By Stuart Matthews
The addition of a new member and the threat of more production cuts make for an eventful OPEC meeting
Meeting in Abuja, Nigeria on December 14, the 11 OPEC member countries decided to cut production by a further 500,000 barrels per day (bpd), effective from February 1. The organisation also decided to admit Angola as the twelfth member from the beginning of January, although it will not be affected by the cuts. Ecuador and Sudan are also planning to join. This was the second production cut announced in the last few months, as OPEC had earlier said it was reducing output by 1.2 million bpd, effective from the beginning of November. Explaining the decision, OPEC noted that on its current forecasts global demand for oil will grow by 1.3 million bpd in 2007, a rise that will be offset by a projected 1.8 million bpd increase in non-OPEC supply – the largest jump in more than a decade. It argued that the November production cuts “had succeeded in stabilising the market and bringing it into balance, although prices remain volatile, reflecting the continuing supply overhang in the market.”
The official communiqué then added, rather confusingly, that the further 500 000 bpd cut from February was seen as necessary “to balance supply and demand.” Saudi Arabian oil minister Ali Naimi explained by saying that while the first cut had improved the market, the second decision helped what he described as the process of re-balancing.
OPEC president Edmund Daukoru of Nigeria said “the market is out of balance, stocks are at more than a five-year high.”
In round numbers, the November cuts represented around 4% of OPEC supply, taking total output down to 26.3 million bpd, while the promised February reduction represents a further 2%, down to 26.12 million bpd. The cuts are calculated on production levels, rather than on the older quota system. A number of members have been producing below historical levels for technical reasons (Iran and Venezuela). Nigerian output has been under par because of civil strife in the Delta region of the country.
As might be expected, OPEC’s move was subject to a wide variety of interpretations. Given that oil prices, having reached a record peak of US $78 per barrel in the late summer, had fallen by 17% to around US $62 in the subsequent 10-week period, some price softening had indisputably taken place in the market. But ‘softening’ is a comparative term, and many observers noted that US $62, while lower than the summer peak, was still more than double where prices stood three years earlier. A variety of analysts also questioned whether there was a real overhang of oil in the market at all.
“It is important to note that not very much happened on the oil market in response to OPEC’s Abuja decision,” said John Hall, a UK-based energy analyst at John Hall Associates. Prices in fact rose less than one US dollar on the announcement, at just over US $62, while the OPEC basket rose modestly from US $57 to US $57.43.
“I calculate that cuts of only around 500 000 bpd, out of the promised 1.2 million bpd, have actually been implemented since the November announcement, and this promise of a further 500 000 bpd cut, delayed until February, may or may not happen.”
In his view, OPEC would watch prices over the winter peak demand period and closer to the time decide whether to stick to the additional February cuts or not. As he put it “OPEC has made a statement without actually committing its members to any action. The threat of a cutback to coincide with the usual highest demand quarter in the year will have the desired impact. To compensate for this threat, consuming nations will no doubt increase their demand to build up stocks in advance, and particularly in January, the peak demand month in the year.”
Hall therefore argues that while effective in the short term, OPEC’s decision could rebound further ahead, as the US economy slows, and supply and demand for non-OPEC oil and alternative energy sources increases. At the moment, and acknowledging the wide range of uncertainty, Hall predicts that prices are likely to remain in the ‘high sixties’ during the first quarter of 2007. He notes that for the moment the market has remained relatively quiet, without any major bad weather or hurricanes, and since the Israeli pull-back from Lebanon, without major political factors influencing prices.
A similar interpretation came from John Kilduff, at energy consultancy Fimat USA, who said, “OPEC seems content to let natural winter demand eat away at stocks which, in their view, are ‘out of balance’. The next tranche of production constraints will begin after the bulk of winter has passed and just before the spring replenishment.”
