Are oil markets ready for war? The answer appears to be yes, based on supply/demand balances for the months ahead projected by EIB's sister publication Petroleum Intelligence Weekly.

Even assuming relatively strong global oil demand growth and no extra supply surge from Opec, military action in Iraq would probably leave the supply/demand balance looking much as it usually does at the end of the June. Whether futures traders interpret war risk the same way is another story. There focus appears to be more on commercial inventories that are starting the year off on the low side of normal at the global level and at unprecedented lows in some regions.

Under a 'short war' scenario -- which doesn't start until mid-March and lasts a month or so -- stocks should build at a healthy rate in the second quarter, albeit from low levels. This recovery may even require Opec to cut back sharply to keep markets on an even keel. Under a 'long war' scenario -- a mid-February start lasting for at least four months -- a slightly below average rate of stock building in the first half would keep fundamentals tight at least until the summer. This outlook assumes no release of strategic inventories and no compensation for an Iraqi outage by other Opec members (see table).

However, in the event of a longer war, release of oil from the US Strategic Petroleum Reserve and other International Energy Agency country stocks is increasingly likely, and Mideast Gulf Opec members with excess capacity would probably move to boost supplies, as well. The effect on Iraqi oil production, which would be expected to drop to a dribble with none exported in the event of an invasion, would last longer than military activity as oil fields would need to be restarted and any collateral damage repaired. Even in the short war scenario, Iraq's output is only seen as rising to 1.5 million b/d by June from nearly 2.5 million b/d in January, but reductions in domestic demand due to the war could leave a few 100,000 barrels per day more available for export.

Supply/Demand Balance Under Two Iraqi War Scenarios

Source: Petroleum Intelligence Weekly, Feb.10,p5.
* Gulf producer supplies assumed to be at Feb. 1 quota March-June.

Whether the US-led war to disarm Iraq is short or long, global supply levels depend critically on the interplay between expanding production in Venezuela and the supply response of other Opec countries, as well as the timing and duration of an Iraqi outage. Opec's Mideast members are assumed to drop back to their current quotas from March, with other members holding at around current levels of production through June. Non-Opec supplies look set to stay at January levels of around 48 million b/d for the next two months, helping cover some of the losses from an 'early' war. But beginning in April, the amount of help from non-Opec producers will begin to ebb. Seasonal declines will begin in North America and the North Sea, although maintenance activity in the latter is already expected to be pushed back into the third quarter to take advantage of higher expected prices in the first half of the year. Non-Opec supply in the second quarter is projected to drop by 755,000 b/d from the first-quarter average, with the North Sea accounting for 535,000 b/d of that and North America losing just under 200,000 b/d.

But even with the long-term loss of as much as 500,000 b/d of Venezuelan productive capacity, the country appears set to contribute a substantial increment to crude, synthetics, and natural gas liquids supplies over the next four months. After dropping to 625,000 b/d of conventional crude only in January, with the strike easing, Venezuelan output is expected to double this month to 1.26 million b/d of crude and synthetics, and add nearly 1 million b/d in March to reach 2.24 million b/d. In addition, restart of natural gas and orimulsion production should add over 300,000 b/d to already growing Opec NGL & other supplies this month and about 60,000 b/d in March. Other Opec producers have significantly ramped up production in response to the Venezuelan strike and resultant high prices. Assuming they will cut back now that Venezuelan production is on the rise is probably unrealistic with war still looming. At best, the five Mideast Gulf Opec countries, excluding Iraq, might honor their new quotas set from Feb. 1, as is assumed here, but others like Nigeria and Algeria with new oil fields, foreign investors and in Nigeria's case elections figure to stay up. Even among the Gulf producers, Qatar is currently assessed at 750,000 b/d compared to a Feb. 1 quota of 635,000 b/d and may decide to be a renegade on production as well as regional politics.

The projected balance also assumes fairly strong global oil demand growth though June, in the neighborhood of 2.4% compared with first-half 2002, when demand fell by 1%. If anything, that may be overly generous. Global oil demand has not grown that fast in years. Even in 2001, when cold winter weather and gas-to-oil switching still propped demand early in the year, global oil demand grew by only 1.8% in the first half. And that was before the US economy took the blow of the Sep. 11 attacks. This year has cold weather again, but the economic outlook is still less than certain, and prolonged high oil prices should crimp usage. The seasonal demand pattern is expected to be typical, with strong demand in January and February, a drop-off between the heating and driving seasons, and another upward climb again in June. Growth should be led by the US, Japan, China, and the former Soviet Union, while European growth is expected to be largely flat in the first half, picking up slightly closer to summer.

Stocks normally fall in the first quarter of the year, and build in the second, ahead of the driving season. Either war scenario yields implied stock changes within the normal historical range in each period. But with inventories on the low side of normal now -- particularly in the key US market -- two fairly hefty draws in January and February, under the early, long war scenario, would keep the boil in the balance, and therefore prices. But under either scenario, the balance would start to look sloppy by June unless Opec acted to restrain output.

One mitigating factor in the tight first-quarter outlook is the barrels of Mideast oil already en route to the US. Fixtures from the Mideast Gulf bound for the US leapt in January -- by an estimated 40% from December, according to one source. With a 35-40 day sailing time for that journey, those cargoes should show up in the US anytime between now and mid-March, which may coincide serendipitously with a loss of Iraqi output.

By David Knapp, Katherine Spector, and Madeline Jowdy in New York