Nigeria fuels prospect of a sharp fall in oil price

ECONOMIC VIEW

Suspension from the Commonwealth is one thing; an oil embargo is something else. The first was easy and swift to accomplish for it simply required a vote, and there are few costs imposed on the other Commonwealth members. The second would also only require a vote, though at the UN rather than the Commonwealth, but to make it effective would need a high degree of agreement by all the large consumers of oil. It is a pure political judgement whether that consensus exists.

We will see. Meanwhile there is an economic judgement to be made: what impact might possible sanctions against Nigeria have upon its oil exports? It matters because the outrage at Nigeria's action coincides with great tension in the oil market. Put at its simplest, the clear possibility facing the delegates at next week's Opec meeting is that the oil price might fall sharply. If that were to happen, Nigeria would be one of the main causes of the collapse.

The oil story runs like this. Since the last Opec meeting in June the oil price has been stuck in the $17-$18 range. Low US stocks and higher demand have balanced higher production from non-Opec producers. Looking ahead, consumption will creep up, but so too will non-Opec supplies. The key therefore is how restrained Opec will be in its production, and whether Iraq will disrupt the market with another embargo-busting oil sale.

In recent months two main Opec members, Venezuela and Nigeria, have pumped above their quotas. (In addition Saudi Arabia has been producing more for winter storage, but this is not counted as supply until it is sold.) To hold oil prices in their present range, therefore, requires not just a continuation of present production, but for Venezuela and Nigeria to cut back and for Saudi Arabia to drop production as it runs down the winter stockpile.

The judgement of many oil analysts for some weeks has been that the oil price might fall out of its present trading range. For example, writing ahead of the executions in Nigeria, JP Morgan in New York was warning of a 50/50 chance of just such a fall. Its judgement has been that without cuts by Venezuela and Nigeria the rest of Opec would increase production, however strong the rational case for holding back supply to shore up the price. Its estimates of the supply/demand balance for Opec crude (world consumption less non-Opec production) is shown in the charts.

If Opec next week cannot persuade its members not to cheat on their quotas, the only issue is how higher production is accomplished. A unilateral increase by the countries which have lost most market share (those who have adhered most closely to their quotas) could push prices below the $15 point before some recovery took place; an organised quota increase agreed at the meeting, on the other hand, would result in a fall to perhaps $16 a barrel. If, looking further ahead, Iraq negotiates some deal, the price would be weaker still.

This 50/50 outlook is undoubtedly changed by the Nigerian executions. In the long term there is the possibility, no more at this stage, of an oil embargo on Nigeria. Were that to happen, it would of course underpin the price in just the same way that Iraq's exclusion from the world oil market has done. In the short term, however, the hostile world reaction to the executions may encourage Nigeria to increase its production - to over-produce to an even greater extent than at present. That oil will find its way on to the world market whatever the reaction of Western consumers. Other Opec members, already angry at Nigeria, will be in little mood to accommodate it now.

Let's accept as a starting point that JP Morgan position of a 50/50 chance of a sharp fall in the price. The balance of probability therefore seems to me to have shifted further towards a fall. The profile of that decline is hard to call, but if this argument is right it is now odds-on that the oil price will be, say, 10 per cent lower next spring than it is at present.

This may well coincide with a similar fall in commodity prices. Non-oil commodity prices reached a peak in February this year and have come back about 5 per cent on average since then. Softer-than-expected growth in the OECD countries will hold back prices further.

Some calculations by HSBC Markets suggest a further fall of 10 per cent between now and the end of next year. Even if growth does pick up, HSBC still expects some fall, and this despite a rise in demand from non-OECD countries.

Put these trends in the oil market and the commodity markets together and the surprises seem likely to be on the downside. Result: lower world inflation next year than is currently factored into world markets.

What might upset this?

There seem to be two main unknowns. First and most obvious is the reaction to the Nigerian executions. If an oil embargo were agreed and if it were supported by reasonable discipline among the other Opec members (so that they did not swiftly "use up" Nigeria's quota), then it is quite hard to see the fall in the price suggested above.

But as non-Opec supply inexorably increases and the Opec share of the market is compressed, it is equally hard to see a surge in the price sufficient to generate a sharp rise in world inflation. And eventually Nigeria would return to the fold, as will some day Iraq.

The second unknown is the demand on all commodities, including oil, from rapid economic growth in East Asia.

The region is resource-poor, and there is no sign yet of growth tailing off. We are talking about at least another generation of very rapid growth before it pulls back to the 2-3 per cent growth rates of Europe and North America. So there will be a strong underlying demand for resources, which may eventually reverse the long decline in commodity prices.

But this is all a long way off. In the next few months the balance of probability is for lower oil and commodity prices, and that equation was tilted a little further by the sad events in Nigeria last week.