TITLE: CERA Monthly Oil Briefing: Fundamentals Update 
E-mail Category: CERA Monthly Briefing 
CERA Knowledge Area: World Oil 

In the past two weeks, oil prices have sold off the premium or price strength 
that had been built into the market in anticipation of possible shortages 
this winter. The exact cause of the sharp switch in market psychology is hard 
to pinpoint but seems to be a combination of very early signs that the oil 
stock situation is at least stabilizing, even if stocks have not built 
substantially, and that, thus far, despite a few weeks of colder-than-normal 
temperatures, heating oil supply has been adequate to meet demand in the key 
US market. That has allayed some of the concerns that were driving 
speculative interest into the market. Furthermore, the potential for weakness 
in the US economy may be creating expectations for weaker oil demand in 2001. 

The change in market psychology was dramatically illustrated when news that 
Iraq was cutting off exports caused prices to slide, yet, the Iraqi export 
cutoff is having a concrete effect on fundamentals. If the cutoff lasts 
through December, the effect will be pronounced-it would turn a projected 
fourth quarter 2000 stockbuild of 0.5 million barrels per day (mbd) into a 
stockdraw of 0.1 mbd. We expect Iraqi production levels to remain erratic 
because of its dispute with the UN Security Council over sanctions, and 
exports may again cease. At some point such a development would have a price 
supportive effect. 

CERA's price outlook for 2001 remains the same as that in the World Oil Watch 
released in late November. Assuming normal winter weather and no prolonged or 
repeated shutdowns of Iraqi production, the projected average for first 
quarter 2001 is $29 per barrel for WTI. However, this outlook is based on 
OPEC's announcing an agreement early in the first quarter to cut its 
production by the start of the second quarter. A failure to restrain output 
would result in a downward adjustment to an average of $27 WTI for the first 
quarter of 2001, with prices lower in the second half of the quarter than in 
the first. The downward pressure results from the prospect of a 
larger-than-usual implied build in stocks during the second quarter of about 
3.0 mbd-with a cut in OPEC output.

Iraq in a Twilight Zone 
As anticipated, Iraq ceased exporting oil under the UN-controlled "oil for 
food" program as of December 1 in protest over the rejection by the Security 
Council's sanctions committee of its proposed December export price schedule.*

Iraq's pricing was judged by the UN overseers, who monitor the export program 
and advise the sanctions committee, to be about 60 cents per barrel below 
comparable crudes in an apparent attempt to offset an illicit surcharge that 
Iraq was seeking from buyers.

Although the standoff with the sanctions committee continues, Iraq partially 
resumed exporting on December 13. Since then, about 1 mbd has been exported 
from the Mina al-Bakr terminal in the Persian Gulf. Prior to the shutdown, 
Iraqi exports under UN auspices were at a rate of 2.21 mbd for November, as 
compared with 2.08 mbd for the third quarter. Exports for November were about 
1.3 mbd from Mina al-Bakr and about 0.9 mbd from Ceyhan in the Mediterranean. 
Exports from Ceyhan have not resumed, owing to the surcharge dispute, with 
the result that about 1.2 mbd of Iraqi crude remains off the market.

Iraq's semi-shutdown has put it into a kind of twilight zone while its 
dispute with the sanctions committee over pricing continues. (In the midst of 
this dispute, the UN Security Council approved phase nine of the oil-for-food 
program at the last minute on December 5; it became effective on December 6 
and has been accepted by Iraq). As of December19, Iraq's revised export price 
for Ceyhan, proposed for the remainder of December, has again been judged too 
low by the overseers and is expected to be rejected by the sanctions 
committee. Additionally, the overseers have notified lifters of Iraqi crude 
that any oil payment made directly to Iraq rather than to the UN escrow 
account would be a violation of UN sanctions. Buyers of Iraqi oil from Mina 
al-Bakr have consistently been reported as saying that they are not paying a 
surcharge to Iraq.

How long Iraq may operate at about half capacity is unclear, but it continues 
to request a surcharge payment from prospective lifters at Ceyhan in an 
apparent effort to circumvent and degrade the UN financial controls that are 
the heart of the sanctions system. The distinction that Iraq has made between 
Mina al-Bakr and Ceyhan arose when it resumed operations at Mina al-Bakr by 
loading two cargoes for the India Oil Company. Iraq may have judged this 
accommodation to be in its interest, since it recently also signed an oil 
exploration contract with India under which payments would be made in oil. As 
currently structured, the deal would violate UN sanctions, but India is 
seeking an exception from the Security Council on grounds of economic 
hardship. The exception seems unlikely to be granted, which may lead Iraq to 
cease exports from Mina al-Bakr again.

There are many possible scenarios that Iraq could follow, but we expect 
uncertainty about Iraqi exports to continue as Iraq uses its oil exports as 
leverage to undermine sanctions in its ongoing struggle with the Security 
Council to end all restraints. Consequently, the Iraq factor will remain an 
element in the oil price outlook. 

