Now comes the hard part.
The August contract price for light, sweet crude on the New York Mercantile Exchange exceeded $20/bbl at times last week. At midweek in London, dated Brent Blend sold for $18.50/bbl, Dubai crude for more than $17/bbl. Just a few months ago, these prices languished in the $10-12/bbl range.
The quick rebound results from extraordinary cooperation among producers universally hurt by $10/bbl oil. Whether cooperation to limit production can survive $20/bbl oil, however, lies at the core of several questions now looming over a market not yet out of trouble.
Growing temptation
When it results from shared production restraint, a trend of rising price becomes difficult to sustain. The trend raises not only revenue per barrel of oil produced but also the per-barrel cost of opportunity forsworn from holding oil off the market.
The temptation to tap idle but economically operable capacity thus intensifies as the price climbs. Producers inevitably succumb. When they do, supply rises relative to demand, threatening if not reversing the price climb. This is why cartels seldom work.
So one question for the market is whether recent crude prices are high enough to tempt members of the Organization of Petroleum Exporting Countries to violate quotas, as they usually do. Memories of the hardship that came with $10/bbl oil will help keep producers in line. But memories fade with time.
Another question is how rising prices will affect demand. A crude price of $20/bbl is hardly high enough to crush the market. Yet it is often the speed of a price change, rather than the price levels involved, that produces the greatest immediate effect on consumption.
Demand is especially important in a period of inventory adjustment. Inventories, having grown far too large last year, need to come down. But to what level? There is no absolute range of volume that can be considered optimum. Too many other factors enter the analysis, including seasonal and other operating considerations, interest rates, and demand.
While it is but one important factor among several in the amount by which inventories must fall to restore normalcy, demand affects an overstocked market by more than the size of its changes. With production held roughly constant below current rates of consumption, a demand gain obviously speeds the stock draw and is important for that reason.
But rising demand also lifts the theoretical inventory volume that can, within the context of forward stock cover, be maintained without threatening price. Forward cover is inventory volume divided by the rate of consumption, expressed as days of supply. This is another value for which no optimum range exists because of the influence of other variables. Crude price behavior nevertheless made it clear that the 90 days` worth of oil stored by members of the Organization for Economic Cooperation and Development last year was too much.
A rough goal this year is to pull OECD forward cover to less than last year`s 90-day average. Within this framework, rising demand provides the extra benefit of cutting the amount of oil that needs to move out of storage to lower the days` supply quotient. But demand leverage works in both directions. A consumption slump would both slow the stock draw and restate forward-cover comfort in the wrong direction.
Job gets tougher
In any event, falling inventories mean the market is undersupplied from production, now deliberately constrained. Current inventory totals are below levels of corresponding months a year ago, when the trend headed the other way. An essential adjustment is thus in progress. The remaining question is how far it goes before production and consumption trends change, as they will.
The answer depends greatly on OPEC and its allies in production restraint, who have assumed responsibility for managing the supply dimension of this tricky balance. Their reward-a rising crude price-also makes the job tougher.
