Reality check

Oil prices could be set for a reality check. The four per cent drop in the cost of a barrel of Brent crude yesterday, was part of a broader end of year sell-off. But, it could also be the start of a bigger fall in the price of the black stuff. Increasingly bleak prospects for global growth are beginning to outweigh the current risks of another major disruption in the Middle East. That could throw the market into oversupply.

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The decision by the Organization of the Petroleum Exporting Countries to maintain its daily output at 30 million barrels will keep supply and demand in balance going into next year, according to the 12-member cartel and the International Energy Association. But that's only true if the relatively-rosy economic growth forecasts made by both groups prove accurate. Opec reckons that the world economy will grow by 3.6 per cent next year, with the euro zone expanding by 0.4 per cent.

While OPEC acknowledges a wide range of market forecasts in its latest monthly report, even that stated range fails to fully capture more pessimistic assessments. The low end of Opec's range is for world growth of three per cent. But economists at Standard Chartered are predicting a euro zone recession, with the economy contracting by 1.5 per cent, and global growth slowing to just 2.2 per cent.

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Investors have to weigh up the current risks of recession against a volatile geopolitical backdrop. Libya is forecast to return to full pre-war oil production by the second quarter of next year. And while any disruption in the Strait of Hormuz would send prices soaring, the risk of an actual conflict there looks muted, despite tougher sanctions against Iran.

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A relatively rosy world view suits Opec for now, allowing its members to pump almost flat-out to achieve near-record annual revenue. But a bigger-than-forecast slump in growth would force Opec members to cut back production at a time when the cartel can't even agree on individual output quotas for each country and members like Iraq continue to ramp up production, threatening to overrun the new ceiling. Any infighting amongst Opec as demand slows would only serve to accelerate falling prices.