OPEC's compromise deal: Will it work?

OPEC has effected a compromise between its price hawks and doves that won't put that much more crude oil into the market in the near term but probably will take some heat out of oil prices eventually.

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OPEC has effected a compromise between its price hawks and doves that won't put that much more crude oil into the market in the near term but probably will take some heat out of oil prices eventually.

That wasn't the initial response, of course. Futures jumped again yesterday, with NYMEX August crude topping $32/bbl, as traders acted surprised at what most of them (and us) had been predicting, anyway: that OPEC is not going to allow a repeat of the 1997 fiasco (by hiking production just when demand starts to taper off) and instead is still looking for that soft landing for oil prices.

OPEC has a legitimate concern. Although the group boosted production quotas in April (and has exceeded that quota ever since), which softened prices somewhat in the early spring, oil prices are right back at the lofty level they were before the cuts. But what is uncertain is why prices are so high. There is every reason to believe that oil prices are being pulled up by high gasoline prices, especially high in the US and most especially stratospheric in the Chicago and Milwaukee areas. And despite what Al Gore and Carol Browner (those noted oil market specialists) would have you believe, there are a number of complicated and decidedly provincial reasons for US gasoline prices being as high as they are-not just OPEC and refiners' vaunted greed.

Permit a digression. If the notion of refiner price-fixing and collusion isn't silly enough, we now see press reports of "some market sources" (probably a disgruntled service station owner) noting the "coincidence" of upper Midwest gasoline prices starting to retreat just as the Federal Trade Commission launches its investigation into allegations of collusion. Ah-hah! (You don't suppose that price slide has anything to do with the huge Explorer products pipeline getting back on line, or that some of that increased April crude is starting to reach US shores, or that US refiners are frenziedly making every barrel of gasoline they can, or that the lofty prices in the upper Midwest are drawing supplies to that region like flies to an Al Gore elocution, do you?)

Nothing like a conspiracy theory to trump its own stupidity with ever-fresher inanities. Just how many times are we going to have this same, fruitless investigation every time gasoline prices spike?

Back to OPEC. The president and secretary-general of OPEC this week both pointed to the possibility that maybe crude prices are being led up by spikes in the price of gasoline caused by tightness in gasoline supplies owing to low stocks, switchover to summertime-spec reformulated gasoline, hesitance of refiners to make RFG because of the Unocal patent suit, and strong demand ahead of the biggest US motor travel period of the year-and that perhaps such parochial, temporary factors are giving a misleading gauge of underlying oil demand. Hence, it would be self-destructive to feed much more crude into a demand situation that might deflate in the weeks to come.

But there are some signs of unexpectedly strong underlying demand growth in Asia, notes London think tank Centre for Global Energy Studies: "OPEC's output boost was meant to deal with the market's need for more oil, particularly in the US. Strong demand from Asia, however, has limited the amount of Middle East crude coming west, despite a sharp upturn in liftings.

"Burgeoning demand from China and India has prevented the Atlantic Basin from receiving all of the additional supplies it so urgently needs, keeping stocks low and pushing up prices for short-haul crudes in the region."

With crude tight, refiners can't make enough gasoline to meet demand at a time when stocks are dangerously low. And this problem will replicate with distillates, so look for another round of price spikes and political hysteria over heating oil this winter.

What OPEC accomplished

What OPEC accomplished was a compromise that appeased the likes of Iran and Libya and Algeria by not putting too much crude on the market. At the same time, the agreement helps the Saudis save face with the US by ostensibly fulfilling OPEC's "commitment" to implement its official price-band mechanism. In fact, the increase represents an amount pretty close to halfway between the 500,000 b/d automatically triggered by the price-band mechanism and the US-favored 1 million b/d (perhaps the US would have gotten the 1 million b/d it wanted if not for the rancor left behind by Sec. Richardson's arm-twisting during OPEC's March meeting).

Most importantly, the agreement bought a little more time for OPEC. Certainly, OPEC's new quota increment just validates the current level of cheating by OPEC members (see Table 1). But the question then becomes: Will OPEC cheating increase even beyond the new quota? Together with new supplies from the likes of Norway, Mexico, and Russia-plus price-induced hikes in mature, high-cost areas like Alaska and the heavy oil regions of Alberta and California, this may put enough crude on the market in the weeks to come to settle prices back down enough to stifle the witch hunt atmosphere in Washington.

But if OPEC is as wrong about Asian demand as it was in 1997-albeit in a different direction-then 708,000 b/d won't cut it. Especially when it's not a true net increase of 708,000 b/d and is just an adjustment to match cheating levels-OPEC itself claims that the increase will put 600,000 b/d of fresh supplies onto the market.

IEA is now predicting the Asian economic rebound will fuel a much bigger rise in demand than hitherto believed. According to the CGES chart attached below (made just before the OPEC meeting), if OPEC were to put another 500,000 b/d onto the market and IEA's demand projections were to materialize, then prices would settle back down to below the price-band trigger by the first quarter. But with that incremental oil and without IEA's demand scenario, oil prices are well on their back down to the bottom level of OPEC's price band, when it would have to start thinking about taking barrels off the market again. Without more oil and with IEA demand, the trajectory just stays on an upward course.

That's OPEC's dilemma. A little patience on everyone's part is called for now.

Price June 23, 2000

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