The difficult balance of supply, demand and investment

Investment in oil and gas production is a double-edged sword. On the one hand, falling investment, in response to falling prices, will likely contribute to an unwelcome sharp rise in prices as soon as demand recovers. The IEA, among others, has repeatedly warned of this in the past six months.

But big production projects are expensive and requires years of planning, so they are not easy to turn around (which is why they tend to be delayed rather than cancelled). So even though demand is falling, production capacity is, for the time being, continuing to increase – which is why we are seeing inventories rise.

The tensions between the short and long-term effects of investment are underlined by the IMF’s April World Economic Outlook:

When Will Commodity Demand Recover?
Considering the case for a return to high
commodity prices from a fundamental perspective,
the key question is whether and, if so, how
fast the interplay of demand and supply factors
will again lead to supply-constrained market
conditions. With demand now below production
and inventories rising, this will significantly
depend on demand prospects. Although the
supply side also matters, it is less likely to be a
constraint in the early stages of the next global
expansion. The reason is that despite the
postponement of some capital expenditures,
especially on new projects, investment is likely
to decrease only gradually.
Spending on large
investment projects that have been in train for
some time will continue, given the high costs
of project delays or, even more so, shutdowns.
As a result, although producers may seek to
curtail actual output—which may limit price
declines—capacity will continue to increase
into the downturn. In a global recovery, spare
capacity and inventories can then absorb rising
demand in the early stages, and price increases
will primarily reflect the cyclical rebound in
costs and margins rather than rents from capacity
constraints.

The IMF says a quick rebound in commodity prices to 2007-08 prices was a ‘rapid recovery’ to the record price levels seen in the first half of 2008 was ‘unlikely’. Further on in the report it describes three scenarios (illustrated in the charts above) based on demand data from 1970 to 2008:

• In the case of copper and crude oil, average
growth during 2006–07 would be reached again
in 2011 in the baseline scenario and by 2010
in the high-growth scenario
. In the low-growth
scenario, demand growth would again remain
below recent average rates through 2013.
• Comparing the implied path for oil demand
with capacity estimates suggests that in the
high-growth scenario, spare capacity would
again fall to the average level of 3 million barrels
a day over 1989–2008 by 2010 and reach
recent lows by 2011. In the baseline scenario,
spare capacity would decrease more gradually.

Related stories:
IMF says rapid rebound in prices ‘remote’
(FT)

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