Roger Diwan, an analyst at PFC Energy in Washington said, “this is an option on a second cut. They want to signal an aggressive oil-market-management strategy, but the decision also allows them to retract if the market over tightens.” Ehsan Ul-Haq, chief analyst at Vienna’s PVM Oil Associates, said that by the start of the New Year oil inventories would have been reduced by close to the amount OPEC wanted, even without the further decision to reduce output in February. “I think OPEC is thinking of second quarter demand” next year, he said, once the traditionally high-use Northern Hemisphere winter has ended. He said he expected world demand then to fall by 2 million bpd.
In theory, the decision reached at Abuja was not written in stone, permitting the organisation to reverse it, should inventories fall faster than expected, leading to a spike in demand that sends prices sharply upward. Ul-Haq also said OPEC “might reconsider its decision, if at the end of December prices have risen. Ultimately ... prices are likely to be influenced more by the weather than by the OPEC decision,” he said.
The Paris-based International Energy Agency (IEA), representing energy consumers, was critical of OPEC’s move, saying that “further cuts are unwelcome in the light of existing high prices, elevated supply risks, and the onset of the peak winter heating season. The moves that OPEC has already made have quite significantly begun to tighten the market.”
The IEA disputes OPEC’s claim that stocks have built up to excessive levels, saying that global inventories have fallen by around 41 million barrels since October. IEA analyst David Fyfe said OPEC had trimmed output significantly by November, falling by around 780 000 bpd on September levels to 28.9 million bpd. “What OPEC has done so far in terms of trimming output versus September looks like it would tighten the market significantly,” he said. “Our concern is the we still have to navigate through a very uncertain winter with Iraq, Nigeria and the weather, with the growing concerns about supply in Russia and the FSU.”
However, if the 41 million barrel inventory reduction figure is correct, it is still less than the 100 million barrels, which OPEC has set as its target for inventory reduction. Expressing the same thing another way, current calculations show that the world’s oil inventories are equivalent to around 54 days worth of consumption, down from 55. To improve security of supply, consumer countries argue that it would be prudent to push that up to 60 days or over. OPEC, representing the producers, is arguing that a little further trimming is necessary in the other direction because of oversupply, cutting back by a further half-day or day. The world is currently consuming around 85 million bpd. Before the Abuja decision Vera de Ladoucette from US think tank Cambridge Energy Research Associates (CERA) said, referring to inventory reduction, that “half the job is done, so why not wait for another month to see how it goes?”
In the US, the Energy Information Administration (EIA) in December forecast that West Texas Intermediate (WTI) spot prices would rise from an average of US $60.32 a barrel in the fourth quarter of 2006, to US $64.33 in the first quarter of 2007 and further to US $66.33 in the second quarter of the year. The reason given for the forecast increase was a combination of OPEC cutbacks, increased northern hemisphere winter demand, and an expected drawdown of surplus inventories. The EIA’s December ‘Short Term Energy Outlook’ report, issued before OPEC’s decision on a second cut, said that OECD oil stocks would fall ‘sharply’ in the fourth quarter of 2006 as a result of the first cut from November onwards. It noted that inventories had been built up above normal in any case during the summer, on fears of supply disruptions due to Gulf of Mexico hurricanes, which never happened.
Within OPEC, of course, different member countries favour somewhat different strategies. The Abuja decision can be seen as a way to buy time as the harder line producers such as Iran and Venezuela push for higher prices, and the more moderate group led by Saudi Arabia seeks to iron out the peaks and troughs of the market. Iran, Venezuela, and a number of other producers suffer from the ‘ratchet effect’: when prices rise they immediately boost their budgets and spending, but when prices fall they are extremely reluctant to cut back, and would rather that OPEC impose production restraints in an attempt to prevent a price slump.
The Saudis, on the other hand, have the resources to be flexible and to adjust downwards as well as upwards. Interestingly, in a brief interview with the Wall Street Journal after the Abuja OPEC meeting Ali Naimi, the Saudi oil minister, stressed that OPEC would not deny the international oil market extra supplies if they were needed. He referred to the situation in early 2004, when OPEC, led by his country, reversed production cuts and began pumping much more oil as it became evident that global demand was booming. “What did we do before?” he asked the Wall Street Journal reporter rhetorically. “People don’t know the trouble we go to, to balance the market. Without us, the oil market would be chaotic.”