Wild oil price volatility underscores gravity of OPEC's challenge

Unprecedented oil price volatility this week underscores OPEC's challenge in Vienna Mar. 27.

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The run-up to the watershed Mar. 27 OPEC meeting in Vienna is proving to be a wild ride, indeed. Not since the Persian Gulf war have oil prices been so volatile.

Oil markets experienced swings of about $2/bbl twice this week, a circumstance unheard of absent a geopolitical crisis. Such volatility can suggest only two things: 1) that traders are, to pardon the colloquialism, "as jumpy as a long-tailed cat in a room full of rocking chairs;" 2) that nervousness is based on a very real impending shortage of supply in the market.

The latter point can be shown by the fact that oil prices are still hovering near a stunning $32/bbl despite overwhelming evidence that OPEC's storied compliance with pledged production cuts is weakening and despite comments from key OPEC and non-OPEC players (Mexico, Venezuela, and Saudi Arabia, the architects of the production cuts that have produced this long bull run) that production must increase. Fereidun Fesharaki, head of FACTS Inc. and an official with East-West Center, Honolulu, contends that all the OPEC members are currently producing above quota, and he estimates the total OPEC overproduction at 1.3-1.5 million b/d.

It boils down to a simple numbers game: How many incremental cargoes of crude can make their way to the key refining markets before the start of the summer driving season begins, even if OPEC agrees to production cuts effective Apr.1? The answer: not enough. While the current OPEC overproduction may mitigate the situation somewhat in the next few weeks, this extra increment is still far short of the 2 million b/d or more that the market has been clamoring for.

So all the evidence points to the crunch in heating oil supplies that drove prices to about $2/gal in the US Northeast during the winter's coldest stretch being "carried over" to gasoline. The US Energy Information Administration darkly warns of $2/gal gasoline this summer, as the US average self-serve unleaded retail price hits $1.50/gal this week.

There are still some OPEC members who doggedly insist, defying reality, that it is premature to increase production. For the most part, their views (at least the likes of Libya and Algeria) are irrelevant. Most of these naysayers couldn't increase their production significantly enough to make a difference in any event. It is safe to say that they are trying keep the skittish market psychology buoyed as long as possible so as to extract the maximum rent from the moment.

But at least one naysayer has considerable clout (if not immediate potential to significantly hike output): Iran. Tehran has argued that the projected level of second-quarter oil demand does not justify any increases in OPEC quotas at this point, claiming that a boost in output is not warranted before this coming September. That has put Iran at odds with Saudi Arabia, a troubling element for OPEC cohesion, because an earlier rapprochement between the two nations was as important for the market-rescuing securing of OPEC solidarity on production cuts as it was between the Saudis and Venezuelans.

Fesharaki contends that "… (I)t is possible that Iran would wish to use the issue as a bargaining point to gain other concessions, perhaps on the OPEC secretary general issue, which remains on the agenda.

"Moreover, Iran has just come out of a stunning election victory for reformers (which includes many leftists), with many new faces in the Parliament. It is politically correct (domestically) for the government to take a strong line publicly. In the OPEC negotiations, final decisions can be reached, and compromises will be made."

It may be that Fesharaki's prediction has already come to pass. A few days ago, Iran railed against the prospect of production increases for the second quarter. Then, after a meeting between Saudi and Iranian oil ministers, Iran declared its support for production increases getting approved in Vienna. It is likely that the deals have been struck already and that the Mar. 27 meeting will be a simple ratification of those closed-door deals.

So it's all well and good that production increases are all but inevitable at the Vienna meeting, but where does that leave markets that are short of oil now? And when and how much relief will there be?

Again, that brings us back to the fabled "soft landing" of oil prices that OPEC must engineer, to $20-25/bbl. If OPEC lets the quotas stand but winks at cheating of, say 1.5 million b/d, that falls short of market needs and expectations, and prices could, in fact, increase. Hiking the quotas by, say, 2 million b/d while trying to squelch overproduction could backfire, if cheating continues but at a much higher quota level-resulting in a price decline, perhaps below $20/bbl.

"It is important to note that a 2 million b/d quota increase has a much more negative impact that a 2 million b/d overproductionm" Fesharaki said. "Although the physical volume is the same, if OPEC cheats and the policy does not work, OPEC can always go back to the quota. If, on the other hand, the quota is increased, it is not so easy to go back to the base, as a new base needs to be renegotiated."

Fesharaki estimates that the market actually needs 2-2.5 million b/d of oil beyond the current quota with an assurance that more oil will be forthcoming if needed later. His scenario is that OPEC could: allow overproduction levels of about 1.5 million b/d; raise the group quota by 750,000 to 1 million b/d; and convene another OPEC meeting in 90 days to fine-tune the market and add more to the official quota if necessary.

Under such a scenario, he says, oil prices will come down not rapidly but slowly as inventories are rebuilt and a level of comfort returns to the market about the prospect of physical shortages.

Sounds eminently reasonable. If OPEC pulls it off, then this fine-tuning supply-management approach is likely to be the group's template for the future, which promises, at least on average, long-term stability in oil markets. Then all OPEC ministers will have to worry about in the future is what to do with all their frequent-flyer miles.

OGJ Hotline Market Pulse
Latest Prices as of March 10, 2000

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