in July.



In Asia, marker grades Dubai and Oman were both strengthened vis-à-vis Brent by stronger fuel oil.  Dubai lost around $5/bbl less than Brent since highs reached in early/mid-July.  Regarding light sweet imports, Asian refiners were reportedly seeking 1.4 mb/d of West African crude for August loading, the highest in over a year.  Nigerian premia to Brent have fallen, partly due to lower US interest on weaker gasoline and diesel cracks.  A narrower Brent/Dubai spread and Malaysian Tapis soaring to a near $20/bbl premium to Brent in mid-July both assisted the flow of Atlantic Basin crude towards the east.



Refining Margins

Cracking margins remain low and on average fell in July month-on-month due to a decline in distillate cracks, while gasoline spreads remained weak.  This remains especially true in the US, where cracking Brent or Bonny Light on the Gulf Coast remains unprofitable (based on full-cost calculations) - not least due to high freight rates.  However, by early August, US cracking margins had picked up due to some improvement in gasoline prices.  Conversely, coking margins were not improved by fuel oil's gains, as long as gasoline remains weak.

The more unusual development was the increase in hydroskimming margins on the back of a sharp narrowing of fuel oil's discount to crude.  Thus in Europe, Brent and Urals hydroskimming rose around $1-2/bbl in July, though margins remain negative due to sliding distillate and still-weak gasoline cracks.  In Asia, Dubai hydroskimming also improved by $1.50/bbl.  Tapis margins meanwhile - both in simple and more complex refineries - fell sharply in July and early August, due to the crude grade's strength.  Tapis hydrocracking was especially low, falling to -$5.62/bbl on average in July and even further in early August.





Spot Product Prices

On average in July, fuel oil was the only product for which prices increased.  Against a background of sliding distillate and still-weak gasoline crack spreads, fuel oil's discount to crude has narrowed substantially in all regions, both for high and low-sulphur product.  This appears to be largely due to tightening fuel oil fundamentals.  Structurally, many refineries have been forced to upgrade in order to remain profitable, as fuel oil discounts have in many cases been prohibitive in recent years.  Meanwhile, a hot summer is raising utility demand in the Middle East, halting Saudi fuel oil export volumes entirely - a key source for Asia.  Iran is expected to curb exports later in the year due to extensive refinery maintenance and strong demand.  South Korea has also cut August fuel oil exports by around 15% on higher domestic refinery use.  Asia, the key fuel oil market, is expected to see August imports around only 2 million tonnes, some 30% lower year-on-year, also hampered by strong dirty freight rates in most of July.  High shipping demand has also boosted bunker needs, while in Japan, key nuclear power stations will likely stay shut-down for longer than expected.



Middle distillate cracks - which have been a key pillar of support for oil prices in general so far this year - fell in July and early August, as refinery throughputs reached seasonal peaks and efforts to maximise distillate yields have borne some fruit.  Russia, which has recently started up a new, dedicated pipeline to Primorsk on the Baltic Sea, is expected to export 200,000 tonnes (~48 kb/d) of 10 ppm ultra-low-sulphur diesel in August, up from 85,000 tonnes in July.  Moreover, key centres of recent additional demand are seeing some relaxation.  China is reportedly expected to cut August diesel imports to around 120 kb/d, from 240 kb/d in June and 200 kb/d in July.  Many had surmised that China has been stockpiling diesel and other products ahead of the Olympic Games, though insufficient data prevent a conclusive answer on this.  Elsewhere, Chile, which has imported around 165 kb/d of diesel for additional power generation in the first half of 2008, hopes to slash this volume to around 40 kb/d in the latter half of the year, as heavy rains have boosted hydropower.  In Australia, the Varanus gas plant is gradually coming back on line, implying that diminishing volumes of diesel imported for power generation are likely needed.



Gasoline crack spreads to benchmark crudes remain weak, but saw some improvement in the latter half of July and early August.  Demand in the key US market is still weak, with below-average summer driving.  However, New York Harbor cracks picked up again slightly from mid-July as stocks fell.  US refiners have reacted to unseasonably weak gasoline cracks by maximising distillate yields, but despite two weekly US stock draws, total gasoline stocks remain at the top end of the range in absolute and forward demand cover terms.  Relative economics curbed the usual transatlantic arbitrage flow in July, as evidenced in declining clean freight rates.  European and Asian gasoline cracks remain subdued.

