Saudis' surprising unilateral move: method to their 'madness?'

The Saudis' unilateral threat to produce more--is there a method to their 'madness?'

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The Saudis' move to add, unilaterally, if necessary, another 500,000 b/d of oil to the market was a stunner. No matter that an International Energy Agency analyst was quoted as saying that the move was expected-sure don't remember that prediction being publicized by the IEA--no one really anticipated the very public nature of the Saudis' announcement.

Even in this corner we were anticipating that OPEC would agree at their June 23 meeting in Vienna boost oil output somewhat. And, like others, we felt that increase would still fall short of what the market (namely the US) was calling for and would be largely an affirmation of existing production levels in light of quotabreaking that was spreading throughout the organization (aboiut 500,000 b/d). That it turned out to be marginally higher than that simply reflected the Saudis' willingness to compromise with the price hawks on a level between the 500,000 b/d amount that would be triggered by the $22-28/bbl price band formula and the 1 million b/d those outside OPEC were asking for (demanding, actually, in the case of Washington). What we pointed out at the time was that the actual volumes indicated by the agreement alone would not suffice to bring oil prices down much soon enough to take the heat out US gasoline prices. It would, however, we speculated, set the bar a little higher for cheating, so that the Saudis and others with a bit of spare capacity could put a little more oil on the market so as to moderate what would otherwise surely be untenable oil prices in the third and fourth quarters-especially with the tightness in heating oil.

The shocker is Riyadh unabashedly declaring that this further increment of crude will be placed on the market with or without the rest of OPEC's participation. The shocker is not the decision, but the overtness of it. There seemed to be some conciliatory language emanating from the Saudis shortly thereafter, something about the decision being taken in consultation with others in OPEC, notably Kuwait and the UAE. But there is no mistaking the assertion of market power behind such a public declaration of intent.

One must wonder, then, about the subtext of this move. Do the Saudis simply want to take high oil prices as an issue out of the US presidential campaign? Could it be that the Saudis weren't willing to wait longer for oil prices to slide below $30/bbl in response to the June 23 accord-for that reason? One trait seldom attributed to the Saudis in such matters is impatience, but the only thing that seems to make sense here is that these two questions combine to serve as a rationale for the kingdom's behavior.

The irony of all this, of course, is that market developments would suggest that the Saudis and others in OPEC are probably correct in their assumption that the market is being driven by high gasoline prices in the US--which in turn are a parochial development resulting largely from the US Environmental Protection Agency dictating gasoline formulas to US refiners, exacerbated by some shipping outages.

In fact, the underlying physical fundamentals of the crude oil market are improving, the high prices notwithstanding. As WEFA Inc.'s energy services group points out, glboal crude inventories grew by a rate that outstripped IEA's expectations. IEA had predicted a modest inventory build in the second quarter of about 1.2 million b/d, OECD stocks instead rose by at least 1.75 million b/d in April and by 1.7 million b/d in May. At the same time, the supply--demand gap widened to about 3 million b/d, as the expected signs of weakening demand appeared in concert with a rise in global oil production of about 700,000 b/d.

"Even with growing demand in June, due to summer driving in the dominant US market, it appears that the second quarter will see a large inventory build, on the order of 1.5 million b/d minimum, which is on the high end of the seasonal norm," WEFA said.

"While this does not restore the market to adequate inventory levels, it is a major improvement over the tightness earlier this year."

With such signs appearing, is it any wonder that OPEC was reluctant to take the leap with a production increase of more than 1 million b/d?

But oil prices have remained stubbornly high, even with the June OPEC agreement, and that can be laid largely at the feet of market speculators continuing to remain long in the market. Those speculators are looking at it from a downstream perspective, largely the supply problems with gasoline (immediate) and with heating oil (looming). The problem with inventories, now dissipating with crude but still severe with these two refined products, is the tail that wags the oil price dog.

Perhaps the Saudis recognized this and decided that it was necessary to deflate the overheated psychology of the market immediately, because reason--not to mention a basic understanding of economics--will not prevail in the US at present.

So why the rush? Here's a thought, and once again, we must turn to the Iraqi wild card: Oil price volatility only plays into Saddam's hands. It still is a reasonable speculation that Baghdad will try an "October surprise" on oil supply and prices in order to influence the Clinton administration into abandoning sanctions. Right now, polls suggest that consumers are pointing fingers at OPEC and oil companies for the spike in gasoline prices. As the industry continues to get the truth out about the role of EPA in the current gasoline price mess and the true stance on fuels prices of Al Gore, those fickle fingers will begin pointing elsewhere.

(See OGJ's two--part special report July 10 and 17 on the subject; the second part comprises testimony to be given next week in the Senate on the gasoline price furor by Petroleum Industry Research Foundation Inc.)

As the heat begins to shift back where it belongs, to the Clinton administration, will Baghdad offer the prospect of more crude oil supplies to cool the market as the already--tight presidential election approaches, in exchange for signs of the US relenting on sanctions? With that "carrot" offered, will the "stick" of withholding all Iraqi supplies from the market be waved in the background (translation: $50/bbl oil)?

Maybe the Saudis have been doing some speculating on their own. Maybe this move was a tacit recognition of--and attempt to signal intent to deleverage--a possible Iraqi threat to further destablize markets.

If such a move also serves to remind the world just who wields the biggest club in the world of oil geopolitics, well, that's just icing on the cake, isn't it?

Sound crazy? Re--read Dan Yergin's The Prize. Then tell me it sounds crazy.

OGJ Hotline Market Pulse
Latest Prices as of July 7, 2000

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