Is OPEC production cut warranted? Maybe, but not in January

Is OPEC's consideration of a production cut after the first of the year warranted?

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Is OPEC's consideration of a production cut after the first of the year warranted?

The hints coming from various OPEC members of a possible output at the group's next ministerial meeting in January have elicited an outcry from Western government officials. The alarm stems from the prospect of what might be further reductions in OPEC oil flow at a time when weather-related demand spurts or a possible disruption in Iraqi oil supplies loom as very real possibilities on the horizon.

OPEC insists there is an ample amount of oil on the market, the high price of oil notwithstanding. It continues to claim that the high oil price owes to the dangerously low level of product stocks, particularly of heating oil, in tandem with futures market speculation. There is something to be said about both claims. Heating oil stocks have refused to show any signs of building to acceptable levels. And certainly the latest twist in the Palestine intifada saga or twitch of Saddam's Machiavellian brow sends the traders scurrying. These two factors alone probably account for much of the rise from the $30/bbl watershed in recent weeks to more than $35/bbl.

But the fact remains that even that $30/bbl watershed is well above the $22-28/bbl price range that OPEC has established as its target zone and that any price above or below that automatically triggers a 500,000 b/d boost or cut, respectively, in collective output. And OPEC has dug in its heels over hiking production quotas yet a fifth time within the past year rather than invoke the price-band trigger this time. Is it a coincidence that the price-band trigger mechanism is being shelved this time around at a time when the device's author is also the new secretary general-elect and emerging new price hawk of the group-Al

If this is fine-tuning the market, it's a pretty hamfisted fine-tuning. But then, given the wildly disparate numbers the market produces, that might be the best that we could hope for. According to London think tank Centre for Global Energy Studies, a look at raw supply and demand data suggests that global stockbuild was supposed to have reached 230,000 b/d at the end of the third quarter. But, says CGES, OECD industry stocks in that period rose only 68 million bbl and floating stocks climbed by only 40 million bbl. That means as much as 126 million bbl of oil stocks are unaccounted for.

"If these barrels do exist, then they must be in the wrong place and cannot reach refiners due to shipping constraints," CGES said. "If they are phantom barrels, they are not part of global supply.

"Either way, the market is probably tighter than we previously thought, providing fundamental support for the recent oil price jumps due to turmoil in the Palestinian territories and Saddam's threats to suspend oil exports if he does not get his way."

Crimping stockdraws

Looking just at the raw numbers, OPEC (excluding Iraq) contends it has boosted production by 3.2 million b/d during March-October this year, more than enough to balance the market.

But CGES contends that the actual increase was no more than 2.1 million b/d because some members were already producing over quota in March. Demand this year is up about 1 million b/d vs. a year ago, while OPEC and non-OPEC supply increases this year are pegged at a combined 2.7 million b/d. That ostensibly would suggest a supply glut this year, but it does not take into consideration the massive global stockdraw of 1.2 million b/d in 1999 that was required before a 2000 stockbuild could begin.

"OPEC's real achievement in 2000 is to have prevented further global stockdraws, but stockcover has remained at low levels-hence the persistence of high prices," CGES noted.

Price slide ahead?

Nevertheless, OPEC's concern about a price slide in the year to come is well-founded. If there are no disruptions in Iraqi supplies and if winter temperatures are normal (meaning colder than the previous three winters), heating oil and other products stocks will continue to build (there is ample evidence, as cited in this space before, that a buildup of secondary and tertiary stocks of heating oil is being overlooked by a market fixated on primary storage levels. A healthy level of demand will keep margins sustained, and refineries will continue to operate near capacity. As the winter winds down, and it turns out that there was no crisis in heating oil supply after all, the first quarter will end with a hefty buildup in both distillate and gasoline stocks. Refiners will trim back runs just ahead of the seasonally slack second quarter, demand for crude will drop, and then so will crude prices.

Of course, the key question here for OPEC is when will crude prices slide? The timing of inventory buildup suggests that it will not occur soon enough to trigger output cuts by the time of OPEC's next meeting in mid-January.

"OPEC, however, may need to cut output in March to stabilize prices at $25/bbl for the rest of the year," CGES said. "Prices are unlikely to be low enough by then to prompt them to take the necessary action."

And if it doesn't take action then, the analyst warns, the continued additional output will spawn a glut that will take oil prices back down to $18/bbl.

So it all boils down to a matter of timing-and prescience. If OPEC anticipates this latest twist in the oil market saga, it will have an accord essentially in place by the time it meets in March. It is unlikely to have the political will to take the risk of cutting output in January, especially if Saddam is still blustering and continued cold weather keeps pulling on supply. If OPEC is truly to be effective in micromanaging the market, it must do a better job of anticipating future demand, as its supply responses are too slow and cumbersome to be effective. It should develop a viable scenario for 2001 oil demand that takes into consideration the effects of recently high oil prices on demand. Then it should lay the groundwork for a well-reasoned production cut in March at the January meeting and have an accord well in hand and ready for rubber-stamping in March. All the while, it can assure the market that there is ample oil on the market for the winter and decide not to take action. Everyone will be so relieved that OPEC did not actually cut output that price pressure will probably ease up. It may then only take a couple of warm spells and a hoped-for fade into the background by Saddam-once he gets the mileage he wants out the latest sortie in his war of attrition on the sanctions regime-to allow oil prices to drift back below $30/bbl.

If OPEC can learn the game of anticipation rather than reaction, it may well yet master this art of market micromanagement.

OGJ Hotline Market Pulse
Latest Prices as of November 24, 2000

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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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