End-User Product Prices in July

End-user product prices on average rose 3.5% in July month-on-month in surveyed IEA countries - in US dollars, ex-tax.  This was mainly driven by a 13.5% surge in low-sulphur fuel oil prices.  In comparison, retail transport fuel prices on average rose 1.8%, in US dollars, ex-tax, with the highest increases in Japan, where gasoline and diesel prices grew up by 6.3% and 7.0%, respectively.  In July, consumers in the US on average paid $1.075/litre ($4.11/gallon), in Japan $1.681/litre (¥182/litre) and in Europe from $1.948/litre in Spain (€1.248/ litre) to $2.453/litre in Italy (€1.571/litre).  Heating oil retail prices on average rose by 1.9%, in US dollars, ex-tax.  Compared with July 2007, retail prices are now approximately 70% higher than a year ago with the largest increases in low-sulphur fuel oil (89%), heating oil (81%) and diesel prices (74%).  Gasoline prices rose by 46% since July 2007.

Freight

VLCC charter rates stood firm at historically high levels for most of July before plummeting at the end of the month.  A late-July downward correction also reduced Suezmax rates from a mid-month spike which had broached record levels.  Transatlantic clean rates dropped in July as New York gasoline prices fell relative to those in Rotterdam while Asian clean rates firmed on higher eastbound naphtha volumes.

VLCC rates on the benchmark routes from the Middle East Gulf to Japan remained above $40/tonne for most of July, extending the unseasonably firm run in VLCC rates to a third month.  High levels of oil in transit on long-haul routes, a result of apparent increases in OPEC production, pushed rates very close to the record highs of $45/tonne witnessed in late 2004.  At the same time, Middle East Gulf tanker supply remained subject to the constraint of eight Iranian VLCCs still apparently storing crude offshore at end-July.  However, the final week of July witnessed a dramatic halving of VLCC rates (on the same MEG-Japan route) to $21/tonne.  While reports emerged of increases in prompt tonnage, this could have also marked a sudden lull in demand after the initial tranche of extra OPEC exports.  Approaching autumn refinery maintenance may lead to a more sustained easing in tanker demand and, by extension, VLCC rates.  Downside potential in crude-in-transit levels in the third quarter was supported by last week's stories of refiners refusing extra crude cargoes offered by the UAE prior to the onset of field maintenance.

Suezmax rates from West Africa to the US Atlantic coast surged to record highs of almost $50/tonne in mid-July, a rise of $20/tonne from the start of the month.  Suezmax demand was boosted by an overspill from the buoyant VLCC sector.  Demand from Asia was also supportive, but low US cracking margins and high early-month Bonny premiums to Brent kept transatlantic arbitrage economics unfavourable, in theory.  China increased monthly purchases of West African crude for August loading to 675 kb/d, while Indian buying of cargoes in July and August was also high.  The logistical flexibility of Suezmaxes (they can load and discharge at a much wider variety of terminals compared with VLCCs) may have been another factor supportive of demand, in the face of disrupted Nigerian loadings and the threat of hurricanes in the US Gulf.  Suezmax rates also declined steeply in late-July, potentially linked to improved Atlantic Basin vessel availability.



Clean rates in the Atlantic basin dropped markedly in July, coinciding with continued weak US gasoline demand (and falling prices) which undermined transatlantic trade.  UK Continent to the US Atlantic Coast clean rates for 35 kmt vessels neared $25/tonne towards the end of July, having started the month above $40/tonne.  A late-month rise in the US-Rotterdam gasoline spread allowed these rates to rebound slightly.  By contrast, 75 kmt clean rates from Middle East Gulf to Japan gained around $8/tonne in July to reach $54/tonne, as Asian naphtha demand was reportedly boosted by easing prices.

Refining

Summary

  • Global crude throughput averaged 75.0 mb/d in July, a month-on-month increase of 0.1 mb/d.  Lower OECD crude throughput estimates for the month, following continued weak cracking margins in the US, offset the upward revision to Chinese crude runs, following the country's record throughput level in June.  Year-on-year growth drops to 0.4 mb/d in July from 1.2 mb/d in June, as OECD crude throughput falls 0.9 mb/d below levels of a year ago.
  • The 3Q08 global crude throughput forecast is unchanged at an average of 75.3 mb/d, as higher Chinese and Middle Eastern forecasts offset weaker the OECD throughput estimates.  Increased maintenance estimates for OECD Europe and Russia, in addition to lower 2Q08 Nigerian runs also reduce our 3Q08 forecast.  Year-on-year growth is lowered to 0.6 mb/d, as non-OECD growth of 1.2 mb/d more than offsets the 0.6 mb/d decline in the OECD.  In addition, 2Q08 crude throughput is revised up by 0.1 mb/d, following surprisingly strong Chinese and Middle Eastern June crude throughput and upwardly revised May OECD Europe throughput.


