By Greg Peel

You could say that mid-2005 to mid-2006 was one big oil shock. However, comparisons to the 1970s highlight that the famous oil shocks of that time were supply-side – OPEC simply withheld stocks. This century's price surge has been all about an underlying demand surge from China et al.

With demand soaring and supply struggling to keep up, it was no surprise that the oil price was then scared even higher by (a) the peak oil debate, (b) Katrina and (c) tensions with Iran. As panic has turned to more circumspect assessment, the oil price appears to have settled down around this high-fifty/low sixty level.

Much was made of the northern hemisphere's warm start to winter. While warm weather quickly turned to cold, the significance of the warmth was that supplies that had been running close to balanced were able to top up to a more comfortable level. And now it appears the north will exit winter with less chilly conditions.

Often overlooked in the oil price collapse of January was an adjustment to the Goldman Sachs commodity index. By reducing the ratio of oil within the basket, Goldmans effectively forced index trackers to sell. This is a somewhat self-fulfilling mechanism, as a lower price would again see an index reduction which would again force sales and on we go.

In the meantime, OPEC was not about to sit around and let its margins evaporate, so it announced production cuts in order to support the price. As to whether bickering OPEC members will actually make good on the new quotas is anyone's guess, but such cuts do have an important effect on spare capacity.

Just as warm weather allows refined product – such as heating oil – inventories to build up a bit, so too do OPEC option cuts affect an increase in spare capacity. While lower production puts a floor under prices, were there to be some supply shock or demand surge then OPEC can fire up the rigs once again. This reduces the prospect of a panic price rally.

This is effectively good news, although one piece of bad news is that OPEC has admitted Angola into its fold – the first new OPEC entrant since 1975. Angola may have been a political basket case for decades, but it does have a lot of oil, and does have a lot of foreign investment in oil. Now that it is part of OPEC it will supposedly have to bow to quotas, and may also make life difficult for foreigners. Expansion plans are now in jeopardy.

Over in Iran, not a lot has really changed. When oil was testing US$80/bbl, fears were that an Iranian withdrawal of sales, or worse still a blockade of the Persian Gulf, would send the price straight through US$100/bbl.

Iran has strung the UN along somewhat in regards to the ongoing nuclear issue. It has made some concessions, but at the end of the day it has refused to stop enriching uranium. We have not arrived at a solution. As we speak, George Bush stridently rules out an attack on Iran while building up a warship presence nearby. Certainly the
fears of last year cannot be said to have abated.

There are those who suggest the oil price will continue to trend down from here – based largely on supply building as more capacity comes on line and demand easing as global economic growth eases. In the shorter term, analysts are inclined to believe oil will hang just here for the moment.

National Bank has lowered its 2007 average price forecast by 6% to US$62/bbl to account for the January drop. Commonwealth Bank believes the price will stay around the fifties for the time being.

Any upside shocks should be tempered by the inventory and capacity expansions as noted, although there remains a clear and present danger of such shocks. On the downside, the greatest risk is a mass exodus of oil positions by investment funds, particularly due to the ongoing contango.

We appear to be in a range-bound state at the moment.

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