Producing nations' support of OPEC quota cut may surprise markets

Nov. 12, 2001
OPEC members seem determined to reduce production quotas by 1.5 million b/d at their Wednesday meeting, with the support of Russia and Mexico. That could trigger volatile price swings in world markets that may have underestimated world demand for oil and overestimated the willingness and ability of non-OPEC countries to increase production.

Sam Fletcher
OGJ Online

HOUSTON, Nov. 12 -- With a little help from their friends in Russia and Mexico, energy ministers of the Organization of Petroleum Exporting Countries seem determined to reduce the group's oil production quotas by 1.5 million b/d at their meeting Wednesday in Vienna.

That will likely trigger a period of even more volatile energy price swings as world energy markets try to adjust after apparently underestimating world demand for oil and overestimating the willingness of non-OPEC producers to make up any production cutback by OPEC, analysts said.

Ernesto Martens, Mexico's energy minister, joined his counterparts Ali al-Naimi of Saudi Arabia and Alvaro Silva Calderon of Venezuela Sunday in declaring "their commitment to implement the necessary decision, over the coming days, to reduce the existing oversupply" of oil on world markets."

The three met in Spain to discuss "a growing imbalance between supply and demand" in world oil markets.

Energy prices shot up in world markets Friday after Russian Prime Minister Mikhail Kasyanov announced Russian oil companies are prepared to reduce crude exports in support of the proposed reduction in OPEC production quotas.

The OPEC news agency Monday quoted Alexey Ermakov, Russian ambassador to Venezuela, as saying his country is ready "to coordinate efforts with Venezuela and other OPEC countries for maintaining stable, fair, and predictable oil prices."

That show of support seemed to undermine previous predictions by many energy traders that major non-OPEC producers would bring more oil to market to replace any that OPEC members back out.

Markets took comfort in the prospect of non-OPEC production when, a few weeks ago, Mexican President Vicente Fox said his country would not cut production "for now."

"Most coverage seemed to forget the 'for now', which in no way would make (current) Mexican support a reversal of policy," said Paul Horsnell, head of energy research for JP Morgan Chase & Co.

"Although OPEC is willing to sacrifice market share near term for the sake of higher prices, we believe the cartel will ultimately regain market share, as the only non-OPEC country that poses a credible threat longer term is the former Soviet Union," said Bruce Lanni, energy analyst at the investment firm of A.G. Edwards & Sons Inc.

"Furthermore," said Lanni, in a report issued late Friday, "if you assume an annual demand growth rate of 1% following economic recovery, this translates into a need for an additional 800,000 b/d and does not take into account a worldwide natural field decline rate estimated at 2.6%, or another 2 million b/d."

However, Horsnell said Monday, "It is important not to let the non-OPEC developments distract from the main issue.

"The main driver is that the OPEC 10 (minus Iraq, whose oil exports officially are restricted by UN sanctions) have cut their production by more than 1 million b/d over the last 2 months and are now about to announce a further cut."

As a result, he said, "The contraction on the supply side is overwhelming the weakness on the demand side. After last week's figures showing US oil demand at an all-time high for October, there is also a suspicion that the weakness in oil demand could be far greater in market perceptions than it may prove to be in reality."

Like Horsnell, Lanni noted that OPEC members' compliance with production quotas improved in October after generally exceeding assigned levels in September. "While skeptics portray the relatively low level of compliance as a breakdown in OPEC discipline," he said, "we believe the last 2 months were an aberration that is partly attributable to the cartel's uncertainty over the impact of the Sept. 11 events and the tenuous states of the US and global economies."

Moreover, Lanni noted, "The market does not appear to be discounting any future supply disruptions, which may prove wrong if military activities expand outside of Afghanistan."

The current phase of the UN-administered Iraqi oil-for-aid program expires at the end of this month, with Iraq accused of having violated that program by smuggling out excess oil to world markets. As a result, US and UK officials may again push to impose a "smart sanctions" program that would stiffen the ban of military goods for Iraq.

"This time around, Russia, with its renewed relations with the US, is not expected to veto the change," said Lanni. "Iraq will likely reject any such move and retaliate once again by halting its oil exports of roughly 2 million b/d."

Record trading
Meanwhile, the US Commodities and Futures Trading Commission revealed Friday the largest collective speculative short ever in the oil market. The net short position -- involving an excess of open futures sales over open futures purchases -- by noncommercial traders such as hedge funds and commodity trading advisers exceeded 94.5 million bbl of both crude and refined products, the CFTC reported.

That far surpasses the previous record of 78.2 million bbl in early 1998.

"Over the last week, the noncommercials added a net 29.8 million bbl to their short positions. The short on crude alone stands at 64.3 million bbl, another all-time record high," Horsnell said.

In addition, he said, the CFTC data relates to Nov. 6 market positions, well before the current surge in oil futures prices.

Compared to the subsequent lows that energy futures prices hit Wednesday, Horsnell said, the value of those short positions had lost more than $250 million as of early Monday.

"That's a lot of money, even in oil trading," he said. "The presence of so large a speculative short in a rising market injects a further bullish tone, particularly when the positions seem to have been based on a highly erroneous view of OPEC capabilities."

Horsnell warned, "Expect substantial short covering if the noncommercials should decide that discretion might just be the better part of valor, and expect a lot of volatility if they are not prepared to back off too far just yet."

Lanni said, "Oil prices will be volatile near term and may be subject to slight downward pressure, but by no means do we expect prices to collapse as witnessed in 1997-98. We fully anticipate a recovery in the latter half of 2002 and expect oil prices to at least approach the lower end of OPEC's price band."

Contact Sam Fletcher at [email protected]