  • Weak gasoline cracks continue to undermine refinery margins, particularly in the US.  Consequently, refining activity levels have remained more subdued than forecast in the OECD, most notably in the US and there remains a risk that the 3Q08 OECD crude throughput forecast remains too high.  Operational problems at several US Gulf and West Coast refineries, in conjunction with hurricane-related disruptions have also curtailed crude throughput levels during July.  Further disruptions may lend some support to gasoline cracks over the balance of the third quarter.
  • Refineries in all three OECD regions continue to raise middle distillate yields, at the expense of fuel oil and gasoline.  Refineries in the OECD regions have increased middle distillate yields year-on-year every month bar one since the beginning of 2007.  Year-to-date fuel oil yields have remained below the five-year range, driven by investment in upgrading capacity and poor hydroskimming margins.

Global Refinery Throughput

Preliminary estimated July global crude throughput of 75.0 mb/d was slightly below the forecast of 75.2 mb/d contained in last month's report.  Weaker-than-expected OECD activity levels depressed global crude runs, while non-OECD runs appear broadly in line with expectations for the month despite upward revisions to Chinese and Middle Eastern throughputs.

Crude runs are forecast to increase to a seasonal peak of 76.0 mb/d in August, driven by higher OECD runs and higher Middle Eastern and Chinese crude throughput.  September runs should drop back to around 75.0 mb/d, as autumn maintenance starts in several regions.  Overall 3Q08 crude throughput is unchanged from last month's report at 75.3 mb/d as regional changes cancel each other out.  Furthermore, we continue to exclude trial crude runs at the 580 kb/d expansion of the Jamnagar refinery in India.  Some unconfirmed reports suggest that commissioning is likely before the end of the third quarter, offering the potential for an upward revision to September if that in fact occurs.

Refining margins remain a key determinant of refinery activity levels and the continued weakness in US cracking and coking margins underscores the challenges facing some industry players.  Offsetting the recent rebound in US gasoline cracks are weaker middle distillate cracks, although these remain at historically high levels.  Refineries in the OECD continue to adapt to the changes in crack spreads, posting the 19th consecutive month of year-on-year increases in diesel/gasoil yields.  However, conditions remain tough for refineries.  Valero, often regarded as a barometer for US refining, and the largest independent refiner, reported its lowest second-quarter earnings per share since 2003 and 61% below 2Q07.  Furthermore, several independent US refiners reported losses for the quarter, with many lowering expenditure plans for the year to conserve cash.  Similarly, integrated oil companies reported substantially weaker downstream earnings.  ExxonMobil reported 2Q08 downstream profitability was more than 80% lower in the US and nearly 25% lower for its non-US businesses than in 2Q07.

Forecast OECD 3Q08 crude throughput averages 38.6 mb/d, 0.2 mb/d lower than last month's report, due to weak demand and the poor margin environment noted above.  This pushes crude throughput to 0.9 mb/d below the five-year average for 3Q08 and 0.6 mb/d below 3Q07 average levels.



2Q08 OECD North American crude throughput is slightly weaker than reported last month, following weaker June throughput data for Mexico.  The 3Q08 crude throughput forecast for OECD North America is reduced on the back of weak US levels in July and the continued poor outlook for margins.  North American crude throughput is 0.2 mb/d lower, at an average of 18.2 mb/d for the quarter.

US refinery crude throughput averaged 15.2 mb/d in July, according to provisional weekly data, some 0.3 mb/d below our expectations.  Crude runs fells consistently over the course of the month to their lowest level since early May, with precautionary hurricane-related disruptions and operational problems adding to the impact of the poor margin environment.  Only West Coast runs remained at or near typical levels for the time of year, with every other region at, or below, the lower end of the five-year range.  Gasoline imports also collapsed mid-month to the lowest weekly level since February 2004, although unfinished component imports remain within the five-year range, further highlighting the pressure on gasoline cracks and the excess supply potential in the Atlantic Basin compared with demand.



The 3Q08 OECD Pacific throughput forecast is broadly unchanged at 6.8 mb/d, although forecast September runs are raised slightly, due to some planned maintenance being delayed into October.  Weekly data for July indicate that crude runs in Japan were weaker than levels of a year ago, despite the sharp rebound at the beginning of the month, averaging 3.8 mb/d.  On a year-to-date basis the weakness in Japanese demand for transport fuels has been partially offset by higher product exports which, from January to May, have increased by almost 50% from the comparable period in 2007.  Some refiners, notably Nippon Oil, still appear to be curtailing operations, with August crude throughput forecast to be 2% below the rate achieved last August.  Korean runs fell in June to 2.2 mb/d as maintenance activity increased.  Runs are forecast to dip further in July, before recovering over the balance of the quarter to reach 2.5 mb/d in September.





