Is Wall Street Too Bullish on Oil?

This weekend’s decision by the Organization of Petroleum Exporting Countries (OPEC) to leave OPEC quotas unchanged doesn’t mean oil production from the producer group won’t be rising next year. Iraq is expected to add about 200,000 b/d of incremental oil production over the course of 2011 as foreign firms make progress on contracts to enhance output from the country’s existing fields. Gains are also expected from Angola. So chances are, OPEC production will be on the rise next year regardless of announcements from the December 10 OPEC meeting.

Saudi Arabia has made clear that it is committed to “maintain” oil prices in the $70 to $80 a barrel range, as His Royal Highness Prince Turki told an audience recently at the Baker Institute. The Prince also expressed support for the U.S. monetary policy, including the controversial QE2, which might have been seen negatively by dollar holders like the kingdom. Saudi Arabia has ample spare capacity to add several million barrels a day of oil onto markets at will. So since the oil superpower is clear on its intentions to hold prices steady to ensure no surprises for the global economy, why are speculators betting against the kingdom?

Wall Street’s love affair with the “China story” is again being bandied about as an explanation of why oil prices will hit $100 in 2011. Beijing’s failure to raise interest rates over the weekend despite rising inflation was taken by oil traders as a bullish confirmation that $100 oil is on its way. Goldman Sachs says its projection of $105 oil is based on a global economic recovery driven by an improving U.S. economy. Investment bank Morgan Stanley is emphasizing that non-OPEC production is going to decline between now and 2012, meaning that “higher prices will be needed to ration demand.” Morgan Stanley is expecting world oil demand to rise by 1.5 million b/d in 2011 to 88.5 million b/d or by about 1.7 percent, based on projections of 6.5 percent growth in Chinese GDP and 9.8% growth in Indian GDP. But it expects non-OPEC production to fall by 380,000 b/d this year.

But Wall Street forecasts seem out of line with the reality of the global economy. The risk of further meltdowns in Europe and the possibility that China may eventually act to raise interest rates means that rosy forecasts for world economic growth might prove optimistic. Oil demand could easily fall in the OECD in 2011, based on a combination of continuing economic problems and policy-driven improvements in overall oil intensity. China’s oil demand was inflated in 2010 by government steps to meet energy-intensity targets pronounced at Copenhagen by imposing power rationing in the industrial sector, spurring the use of off-grid diesel generators. It remains unclear whether China’s policies in 2011 will support strong oil demand growth or not.

Wall Street’s forecast for lower oil supply seems equally questionable. Not only are gains expected this year from Iraq, but also from Colombia, Brazil, Ghana, Canada, Russia (which is filling its new ESPO pipeline), Kazakhstan and Azerbaijan, to name a few. The impact of the moratorium on drilling in the U.S. Gulf of Mexico is starting to be felt but it is counterbalanced somewhat by onshore shale oil production rises in the Bakken play, potentially leaving U.S. output close to flat for 2011.

Unlike Wall Street, whose forecasts seem to marry well together with the street’s relatively long futures market positions, Energy Intelligence Group (EIG) is forecasting a 465,000 b/d jump in non-OPEC production on top of additional gains from OPEC. If the global economic recovery hits a wall, oil markets could easily be oversupplied. If demand does prove to be robust, it is questionable whether speculators can hold prices up in the face of a Gulf Arab policy to add more oil to the market if prices remain above $90 a barrel.