Crude may plunge if OPEC can't cut it

SHAWN MCCARTHY

Globe and Mail Update

With geopolitical risks off the table at least temporarily, global crude oil prices are now being driven by a more familiar dynamic: OPEC. But can the Organization of Petroleum Exporting Countries act like the cartel it was meant to be in order to tame the swings of a price-sensitive market?

OPEC ministers on Sunday said they had reached consensus to lower production by one million barrels a day, though analysts were skeptical, saying internal bickering could make any deal difficult to enforce.

Without concerted action from OPEC, crude oil prices appear to be headed sharply lower in a real-world demonstration of Economics 101: Record highs seen last year and the first eight months of 2006 have stimulated additional supply and inhibited demand, thus driving prices lower again.

Bearish analysts like Michael Lynch of Strategic Energy and Economic Research Inc. predict that high-quality, light crude could fall below $30 (U.S.) a barrel by this time next year if OPEC fails to rein in production.

He noted that OPEC and non-OPEC producers have added new production capacity in response to record prices — Saudi Arabia alone is expected to add 1.5 million b/d by next year — while consumers are using less because of slowing economies and conservation measures.

Last week, the market was filled with reports of planned OPEC production cuts, rumours that surfaced each time the price of West Texas intermediate fell below $60 (U.S.) a barrel on the New York Mercantile Exchange. By the end of the week, with no solid agreement on cutbacks, the Nymex price for November delivery was again below $60, settling at $59.76. The crude price — which hit a record $78 in July and August, was off 4 per cent on the week, after dropping 3 per cent the week before.

Sunday, the current OPEC president Edmund Daukoru said the group has agreed informally to reduce production by 3.5 per cent to its official 28 million b/d ceiling.

“I think there is more or less consensus for one million [b/d],” Mr. Daukoru told Reuters.

But Mr. Daukoru, who is also Nigeria's Oil Minister, said he was not favouring an emergency meeting later this month to determine how the cuts would be implemented; the next scheduled ministerial meeting comes in December.

Some analysts remained unconvinced of any agreement. The Saudis — who are being lobbied heavily by the Bush administration to keep the taps open so that prices will head lower — are said to be the key.

“Until you've got somebody within spitting distance of the [Saudi] King, saying this is what we're going to do, you've got nothing,” said James Williams, an energy economist at WTRG Economics Inc.

He noted the Saudis have invested heavily to increase productive capacity to 12 million b/d from 10.5. The Saudis, Algeria and Libya have all increased their production capacity well above their official limits and want a revamping of the existing country-by-country quotas. Venezuela, Nigeria and Indonesia are now producing well below their official limits, but are unwilling to formally acknowledge their declining capacity.

Fadel Gheit, an oil analyst with Oppenheim & Co. in New York, said he believes the Saudis are likely to heed the U.S. administration's requests to forgo production cuts, at least until the November mid-term elections have passed.

Of reports that the Saudis have agreed to reduce their output, Mr. Gheit said: “I don't believe them — it is a political statement. They say something, but they do something else.”

With Republican control of the U.S. Congress in jeopardy, the White House is eager to keep pump prices heading down, thereby removing a major irritant among voters.

Mr. Gheit noted that, in recent months, U.S. President George W. Bush has toned down the rhetoric aimed at Iran and its refusal to restrict its nuclear program. The U.S.-Iranian conflict was one of several geopolitical factors that had added a significant risk premium to oil prices.

“I really believe the wheels are set in motion to bring prices down,” Mr. Gheit said. “In my long years of experience in the industry, I have learned that you cannot separate oil from politics; it is part of the price structure.”

Simon Wardell, a London-based analyst with Global Insight Inc., said he believes OPEC could cut production by as much as one million b/d, but the reduction would have a minimal impact on the headline prices for light sweet crudes like West Texas intermediate and North Sea Brent.

Mr. Wardell said the cuts would most likely affect low-quality, heavy oil, thereby reducing the wider-than-average differential between light and heavy crudes.

“If they wanted to make a lot of noise, they would have to reduce the quota [of 28 million b/d] rather than simply say they will trim production,” Mr. Wardell said.

But the Global Insight analyst is not as bearish as some — he said spare capacity remains tight and escalating violence in Nigeria could reduce that country's exports.

“We think prices will firm up this winter, unless it is a particularly warm one,” he said.