Iraq's antisanctions campaign has also raised the visibility of the Iraq 
issue in Washington as the incoming Bush administration prepares to take 
office. Secretary of State-designate Colin Powell has already acknowledged a 
need to reassess Iraq policy and has said that he would work to "reenergize" 
sanctions. The Iraq issue is being debated in virtually every foreign 
policy-oriented think tank in Washington. A consensus seems to be emerging 
around seeking renewed international support and legitimacy for sanctions by 
retaining UN control over Iraq's oil revenue and strictly enforcing a 
prohibition on sales of weapons and related material while lifting general 
trade controls that increasingly are both ineffective and an international 
irritant. There is virtually no sentiment in favor of operations to 
destabilize or remove the Saddam Hussein regime on the pragmatic basis that 
the prospects for success are remote.

Demand Trends 
Record high US natural gas prices have increased the economic incentive for 
gas consumers with the capability to switch from gas to distillate to do so, 
and reports of switching are emerging in a number of areas. Interruptible gas 
customers with resid or distillate fuel back-up have already switched to oil, 
so it is now firm gas supply customers with the potential to add to the 
already high level of distillate demand. So far in December US distillate 
demand is running at a record high December level of 3.9 mbd. However, only a 
small portion of this demand is the result of economically based 
fuel-switching from gas to distillate. CERA estimates that the additional 
demand likely to come from further switching of gas to distillate is 
relatively small, on the order of 0.1 to 0.2 mbd. In CERA's view it is likely 
that only a portion of the theoretical capacity will be switched on short 
notice because in some cases, this theoretically switchable capacity has not 
been used in recent years, and tankage and delivery infrastructure may be in 
uncertain condition. 

Switching by interruptible gas customers (such as utilities) to distillate 
began about a month or more ago, although the volumes involved are relatively 
small. Switching to residual fuel already occurred months ago when gas prices 
started to surge in the summer. A portion of the US secondary and tertiary 
distillate stockbuild seen this autumn was likely prompted by interruptible 
gas customers filling their reserve distillate fuel storage. Given the 
expectations of a tight gas market, regulators have been explicit about 
enforcing back-up fuel storage requirements in the months leading up to the 
current heating season. 

Other end users of natural gas have few or no options for fuel switching. 
Some ammonia and ethane producers have shut down operations because the cost 
of feedstock natural gas is high. Natural gas is also used in some enhanced 
oil recovery operations, and some of these producers have also opted to sell 
gas back to the grid rather than produce oil. 

Supply Trends 
Non-OPEC supply for the fourth quarter is expected to be up 0.9 mbd over a 
year earlier at 46.4 mbd. Recent events include a shortfall in Mexican 
production, curtailed in October by about 300,000 bd owing to the effects of 
Hurricane Keith. Mexico's fourth quarter liquids production is expected to be 
3.64 mbd-about 95 percent of Mexican liquids capacity. Norway's output 
increased 200,000 bd from October to November as maintenance season ended. 
Norway's production for the fourth quarter is expected to be 3.53 mbd.*

Growing Russian crude oil production throughout the year is supporting a 
recent surge in exports, in spite of higher export taxes. Russian exports of 
domestic oil production (excluding transit volumes) reached 2.5 mbd in 
November, after remaining fairly steady at about 2.35 mbd from July though 
October. Fourth quarter oil exports are expected to average 2.5 mbd, 0.3 mbd 
greater than in the fourth quarter 1999.

CERA estimates Iraqi oil production averaged 2.91 mbd in November-down 0.1 
mbd from the October level. The cutoff in exports earlier this month reduced 
Iraqi output for the first 12 days of December to roughly 0.8 mbd. Iraq 
resumed exports of about 1 mbd on December 13, which raised production to 
1.80 mbd. Assuming no change in Iraq's current production stance, Iraqi 
production would average 1.41 mbd for December. On a quarterly basis, the 
decline in Iraq output would lead to estimated OPEC output in the fourth 
quarter of 29.0 mbd and would turn an estimated global oil stockbuild of 0.5 
mbd into a stockdraw of 0.1 mbd. These production estimates include 0.15 mbd 
of crude oil exports to Syria that began on November 20 without UN 
authorization and are continuing.

Oil Stocks 
US crude oil inventories (DOE data) have climbed intermittently from an 
annual low of 280 million barrels in September and reached 292 million 
barrels in mid-December (see Figure 1). Since prices weakened in late 
November, crude oil stocks have stabilized above the annual low in September 
and the ranges seen in October to levels from 289-292 million barrels.

Primary inventories of US heating oil remain well below year-earlier levels; 
at 48 million barrels they are 15 million barrels, or 24 percent less, than 
those of a year ago, but there are indications of builds in secondary and 
tertiary inventories. We estimate that wholesale and consumer stocks are up 
5-10 million barrels since August and are actually higher than they were at 
the end of last year.

In Europe crude oil stocks are at more comfortable levels when compared with 
those of the United States. In November stocks rose nearly 9 million barrels 
to 426 million barrels. At this level they are below the highs of 1999 but 
well above the low levels of early 1996 (see Figure 2). Japanese crude oil 
inventories at end-October were 107.6 million barrels, which is above the 
record low set earlier this year but still well below levels seen in recent 
years (see Figure 3).

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