OPEC the only barrier to an oil price shock this winter?

Well, I guess there's no pleasing some people as far as OPEC is concerned. Here, after the group sustained a remarkable solidarity for months on adhering to pledged production cuts-and in the process restoring oil prices from their cellar to a rather lofty level-the market now seems to be asking the group to throttle back a tad (well, actually, analysts are doing the asking, but we'll let them stand for now as a surrogate).

There is a growing belief that the market is headed for a serious price shock in the fourth quarter if OPEC does not relent on its production restraint. There are even warnings that it is in OPEC's long-term interest to boost output sooner rather than later and that a sustained oil price rise will only cripple anew a nascent global economic recovery.

What would you say if you were in OPEC's shoes? "Gee, where were all you crystal ball gazers when we decided to boost quotas almost 2 years ago to accommodate the continued boom in Asian oil demand that everyone was promising?"

Maybe that is what the group is saying, in effect, when various OPEC country officials insist that the current level of pledged production cuts remain in place until March 2000. After taking such a vicious drubbing from rock-bottom oil prices in 1998 and early 1999, is it so unreasonable to expect OPEC to enjoy the higher prices for another 6 months or so?

It is, warns the Centre for Global Energy Studies. The London think tank, noting that oil prices are up about 22% just in the past 2 months, contends that such price levels are telegraphing the extremely tight oil market to come, rather the current state of physical fundamentals.

"OPEC's 3rd round compliance slipped slightly in July, while Iraq itself managed to post a 500,000 b/d output surge," CGES said. "tocks in the OECD are now thought to have risen in second quarter 1999 by 230,000 b/d, much less than last year's 1.4 million b/d, but an increase all the same at a time when inventories remain excessive.

"The market, therefore, must be expecting an alarming decline in stock cover from third quarter 1999 onwards, for it to have become backwardated now."

So by sticking to its March 2000 target, then, the oil market is headed for a price explosion this winter, says CGES, and only OPEC can prevent that by reversing its policy of output cuts.

Just how big could the third quarter stockdraw get? Noting the recovery in demand of a 3.2% year-to-year gain in the first quarter and essentially flat demand year-to-year in the second quarter, it was OPEC's further cut in that latter quarter that prevented the price collapse from continuing. But it's taking awhile for these cuts to show up in reduced stock cover, which has essentially remained constant at 86 days' worth for all 3 quarters this year. But the approach of the fourth quarter and the cut in OPEC supplies (and a sizable drop in non-OPEC supplies) set the stage for a huge drawdown of stocks of 2.1 million b/d on average for the second half.

What this augurs is a big price spike in the winter, especially if, as is generally forecast, there is a return to normal winter weather after two consecutive unseasonably warm winters. CGES puts the zero stock-change call on OPEC oil in the second half at 2 million b/d more than the group's current output, which would put tremendous upward pressure on oil prices.

A major concern, says the analyst, is that the increase of 80% in oil prices since January is bound to eventually have an effect on oil demand. Indeed, there are signs of that already, with a predicted slowdown of gasoline demand growth in the U.S. to less than 1% year-to-year in the second half. The inflationary impact of higher oil prices has already contributed to the U.S. Federal Reserve's decision to raise its prime rate this week. And then there is the very real concern over whether the Asian economic recovery will die aborning because of an oil price spike.

So what's an oil exporting group to do?

"OPEC has over-achieved its objective of raising oil prices from the depths; surely it should now consider easing the pressure on prices before it damages its own, longer-term prospects...Higher OPEC production need not lead to lower revenues anyway, if properly managed. A 2 million b/d boost should therefore be announced in Vienna (at the September ministerial meeting), its implementation to be determined by market conditions and not pre-set dates (see Table 1)."

In the CGES price scenarios (Table 2), such a move would yield an annualized price for dated Brent next year of $18.80/bbl after dipping to $17/bbl in the fourth quarter-not bad, but well off the current level of more than $20/bbl. Making the production increase move next March, however, yields an average price of $20.70/bbl in 2000, with Brent reaching as high as $23/bbl in the first quarter. But if a mild winter ensues and higher prices spurs more non-OPEC oil on stream and OPEC still raises production by 2 million b/d in April, a $17/bbl annualized price is the result.

What makes the most sense is for OPEC not to jump the gun on projected inventory and demand levels again yet and wait until winter is over. In the meantime, it can build revenues again and sop up that red ink that hemorrhaged all over government budgets in the past 2 years. If markets get as tight as the crystal ball gazers are saying they will, then don't be surprised if the Saudis start to wink at production quotas again. The latest solidarity was accomplished with a new, more OPEC-friendly regime in Caracas and a new rapprochement with Tehran (not to mention increasing desperation in Mexico City). Perhaps these new courtesies will be reciprocated in the Saudis' usual oblique way. And when the March meeting rolls around and everyone has a better sense of where the market has been and is going, it may be Riyadh's turn again to call in a few markers.

Table 1

CGES Outlook
Output increase announced in March, implemented in April

OECD consumption^47.349.049.346.248.249.847.748.4
Non-OECD consumption^27.528.328.027.828.128.927.728.2
World oil demand74.877.377.374.176.278.675.376.6
Non-OPEC supply44.445.445.145.045.346.244.645.4
Call on OPEC crude*27.629.129.326.228.129.527.928.3
Desired stockchange**1.1-1.7-2.91.5-0.8-2.50.4-1.2
Need for OPEC crude**28.727.426.527.827.227.028.327.1
OPEC crude output26.226.326.328.
Supply less demand-1.4-2.8-
Dated Brent ($/bbl)20.0522.523.
OECD ind. stockcover (days)#565350495150
World stockcover (days)#8581777676748576

*=Assuming zero stock change. **=To keep prices constant. #=Stock at beginning of quarter. ^=The Czech Republic, Korea, Mexico and Poland are now included in the OECD in line with the IEA's figures.
Source: Centre for Global Energy Studies

Table 2

CGES Price Scenarios
Period average Brent price

Swaps Market20.
Increase ann. Mar.22.523.
OPEC output (mbpd)26.226.328.
Increase ann. Sep.21.720.619.617.817.018.8
OPEC output (mbpd)26.326.328.
Mild winter21.419.618.115.814.617.0
World demand (mbpd)

Source: Centre for Global Energy Studies

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