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OPEC's compliance should tighten markets

Sam Fletcher
Senior Writer

If the Organization of Petroleum Exporting Countries can achieve just 60% compliance with the 1.5 million b/d production reduction voted at its Oct. 24 meeting, there would be at least a "small" reduction in consumer oil inventories stocks through 2009, said analysts at KBC Market Services, a division of KBC Process Technology Ltd. in Surrey, UK. "Greater OPEC compliance or further setbacks to non-OPEC supplies could leave the market quite tight," they said.

As it stands, the proposed 1.5 million b/d cut "would, allowing for Iraq and Indonesia, take total OPEC crude output to about 30.5 million b/d," said Paul Horsnell, Barclays Capital Inc., London. He said, "That is 2 million b/d less than current output. It is also 700,000 b/d less than the latest OPEC Secretariat forecast of the call on OPEC crude across 2009; 400,000 b/d less than the International Energy Agency's forecast of the call; and 1.5 million b/d less than the US Department of Energy forecast." Horsnell said, "There is then some slack built into the decision, in that it would still represent a significant market tightening after any further large downgrades in demand expectations."

Rapid fall of oil prices in October produced "a meeting of minds" among OPEC members not evident at its Sept. 9 session, said KBC analysts. Crude futures sales in October represented the biggest monthly loss for front-month crude prices since that commodity began trading 1983 on the New York Mercantile Exchange. The front-month contract was down 32.6% or $32.83/bbl during October and finished the month 54% below a record-high of $147.27/bbl in July. Panic in both the equity and commodity markets over deteriorating demand for energy prompted OPEC's Oct. 24 decision to cut production effective Nov. 1, after taking no action at its Sept. 9 session.

OPEC's October meeting "was a quantum leap in cohesion" from its September session, especially since the October meet was called at short notice, emphasizing OPEC's urgency to put a floor under oil prices. Moreover, it was fully supported by all OPEC members, including Saudi Arabia. Moreover, OPEC's cutback announcement was quickly followed by actual reductions by the UAE, Kuwait, Iran, Qatar, Nigeria, and "crucially" by Saudi Arabia, making it "clear on this occasion that the producer group means business. OPEC has a proven track record as a highly effective price defensive cartel," said KBC.

Previously, oil price movements were closely correlated to other financial indicators, especially to exchange rates and strength of the US dollar vs. the euro. Since August, said KBC analysts, oil prices have closely followed equity markets, with both falling sharply as leading Organization for Economic Cooperation and Development economies entered recession, while growth slowed markedly in developing countries. However, they said, "The fundamentals of the oil market itself have begun to play a much more important role, with oil demand destruction a major driver of the recent collapse in oil prices."

Price volatility
According to KBC Market Services, OPEC now has the opportunity to reduce harmful oil price volatility resulting from the financial sector's domination of futures markets. Oil market volatility has increased exponentially since 2004 when OPEC lost control of the ceiling oil prices because of its lack of spare production capacity. "This will increase next year to above 4 million b/d as cutbacks coincide with additions to capacity," KBC analysts reported.

Earlier suspension of OPEC's price band mechanism indicating a target range for crude prices "invited speculators to explore the boundaries to oil prices," analysts said. It also prevented OPEC from responding quickly to price changes. KBC analysts said, "OPEC should now reintroduce a price band of $70-90/bbl, around the level of $80/bbl, which is close to the current maximum sustainable level for producers. It also provides sufficient incentive for consumers to exploit marginal sources of supply. There would be benefits to both producers and consumers in terms of security of demand and supply and also a sharp reduction in volatility."

With front-month crude trading below $63/bbl in late October, KBC reported speculators have taken a net short position of 8,000 contracts in NYMEX. "This is an unusual foray to the short side, leaving some potential for speculative short covering to provide support to any reversal in oil price direction, KBC said.

Meanwhile, KBC analysts said, "OPEC has done enough to provide a floor to oil prices at above $60/bbl, while concerns over the global economy may restrain oil prices from moving substantially above $70/bbl into the first quarter of 2009."

(Online Nov. 11, 2008; author's e-mail: samf@ogjonline.com)


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