October 16, 2006
Winter's coming and oil prices have been falling. That makes OPEC anxious. A quick remedy is an "emergency" meeting of the cartel's members, with a goal of hammering out an agreement on a production cut.
Easier said than done. Oh, sure, there'll be an announcement from the meeting in Qatar later this week. The message for consumption from the confab, which starts on Wednesday, will no doubt be a one-million-barrel-a-day reduction promised (threatened?) by various sources. Algerian Energy Minister Chehib Khelil yesterday said that OPEC will officially unveil such a cut. Meanwhile, Qatar Energy Minister Abdullah bin Hamad al-Attiyah said that OPEC will discuss "the possibility of reducing total oil output by one million barrels a day (b/d) to stop any further decline in prices."
So far, Mr. Market isn't overly impressed. The November crude futures contract in early New York trading today was largely unchanged from its Friday close of $58.57. That doesn't mean that OPEC won't be able to talk up the price this week, or even over the coming weeks and months. With the onset of winter buying, demand is likely to become increasingly robust.
That said, consensus is easier for cartels when prices are rising. It's a whole other ball game when selling dominates. Indeed, OPEC's history is more than a little blemished when it comes to keeping member promises intact on the matter of cutting production in the face of lower prices.
The challenge is hardly unique to OPEC. Human nature being what it is, profit maximizing actions invariably overshadow those that emphasize a group over the individual Adam Smith is always happy to explain the concept in more detail for those who're interested. Suffice to say, past experience suggests that maintaining quotas on new production cuts will be a bit like keeping water from following downhill.
Consider that Iran's reported share of a future one-million b/d cut for OPEC will amount to a decline of 140,000 b/d, according to TehranTimes.com. Embracing such a cut makes a price decline that much more difficult. Back in early September, oil was around $70 a barrel; today it's under $59, as we write. Assuming Iranian exports of 2.5 million b/d, the price decrease shaves $27.5 million a day. That's more than $190 million a week and $825 million a month--figures that are sure to catch the attention of even the most pious theocracy.
Agreeing to more financial pain--self-inflicted, no less--is the essence of a production cut. How much pain? Once again, let's run the numbers for some perspective. Returning again to Iran's 2.5 million b/d export machine, assume it agrees to pare that by 140,000 b/d. That's an addition revenue cut of $1.5 million a day, or a loss of nearly $11 million a week or $46 million a month.
In theory, the pain will be temporary because production cuts will boost price. But theory and practice don't always live a peaceful coexistence in OPEC. All it takes is one cagey member to play fast and loose with its lower production quota to convince the rest of the gang to squeeze a bit more cash flow out of the process by selling a tad more oil than the club officially allows. The incentive to cheat becomes that much stronger if prices continue to slip. And as more members cheat, the incentive for the rest to follow suit rises too. No self-respecting government wants to subsidize other nations by sticking to a production-cut agreement when everyone else is picking up a little extra cash on the side--especially if the economy that's sticking to the straight and narrow heavily depends on oil revenue to keep the masses happy. Not only is that bad economics, it looks foolish too, which goes over like a lead balloon in the image-conscious Middle East.
In addition, cheating has also been promoted by the internal politics of OPEC, otherwise known as the battle for market share, as detailed by WTRG Economics. The essential point: advancing one's self interest isn't easily engineered away, even in a cartel that has a substantial interest in doing just that.
Then again, perhaps things are different this time. Global excess oil-production capacity is at relatively low levels and the odds are slim that major new sources of supply are just around the corner. As such, relatively minor production cuts can have a fairly big impact on prices these days.
Nonetheless, fundamentals reign supreme in the long run. That is, supply and demand will trip up even the most disciplined cartel. Unfortunately for buyers, fundamentals work to OPEC's advantage in the years ahead. A cartel can't do much to circumvent market prices driven by bearish economic fundamentals, as the 1980s proved, but the same will prove true as fundamentals turn increasingly bullish going forward.
Simply put, oil prices are higher today than they were 10 years ago primarily because of market fundamentals rather than OPEC maneuverings.
In the short term, it's another story. If Mr. Market thinks oil prices should be $55, OPEC will have a tough time keeping a barrel at $70. But that won't stop the cartel from trying. Indeed, OPEC will issue press releases and court the media, while Mr. Market will do nothing. Manipulating perceptions is easy for a month or even a year for a cartel desperate to cloak itself in the image of power.
If you really want to know what's going on with oil prices, track the average annual price. Yes, it's been moving up, but the rise is no longer as quick as OPEC would prefer. In fact, it's reversed recently. The secular bull market in oil is alive and well, but it's recent pace can't be sustained indefinitely. Corrections are a fact of life, even for the world's most valuable commodity.
In the short run, anything's possible. That's what this week's meeting in Qatar is all about.
Posted by jp at October 16, 2006 9:54 AM