OECD Europe crude throughput edged up in June by 0.1 mb/d to an average of 13.5 mb/d, from an upwardly revised May level of 13.4 mb/d.  Crude runs remain weak relative to the five-year range and are forecast to peak in August at 13.7 mb/d, below the five-year range.  Negative gasoline cracks and hydroskimming margins, plus operational problems at refineries such as Neste's Porvoo refinery, are expected to limit crude runs over the balance of the third quarter.  Diesel cracks remain strong, although off their recent highs. These have helped European refiners, which typically have a higher distillate yield than US refineries, to remain relatively more profitable during the second quarter.  Autumn maintenance should increase in September, with several large-scale shutdowns, including Shell's Pernis, StatoilHydro's Mongstad and Chevron's Pembroke refineries.



Chinese crude runs jumped by 0.7 mb/d in June to average 7.2 mb/d, according to National Bureau of Statistics data.  This surprisingly strong level of growth, 0.4 mb/d above our forecast, from the May throughput level follows the completion of heavy maintenance work.  The increase could reflect strong demand or the desire by Chinese refiners to bolster product stocks ahead of the Olympics.  However, we consider the impact of the price increase mandated by Chinese authorities on June 20 as being minimal during the month, as it was probably too late to materially increase average crude runs. Nevertheless, we have raised 3Q08 crude throughput forecasts by 0.2 mb/d, to an average of 7.1 mb/d, reflecting the higher June throughput level, but also the uncertainty over Chinese demand, post the Olympics.  However, operating plans at China's ten largest refineries for July and August suggest that runs may reach 7.3-7.4 mb/d if other refineries, including the new 200 kb/d Qingdao refinery, continue at the June level of crude throughput, presenting some upside risk to the 3Q08 forecast.

Middle Eastern crude throughput was 6.5 mb/d in June, 0.3 mb/d above forecast, due to stronger-than-expected Iranian, Iraqi and Saudi Arabian crude runs.  Iranian crude throughput breached 1.7 mb/d, the highest level on record, suggesting that planned work to complete the expansion of the Bandar Abbas refinery, to increase the process capacity for heavy sour crudes, such as Soroush-Nowruz, may have been delayed until July.  This raises the possibility of further increases over the course of the 3Q08 on completion of the work.

Similarly, Saudi Arabian crude runs were above our forecast, reaching 1.9 mb/d, the highest level since November 2006 and close to all-time highs.  This level of throughput suggests that Saudi Aramco refining capacity is running flat out to meet domestic and export demand.  Lastly, Iraqi crude runs are estimated to have reached nearly 0.5 mb/d, a post-war high.  Regional crude runs in July are expected to dip following reports of maintenance at Iraq's Baiji refinery and the expansion work noted at Bandar Abbas, but overall we have revised up our 3Q08 estimates by 0.3 mb/d to reflect the higher 2Q08 base throughput levels.

Offsetting these increases, the 3Q08 FSU crude throughput forecast is cut by 0.2 mb/d, due to higher maintenance estimates for Russia, as several refineries operated by Lukoil and Rosneft undergo maintenance during August and September.  African 3Q08 throughput estimates are reduced by 0.1 mb/d, as despite the reported start-up of the Kaduna and Warri refineries in Nigeria, regional runs do not appear to have increased to the extent expected.

OECD Refinery Yields

Refineries in all three OECD regions continue to raise middle distillate yields, (jet, kerosene, gasoil and diesel) at the expense of fuel oil and gasoline.  Refineries in the OECD have increased middle distillate yields year-on-year every month bar one since the beginning of 2007.  In North America, refineries have increased middle distillate yields year-on-year for 28 of the last 36 months.  Similarly, in Europe, middle distillate yields have increased in 33 of the last 36 months.



Year-to-date fuel oil yields have remained below the five-year range, driven by investment in upgrading capacity and poor hydroskimming margins. The notable exception is in Japan where fuel oil yields have risen above levels of a year ago as Japanese power utilities increase the use of fuel oil to cover shortfalls in nuclear generating capacity.  Recent strengthening of fuel oil cracks are unlikely to raise fuel oil yields at cracking refineries, given fuel oil continues to trade at a discount to crude prices.  However, it may increase crude runs at hydroskimming refineries, which could imply higher fuel oil yields on an aggregate basis.