OPEC faces tough test as oil price tumbles

Posted in Energy Security , Other | 22-Oct-08 | Author: Jad Mouawad| Source: International Herald Tribune

Chakib Khelil, OPEC's president, has said an output cut was "obvious."

At the beginning of the year, OPEC producers felt confident that strong economic growth and tight supplies would keep oil prices high. When oil crossed the $100-a-barrel threshold in February, the cartel's president blamed speculators and said there was not much OPEC could do.

But now, panic is gripping producers as prices drop. Oil is down by half since July, and the speed of the decline has stunned oil-rich governments that have become dependent on high prices.

As the global economy continues to weaken, the Organization of the Petroleum Exporting Countries faces its toughest test in years.

The problem for the oil exporters, who meet for an emergency session in Vienna on Friday, is to find a way to stop the price drop at a time when oil consumption is falling markedly in industrialized countries. Even the Chinese economy, long the biggest engine of growth for oil demand, seems to be cooling.

Most analysts expect the group to announce a production cut of at least a million barrels a day, which would be more than 1 percent of the world oil supply. Chakib Khelil, OPEC's president, said last week that an output cut was "obvious" and suggested the group might meet often in coming months for further adjustments.

History suggests that OPEC will face a tough time propping up prices as oil consumption slows and the world teeters on the edge of a global recession, analysts said. Some experts warn that if the cartel took too much oil off the market, it could push prices up so much as to worsen the global economic crisis.

"OPEC's problem is they don't know how much demand is falling," said Jan Stuart, an energy economist at UBS. "So the risk they run is either they don't do enough, or they do too much. That's a tough choice."

Nobuo Tanaka, the executive director of the International Energy Agency, said a cut in production could harm consumers and delay an economic recovery. "The slowdown may be prolonged," Tanaka told reporters on Monday in Paris, where the energy agency, which advises industrialized countries, is based.

Oil prices settled at $70.89 a barrel on Tuesday, down $3.36 and near the 14-month low they reached last week.

The biggest question is what price the cartel is prepared to defend. In 2000, producers adopted a price band of $22 to $28 a barrel, and adjusted production levels accordingly. The mechanism was imperfect, and many producers felt it constrained them, but it basically worked to ensure stability in oil markets.

But defending a price requires spare capacity, so that production can be raised if prices get too high, as well as discipline on the part of OPEC members, so that production can be lowered when prices fall. OPEC abandoned its price band when its spare capacity virtually disappeared in 2005 amid rapidly rising global oil demand.

Now, with consumption growth slowing sharply and new oil projects coming online, some spare capacity has become available.

Lawrence Eagles, an oil analyst at JPMorgan, said in a research note that he believes the "price-band mechanism offers the best way for OPEC to manage the market under current conditions." Eagles said OPEC did not want prices to slip below $70 a barrel, and would be more comfortable with prices around $80.

The cartel, which controls 40 percent of the world's oil exports, has found it difficult in the past to get all its members to abide by production cuts. When prices fall, producers have an incentive to increase their output to maximize revenue, not stick with OPEC quotas.

Producers are aware that high prices pose a risk to the global economy. Oil consumption is already falling sharply in developed countries, and there is a rising risk that oil demand could slow even in fast-growing developing nations.

OPEC's researchers recently downgraded their forecasts for global oil demand because of the financial crisis. OPEC expects global demand to rise 550,000 barrels a day this year, to 86.5 million barrels a day.

For many analysts, these expectations are still too optimistic. A growing number of independent experts now say they believe that global oil consumption may fall this year, for the first time since 1993.

"OPEC will have to decide how far it can ignore the global economic crisis and pressure from consuming countries," wrote researchers at the Center for Global Energy Studies, a London consulting group founded by Sheik Ahmed Zaki Yamani, a former Saudi oil minister. "The real danger is that a big cut will send prices soaring again, putting the global economy at even greater risk."

Some producers may feel they have little choice. Many exporters have become used to high prices, which feed growing government and social budgets. The group's 13 members earned $730 billion from oil and gas exports last year, up 12 percent from the previous year, according to OPEC statistics. This year they are on track to hit $1 trillion.

Not all oil producers are affected by falling prices in the same way. Iran and Venezuela, for example, need $95 a barrel to balance their budgets, according to various estimates. Both Nigeria and Iraq recently said they would reduce their budgets for next year because of lower prices.

Iran's oil minister, Gholamhossein Nozari, has been among the most vocal proponents of an aggressive reduction in output, suggesting OPEC may have to cut production by as much as 2.5 million barrels a day. "The era of cheap oil is finished," he told reporters in Tehran on Tuesday.

His comments came as Iran, Russia and Qatar discussed the creation of an OPEC-like group for natural gas exports, according to Reuters. The three countries, the biggest holders of gas reserves, will form a "big gas troika" that will meet each quarter, according to Alexei Miller, the chief executive of Gazprom, Russia's state-owned natural gas giant.

Even conservative oil producers allied with the United States, like Saudi Arabia, may take the view at Friday's meeting that prices have fallen too much. In the absence of an official price target, Saudi experts estimate the kingdom needs oil at $50 to $55 a barrel to balance its budget. A production cut would be a major turnaround for the Saudis, who have recently been pumping full out and had been eager to see oil prices fall below $100 a barrel.

Outside of OPEC, producers like Russia are also threatened by a prolonged period of lower prices. Last month, the Russian government sent a high-level delegation to attend an OPEC meeting as observers, a sign that Moscow is anxious.

"OPEC will have to act like a cartel for the first time in six years if they want to stabilize the markets," said Lawrence Goldstein, an energy economist. "The problem is they've been fairly ineffective as a cartel. But they are good at crisis management. And this is a crisis for them."