The oil market's whiplash

The oil market has swung. The price of crude oil has plunged. Producers are cutting output. There is new talk about imminent death of the Organization of Petroleum Exporting Countries. All this for a market swing? Actually, it's something more than a swing. Current conditions feel like whiplash. Indeed, politics has aggravated an essentially economic surprise.

March 30, 1998

4 min read

The oil market has swung. The price of crude oil has plunged. Producers are cutting output. There is new talk about imminent death of the Organization of Petroleum Exporting Countries.

All this for a market swing? Actually, it's something more than a swing. Current conditions feel like whiplash. Indeed, politics has aggravated an essentially economic surprise.

The Asian factor

Asia's financial problems stunned the oil market. A region that had been adding more than 800,000 b/d to each year's growth in worldwide oil demand suddenly hit the economic skids. The U.S. Department of Energy says Asian demand growth may slow by 300,000 b/d this year. Most other analysts put the 1998 slowdown at about 500,000 b/d.

Only a few pessimists see no Asian demand growth at all this year. Even with a relatively warm winter in key consumption areas, therefore, total oil demand probably will increase again. It will just grow more slowly in 1998 than it has done in the past half-decade. Of course, there's too much production relative to the new level of demand, which is why inventories have rapidly increased. Prices do fall under such conditions.

But by 35% in 4 months? Something else is going on.

Its name is Saddam Hussein. The Iraqi president finagled the United Nations into more than doubling revenue targets of its oil-for-food program, which is mistakenly based on revenues instead of volumes. Iraqi exports are rising to capacity levels-about 1.6 million b/d. And Saddam doesn't worry about price. He has no reason to care whether his country meets the U.N. revenue targets. What he cares about is an end to sanctions, not money for food and medicine. Weak oil prices help him squeeze oil-producing neighbors for support in the issue that really matters to him.

Because the U.N. based the oil-for-food program on revenues instead of export volumes, and because Saddam cares nothing about revenues he doesn't control, Iraqi oil enters the market at any price. Other oil sellers might as well subtract 1.6 million b/d from total demand to assess the market in which they must compete.

So the market for commercial oil-oil sold by producers with reason to care about price-isn't just growing more slowly than it did before. It is shrinking. In those terms, $12/bbl oil makes regrettable sense.

Saudi Arabia, Venezuela, and Mexico have responded with an interesting commitment to cut production-interesting because Saudi Arabia and Venezuela have been at odds over the latter's quota-busting and because Mexico doesn't belong to OPEC. Hints of support from Oman and Norway fuel speculation about OPEC disintegration.

In fact, OPEC disunity is nothing new. That two key members have found common cause with outsiders means less about the group's future than do conflicts in place long before oil prices plummeted. This new alliance will have no more success raising oil prices through coordinated production restraint than OPEC ever did by itself. Cartels never work for long because their success encourages sabotage: Rising prices intensify the temptation to cheat on production quotas.

Cuts to come

Production will be cut, nevertheless. The oil market is a physically closed system. Storage has limits. As production in excess of demand tests those limits, prices plummet. Producers then respond to their own economics: Those who find themselves unable to recover the costs of producing oil quit producing. Although technology has lowered the average cost threshold, cuts will occur. Inventories can't rise forever.

Of course, none of this applies to Saddam Hussein, who has been exempted from the rigors of commerce by the U.N. As economic pain elsewhere grows, so too will support from oil producers for an end to the Iraqi sanctions. This political gimmick at work in the glutted oil market is important. It has aggravated the slump, has the potential to stall a correction, and probably will win for Saddam exactly what he wants.