It is apparent that the US is not the only believer in the principle of preemptive self-defense.
The Organization of Petroleum Exporting Countries—in particular Saudi Arabia—also adheres to that doctrine. That is evident in OPEC's surprising decision (surprising perhaps only to market observers that were victims of their own presumptions) to cut production quotas by 900,000 b/d at its latest ministerial meeting.
There can be no doubt now that OPEC is prepared to defend its targeted price band of $22-28/bbl despite the resulting loss of market share. In fact, it is clear that the threshold for a preemptive strike against sliding oil prices is the midpoint of that band: $25/bbl for the OPEC basket of marker crudes.
OPEC's reference basket (ORB) has remained near $28/bbl for most of the year. But that was the result of low global oil stocks, supply outages in Venezuela and Nigeria, and overinflated expectations of Iraqi exports recovery. With the Venezuelan and Nigerian supplies having recovered and Iraq steadily ramping up exports, OPEC ministers were alarmed by a recent surge in stockbuilding ahead of the seasonally strong fourth quarter.
(Could the Saudis' endorsement of the cuts also be an act of defiance in response to the silly efforts by some in the US Congress to blame the summer's rise in gasoline prices on the Saudis?)
It was no coincidence that the rollback of this year's OPEC production quota increase followed a drop in the ORB of $4/bbl, threatening to dip below the $25/bbl threshold. Given the stockbuilding surge and the prospect of rising Iraqi and non-OPEC supply in 2004, OPEC's defense of $25/bbl heading into the winter demanded quota cuts.
ORB and volatility
The OPEC Secretariat offered a more technical rationale for defending the price band: a cure for market volatility.
In its September oil market report, the secretariat pointed to the harmful effects of price volatility—on the downside as well as the upside. It cited disruptive fluctuations of income to the exporting governments and planning uncertainty for consumers and businesses. Such volatility had increased markedly just prior to the institution of the price band. The secretariat claims that the price band is "optimal for minimizing volatility, as volatility is lower within this range than in the ranges above or below it."
The OPEC Secretariat contends that excess volatility creates a disincentive to hold stocks and traditionally signals underproduction even when the market is amply supplied. At the same time, it claims that there needs to be a reevaluation of the accepted minimum operating level for commercial stocks. Noting that some industry quarters have moved to maintaining lower stock levels to cut costs and streamline operations, the secretariat stated, "Uuntil all market participants accept a new norm for 'minimum operating level,' the old measure will continue to affect market psychology and increase price volatility."
In other words, if industry is bent on maintaining a misnamed "just-in-time" inventory-management strategy, it behooves oil markets to accept "just-in-time" supply responses from OPEC to sustain a volatility-flattening $25/bbl ORB.
Trouble is, a "just-in-time" supply response tends to be long-haul crude from the Persian Gulf. Are the Saudis counting on a repeat of its first-half performance of letting its quota exceedance flow into Caribbean and floating storage to serve as the "just-in-time" swing supply for the next outage?
Another cut ahead?
There is every reason to believe that the latest quota cut, to take effect Nov. 1, will not be the last on the near-term horizon.
The Iraqis predict a gradual ramp-up in exports to 1.8 million b/d by the end of March. And the 900,000 b/d quota cut happens to match the year-to-year production increase from the former Soviet Union—a trend likely to continue in 2004.
"All this [quota] agreement does is signal that the Saudis are willing to make room for Iraq and Russia in the hopes that their sacrifice will be short-lived and at some point down the road (say late 2004 or even 2005), the tables will turn and Saudi output can start rising again," said Sarah Emerson, managing director of Energy Security Analysis Inc., Wakefield, Mass. "If the Saudis really want to defend the $25 OPEC basket, the Saudi sacrifice will be deeper, and another production cut of, say, 1 million b/d is likely between now and the end of March."
So next time, don't be surprised.
(Online Sept. 27, 2003; author's e-mail: [email protected])
