Several factors contributed to the recent rally in oil prices including tighter physical oil supply and demand fundamnetals, loose monetary policy and a weaker US dollar.

The global economy is bouncingback after the sharpest recession in the
post World War II period. According to a Bank of America-Merrill Lynch
(BofAML) analysis GDP growth is recovering strongly to 4.3% and 4.5% in
2010 and 2011 from an abysmally low figure of -0.8% in 2008.

Economic recovery is sure to spur global oil demand growth at 2 million
barrels per day (b/d) from 1.4 b/d previously which in effect means
demand in 2010 is expected to overtake the demand in 2008, BofAML
analysis said.Activity has turned around surprisingly quickly in
emerging markets but fiscal spending programs and very loose monetary
policy have also floored the rate of contraction in developed
economies. Key leading indicators for the global manufacturing
cycle—such as exports out of Korea and Taiwan, business confidence in
Europe, the United States and China and industrial orders in
Germany—have recently surprised to the upside. While the recovery might
be choppy and jobless in the United States, business cycle effects,
re-stocking and fiscal spending makeus significantly more bullish on
the recovery relative to consensus, BofAML analysis said.

Almost every single country around the world has been showing signs of
improvement. Final demand is recovering, the global inventory cycle is
turning up and the implosion in global trade that pulled down the
global economy is reversing.

On the supply side, Non-OPEC capacity is set to surge by 244000 b/d in
2010 from the present level of 323000 b/d. New capacity addition comes
from fields in Brazil, Kazakhstand, Russia, Norway, West Africa and the
Gulf of Mexico which have gone onstream in the past few months. The
deceleration in global oil demand growth is easing. From -3.3% in the
first quarter this year, the demand growth has gained at -1.5% during
the past two months. However, BofAML report said that real oil
consumption continues to display cyclical weakness. Demand for gasoil
remain in doldrums. But positive growth in expected in fourth quarter
of 2009.

Non-OPEC oil supply growth is increasingly tilting towards deepwater
production and a recent arrival of ships and floating platforms has
facilitated this trend. Moreover, rising oil prices have helped to lift
crude oil output in Russia where production has hit a record high in
the past three months. In Brazil, Petrobras is expanding crude oil
production by 10% over last year, also setting new record highs.

Going ahead, Emerging Markets will drive demand as its growth is
oil-intensive. BofAML expects EM demand to grow 6.1% in 2010 to 1.5 mn
b/d from 2% this year.Countries like Brazil, Turkey, Indonesia and to
some extent Middle East could lead the oil demand recovery.

Meanwhile, oil demand will expand by 510 thousand b/d in the OECD
countries,following on from a 2 million b/d contraction this year.
Though driven largely by base effects, that expansion signals the first
increase in OECD demand since 2005. Still, continued fuel substitution
towards natural gas and coal as well as efficiency improvements make
the OECD region an unlikely driver of oil demand growth going forward.

Global biofuels output has surprised to the upside recently as higher
oil prices have raised profitability. Moreover, condensate and gas
liquids1 output from OPEC countries, which does not fall under
production quotas, is set to increase by 600 thousand b/d next year.
Global production of this category of light hydrocarbons currently
stands at 9.4 million boe/d, equivalent to over 11% of world oil
production, and is increasing rapidly due to higher investment in the
production of natural gas. While some of these liquids will be turned
into liquid petroleum gas (LPG), sold to petrochemical companies,
others go to oil refineries as light feedstock, competing directly with
light crude oil.

Still, technological challenges are huge for conventional crude oil.
Steep decline rates in existing fields are dampening the rate of
aggregate non-OPEC oil supply growth. In the UK and Norway, production
is likely to fall by a steep 300 thousand b/d this year and 430
thousand b/d next, despite the start-up of new projects The Cantarell
field in Mexico now puts out just 580 thousand b/d, from 950 thousand
b/d a year ago and over 2 million b/d four years ago. Even in Russia,
the production increase is likely to be rather temporary as a lack of
clarity over the longer-term fiscal regime is curbing drilling and
investment.

On the negative side, non-OPEC output growht is stifled by increasing
control of governments over oil sector imposing more taxes and blocking
acess to foreign investment and expertise. Although non-OPEC output is
set to increase, it will fall short of global demand growth.However
there is plenty of excess capacity in OPEC countries to raise output.
With roughly 6 million b/d of spare capacity and a ramp-up of new
fields in Saudi Arabia, Iraq and Angola, there is certainly plenty of
excess capacity to raise output next year. Still, an OPEC supply
increase coming so shortly after the recession could be seen as bullish
sign, as excess crude oil productive capacity will be just 6% of
demand.

Sharp depreciation of US Dollar has contributed significantly to rise
in global crude oil prices more than supply-demand
fundamentals.Moreover, extremely loose monetary policy around the world
is supporting physical oil demand in countries like China, where car
and housing sales are through the roof, and also driving tactical asset
allocation into oil, BofAML analysis said.

BofAML has revised its long term oil price assumptions to $85 for 2011
and $80 for 2012 as long-term price dynamics are determined by the
marginal cost of supply and focus is on Canadian oil sands that provide
a major stream of new-long term production capacity. Moreover, they are
located near the world’s largest consuming market and there are
numerous projects in the pipeline from which to assess costs and
available returns.

Despite the extreme volatility of spot crude oil prices over the past
couple of years, BofAML analysis said the the marginal cost of supply
remained in a relatively narrow band of US$70-90/bbl, depending on the
level of cost inflation. Anecdotal evidence together with the sharp
drop in steel prices points to a 20-25% reduction in capital intensity
from the peak in 2008. With input costs starting to show some
stabilisation, BofAML estimates integrated mining-upgrading greenfield
oil sands projects in Canada will require $80/bbl oil to generate
double-digit after tax internal rate of return.

Source: Commodity Online

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