Latest oil price rally underscores uncertainty for OPEC

The latest oil price rally just underscores the uncertainties facing OPEC ahead of its June meeting.

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Oil prices are surging again, so the market focus again has fallen on how well the Organization of Petroleum Exporting Countries will micromanage oil supply to sustain its unofficial $25/bbl target price.

That was brought to light with oil prices rising by more than $1.50 the past few days after a comment by Saudi oil minister Ali al-Naimi that OPEC is unlikely to increase production at the group's ministerial meeting in June.

As UBS Warburg put it, "The surprise, perhaps, is that such a comment would surprise the market.

"The stock overhang already in place and likely to exist by early June makes it unlikely that there will be a strong enough price signal for OPEC to raise quotas. And without such a signal, don't expect higher quotas."

What UBS Warburg neglects to mention here is that there is little reason for OPEC to raise production quotas at its next meeting because the group already is producing over its quota.

In fact, Merrill Lynch contends that, if OPEC hopes to sustain its official price band target of $22-28/bbl (which equates to $25-31/bbl for West Texas Intermediate), the group needs to tighten the screws on quotabusting. The International Energy Agency this month estimated OPEC's compliance in March with its round of production cuts implemented since last November at only 55% (this excludes sanctions-bound Iraq, which is not a party to any OPEC quota changes). That compares with a compliance level of 70-75% that Merrill Lynch contends is critical for instilling confidence in OPEC's targeted official price band.

Meantime, IEA projected global oil demand this year would rise by only 1.8%, or 1.3 million b/d, and non-OPEC supply would increase by 1.4%, or 620,000 b/d. Merrill Lynch's own forecasts are more conservative, at 1.2 million b/d and 500,000 b/d, respectively.

Other factors

With weakening demand and greater cheating on quotas, then, why have oil prices risen by $3/bbl since OPEC's March meeting?

The answer is that there are other factors at play here. Chief among these is an extremely bullish outlook for gasoline, especially in the US. Exacerbated by recent, accident-related refinery outages in the UK and Aruba, US gasoline stocks have continued to fall.

The newest data from the US Energy Information Administration show that US gasoline stocks in mid-April were 6% below the same level a year ago, which the London-based Centre for Global Energy Studies suggests sets the stage for a possible repeat of the $35/bbl (dated Brent) oil price spike seen last fall. As CGES notes: "Certainly, if we were to transpose this year's gasoline stock position into last year's market, we would be justified in expecting a price explosion (and $35/bbl might even seem a modest price).

"However, the crude oil prices spike in third quarter 2000 was the result of intense competition for oil between refiners in Asia and those in the Atlantic (Basin)-this may not be such a problem this year."

The London think tank blames "excessive" oil buying in fall 2000 for last fall's spike in oil prices and contends that Asian buying will again increase over the next few months, once stocks have been drawn down enough to reduce the current stock overhang. This, in turn, will support oil prices.

"The big question the world is facing concerns the extent to which the US economic slowdown has affected the economies of Asia," CGES said. "The answer, as yet, remains unclear; we must keep a close watch on eastbound liftings (from the Persian Gulf and West Africa) for an early indication."

Skewed perceptions

Complicating the market outlook are the skewed perceptions over US oil demand, which has registered a startling 3.5% increase in first quarter 2001 (a whopping 5.8% rise in January alone).

CGES notes that the January rise was measured against the rundown of the pre-Y2K stockbuild. But, more importantly, the growth in the first quarter owed largely to increased demand for heating oil and other refined products being substituted for natural gas that was too costly or too scarce for its usual buyers. In fact, US gasoline consumption in February actually fell from the year before.

"The economic slowdown in the US is affecting oil demand there, but the natural gas shortage is hiding that effect."

Perceptions are equally skewed over OPEC's role in all of this and what the target price should be.

While UBS Warburg suggests OPEC need do nothing in June, Merrill Lynch thinks the group ought to at least tighten compliance to avoid a price decline. CGES instead suggests that if OPEC is serious about sustaining $25/bbl as an average price (vs. a floor), it should boost output by 1 million b/d in June "to preempt an ultratight market towards the end of the year.

"Unfortunately, OPEC is unlikely to act until prices have risen sufficiently, and by then it will be too late...CGES continues to believe that a $25/bbl oil price is higher than the world economy needs if a prolonged slowdown is to be avoided."

CGES goes further to suggest that, if the current projections of weaker oil demand growth are correct-especially if, in fact, oil demand growth is even lower than these projections-then OPEC needs to increase output to help the world economy through a period of more-moderate oil prices to help stimulate growth again.

"The last thing a weakening global economy needs is high oil prices, while OPEC would find itself on a downward spiral of continuing output cuts," CGES said. "The last time it did that was in the mid-1980s."

The feeling here is that OPEC will do nothing at its June meeting, tacitly acknowledging that its sagging compliance will make more oil supply available as the crucial runup to the summer driving season gets under way, thus cooling off an overheated market.

But it is an equally safe bet that Iraq will be spoiling for a fight as the Bush administration presses for a review of Iraqi sanctions. The likelihood seems inevitable that Baghdad respond to the US initiative by pulling its official (under the UN-administered oil-for-aid program) output off the market and simply step up smuggling amid the resulting higher oil prices. That will bring about $35/bbl Brent right away, not in the fall.

The real question then should be: How long will Iraq's oil supplies be off the market? Enough uncertainty about that prospect could force an emergency meeting of OPEC to roll back this year's output cuts to offset the Iraqi supply shortfall. There is usually a lag of about 30 days in that event, so OPEC can benefit from its price band being exceeded for about a month before its added output cools off oil prices. But should Iraq restore its output in a relatively short time thereafter (which has been the pattern in past-notably last December), then the market will get the oil it needs, and CGES's worst-case scenario for the fall won't materialize. By the time the heating season approaches again-by which time natural gas prices ought to have stabilized at $4-5/MMbtu-then the rise in oil demand in the second half could well absorb the added barrels.

This time around, the real wild card seems to be the tight US gasoline market. Already, gasoline prices are leading the latest crude oil price rally. If demand has not softened enough because of high prices, then the gasoline tightness will persist, spawning tightness in heating oil in the fourth quarter.

It could very well be that the environmentally induced supply straitjacket that US has knitted itself on fuels could provide an entrenched premium for crude oil prices, much like the Iran-Iraq tanker war and Desert Shield did, while they lasted, in the preceding 2 decades. Because the US fuels supply problem is tied to infrastructure inadequacies related to the proliferation of "boutique" fuels, it is fundamental and resistant to quick fixes. Natural gas now has price pressures twice a year-for heating and for cooling-that are also linked to fundamental supply inadequacies (both in infrastructure and at the wellhead). Why not crude oil-for driving and for heating?

If that's the case, then OPEC might do well to ease off on the micromanagement of crude supply and let this product-driven rally run its course each year.

CGES outlook for call on OPEC crude, oil prices

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OGJ Hotline Market Pulse
Latest Prices as of April 27, 2001

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Nymex unleaded

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Nymex heating oil

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IPE Gas oil

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Nymex natural gas

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