Wednesday, September 10, 2008

OPEC Production Cut Surprises the Market

OPEC Production Cut Surprises the Market

In a slap to Saudi Arabia, the cartel's hawks hope a return to 2007 output targets will stabilize oil's price at around $100 a barrel

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OPEC's decision to cut oil production, announced early in the morning on Sept. 10, took most analysts by surprise. The move, which could take about 520,000 barrels a day of oil off the market, is a sop to price hawks, such as Iran and Venezuela, as well as Chakib Khelil, the energy minister of Algeria and current president of OPEC. It was also a mild loss for Saudi Arabia, which has worked to lower prices in recent months. Following the news, oil prices rose about $1 per barrel in trading in Asia, to $103.75, according to Reuters.

What clearly prompted the action was the nearly 30% plunge in oil prices from their high of $148 per barrel on July 11. OPEC was worried that prices would continue to fall. Weakness early this week—despite the presence of a major hurricane threatening U.S. oil installations around the Gulf of Mexico—only added to the unease.

But while many OPEC members don't mind seeing oil fall to the $100 per barrel level, they don't want it to go much below that. Even OPEC doves now regard $80, once considered a rich price, as "unacceptably low," wrote David Kirsch, an analyst at Washington consultants PFC Energy in a note following the announcement.

Complex Compromise

In the runup to the OPEC meeting, dissension broke out among members of the cartel over the health of the oil market. As recently as Sept. 9, Saudi Arabia's oil minister, Ali Naimi, said he viewed the market as "well-balanced." But countries such as Libya and Iran took a more hawkish view. A compromise appears to have been worked out at the meeting that doesn't specify precise cuts but rather follows a complex formula to return OPEC's output targets to their September 2007 levels.

In truth, the Saudis, who are the major overproducers, are unlikely to make big production cuts unless their customers reduce demand. Saudi sources say they'll continue to furnish all the crude their customers ask for but hint that demand from customers may be easing off slightly from the summer months.

Still, traders undoubtedly will note that the tone has changed. OPEC, which has been somewhat laissez-faire of late, is now clearly returning to tighter management of the market. If inventories—currently around average levels—start to build, OPEC is signaling it will take steps to trim output.

Weakening Demand

The cartel may soon find itself under pressure to take further action, because oil demand in the West and Japan is dropping sharply. Edward Morse, energy economist at Lehman Brothers (LEH), estimates that demand in the U.S. will decline by 1 million barrels per day over the course of 2008.

In its communiqué at the end of the Sept. 9 meeting, OPEC struck a bearish tone, noting that "prices have dropped significantly in recent weeks, driven by a weakening world economy, particularly in major Organisation for Economic Co-operation & Development (OECD) countries." The organization also attributed the price decline to the strengthening of the dollar and an easing of geopolitical tensions. "All the foregoing indicates a shift in market sentiment causing downside risks to the global oil market outlook," OPEC said.

The Saudis, the most influential players in OPEC, have not seemed particularly concerned about the price decline. They're more worried that high prices are alienating key Asian customers and will stimulate the quest for alternative energy sources. The Saudis also have been reluctant to take steps that could draw U.S. political fire in the midst of a Presidential campaign. With prices falling fast, however, they decided that agreeing to a symbolic cut, at least, was worth doing to preserve OPEC unity, which has been somewhat frayed lately.

The Saudis' unilateral decision to increase production last summer annoyed other OPEC members. Algeria's Khelil, for instance, openly told reporters that the huge runup in prices earlier this year was due to such factors as the drop in the dollar-euro exchange rate and insisted that he saw no need for an increase in output.

Backroom Deal with Washington?

While the Saudis undoubtedly are the most influential players in OPEC—as the largest producers, they have the greatest capacity to raise and lower output—they try to avoid dissension in the producers' club. Since 2000, Naimi has promoted a professional, nonpolitical approach to decision-making. But the summer production hike, which was ordered by King Abdullah, was seen in some OPEC circles as a political move bowing to Washington and other consuming nations.

While it may be stretching the point, the Saudi willingness to cave in to hardliners may also reflect fallout from the recent Russian intervention in neighboring Georgia. Saudi officials, who count on Washington for protection, were clearly worried by the implications of this move. A large Russian delegation, led by Deputy Prime Minister Igor Sechin, was present at the meeting. Invited by Khelil to speak, Sechin noted that Russia shared the top slot on the oil production charts with the Saudis and spoke of further coordination with OPEC (BusinessWeek.com, 9/9/08).

Although it's still too early to call, the market appears to be moving toward a balance around $100 per barrel. That's an amount most consuming nations seemingly can live with, while still giving major oil producers adequate income to fund their growing budgets. It's also close to the $90 to $95 per barrel cost of developing Canadian tar sands—the most expensive new source of oil. The problem facing OPEC, though, was that with prices falling rapidly, there was no guarantee oil would settle at $100 per barrel. With its Vienna surprise, the cartel is trying to call a halt.

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