KUWAIT CITY, Feb 21: Prices stabilize as supply cuts offset weakness in demand... Kuwait budget to see surplus this year, despite exceptional transfers…  In its latest economic brief on the oil market and budget developments, NBK reports that, the price of Kuwait Export Crude (KEC) hovered at around the $40 per barrel (pb) mark through January and into mid-February, marking the longest period of relative stability in oil markets for months ñ arguably since late 2007. Nevertheless, KECís recent high of $42.2 represents a rise of 32% on its low seen in late December. The somewhat steadier prices witnessed so far in 2009 may be the net result of two offsetting forces: weaker demand for oil by users and speculators on the one hand and falling crude supplies on the other. Some analysts see this as an uneasy truce, with either factor capable of gaining in importance over coming months. One catalyst is likely to be the determination of OPEC to continue to enforce the aggressive production cuts it announced in the final months of last year, as well as the outcome of its next meeting, scheduled for March 15th in Vienna.

Other benchmark crudes have  also displayed more stability in recent weeks. Brent crude, for example, has hovered in the $42-46 pb range since mid January. The price of West Texas Intermediate (WTI), however, remains subject to a heavy discount as a result of a shortage of storage capacity in the US Midwest, the coming expiry of the March futures contract and perhaps competition from Canadian tar sands. At $34 pb, WTI was trading at a record $10 discount to Brent in mid-February, compared to a historical premium of $1.4 since 1985. Analysts are voicing concerns that WTI no longer accurately reflects underlying market conditions, thereby reducing its attractiveness as a market indicator and requiring producers to be more active in terms of adjusting their own WTI-linked prices from the benchmark.

NBK added that, further downward revisions to analystsí forecasts for oil have emerged over the past month, in some IEA global oil demand cases providing a striking contrast to predictions made just a few months forecast for 2009 ago. The International Energy Agency (IEA), for example, have lowered their forecast for incremental oil demand by 0.5 mbpd to -1.0 mbpd (-1.2% y/y). This compares to the expected growth of 0.3 mbpd it predicted last November. The IEAís forecast is now even more downbeat than that of the previously more pessimistic Centre for Global Energy Studies (CGES), which sees demand contacting by 0.7 mbpd (-0.8%) in 2009. The CGES sees demand weakness in most parts of the world ñ including India and Africa ñ as a result of the dire state of the global economy. Absent relatively robust growth in the Middle East ñ no longer a foregone conclusion - global demand for oil could “collapse”.

On the supply side, the picture remains mixed. The dramatic climb in US to the market, with more in crude inventories (which have increased 20% since July 2008 against the the pipeline… typical seasonal drawdown) suggests that the pace of the fall in demand may have taken crude producers by surprise and that there is scope for further price weakness as the process of de-stocking kicks-in. On the other hand, evidence so far shows the OPEC cartel pressing on with its determined attempt to cut output by 4.2 mbpd from September 2008 levels. Production of the OPEC-11 (i.e. excluding Iraq) fell by 1.9 mbpd to 27.1 mbpd between September and December 2008, with more than half of the fall coming from Saudi Arabia. Provisional reports also show further reductions this year of as much as an additional million barrels. Aside from reducing current supplies, signs of effective policy coordination by OPEC members could help in managing market psychology, thereby making it easier for the organization to support oil prices. Outside of OPEC, most analysts expect crude supply to register very little, or no growth at all in 2009, as falling prices reduce the economic viability of some existing production and as credit restrictions provide barriers to bringing new projects on stream.

Accordingly, despite the potential for a through 2009, even without weaker-than-expected global economy to full OPEC cuts… weaken oil demand further in 2009, there is also the scope for prices to rise later in the year if the market tightens too far. Indeed, some observers are already emphasizing the deleterious impact that postponed investment plans might have in generating capacity bottlenecks over the long-term, thereby sowing the seeds of future oil price volatility. In the short-term, however, it seems possible that OPEC falls short of implementing its output cuts in full, perhaps out of fear that the global economy is more fragile than first anticipated and that higher crude prices could worsen the demand outlook. If demand falls by a consensus-like 0.7 mbpd in 2009, and non-OPEC supply were unchanged, the oil market would gradually tighten throughout the year. The price of KEC would rise from $39 in 1Q09 to above $55 in the fourth quarter and average $52 in FY2009/10 as a whole.

NBK noted that if demand were to fall by as much as the IEA suggests (1.0 mbpd), however, crude prices would be unlikely to stage much of a rally through 2009. But OPEC’s pre-announced production cuts – even if not fully implemented - should be enough to prevent prices falling much below their current levels. Under this scenario, the price of KEC hovers just below $40 throughout 2009. To the extent that relatively low oil prices help to stimulate global demand, it could set the scene for a bounce back in crude prices in 2010. If, on the other hand, OPEC decides to implement its already announced quota cuts in full, while demand falls by the more modest 0.7 mbpd, the crude market is likely to tighten markedly through 2009. The price of KEC would be back above $80 by the end of 2009 and average $70 in FY2009/10. Such a move risks leaving the world economy considerably weaker, however, and undermining global demand for oil in 2010.

The budget projections for this year and next reflect these mostly upside risks to oil prices. For the current year (FY2008/09), revenues are likely to be somewhat higher than we had previously expected, partly as a result of the stronger US dollar, which has raised the value of Kuwait’s oil production in dinar terms. With the price of KEC averaging $78-79 pb for the year as a whole, we expect the budget to record a surplus of KD1.8 to 3.7 billion before payments to the Reserve Fund for Future Generations (RFFG) and including exceptional transfers of KD 5.5 billion to the Public Institution for Social Security.

Any projections for the FY2009/10 budget are inevitably uncertain, reflecting not just uncertainties surrounding the price of crude oil - which we assume to average between $39-70 for the year as a whole – but possible revisions to the government’s draft spending plans. Based upon recently announced expenditure plans that have yet to be approved by the National Assembly, but assuming that, as usual, spending eventually comes in 5-10% below budget, we see Kuwait recording a budget balance between KD-1.7 (deficit) to KD+7.1 (surplus) billion next year before payments of 10% of oil revenues to the RFFG. Even the worst case scenario looks considerably better than that envisaged in the government’s budget, which projects a deficit of KD4.2 billion based upon an assumed oil price of $35 pb.

By National Bank of Kuwait