Commentary: Will OPEC Shoot Itself in the Foot?

Saudi Arabia was nervous in the runup to the recent OPEC meeting in Vienna. To a much greater extent than usual, Saudi officials questioned oil experts and traders to gauge how the market would react to various moves. OPEC did wind up announcing a 1 million barrel per day announced production cut, but it was not a decision that the Saudis accepted lightly.

The Saudis know they are playing a dangerous game. They used to be comfortable with oil in the $20 per barrel range, figuring that would give them enough income without hurting the western economies or overstimulating exploration in non-OPEC countries. But beginning about a year ago, with prices soaring, the Saudis sharply upped their target to $25 per barrel or higher for the so-called OPEC basket, which translates to roughly $28 for the U.S. benchmark, West Texas Intermediate.

Several factors are behind the shift of the Saudis, whose huge reserves make them by far OPEC's most influential member. Crown Prince Abdullah, who is now running the kingdom, is much more willing to risk friction with the U.S. than his predecessors were. Indeed, a well-placed Saudi says that Abdullah worries just as much about placating regional rivals such as Iran--an OPEC price hawk. Moreover, the Saudis, who had severe fiscal problems in 1998 and 1999, are now trying to maximize their revenues in the short term.

But this could prove a major miscalculation. "By holding prices up OPEC may be impacting on the economies that they need to buy their oil," says Peter A. Gignoux, head of the oil trading desk at Schroder Salomon Smith Barney in London.

For now, the Saudis brush off any such suggestions. "Our studies show that these prices won't hurt the world economy at all," says a Saudi source. Instead, Petroleum Minister Ali Al-Naimi is focused on short-term management of prices. The world is heading into the second quarter, when demand is usually weakest, so the Saudis are trying to put a floor under prices. "Last year everything was pushing the price up, but this year all factors are pushing it to go down," the Saudi source said. Indeed, promises of cuts buoyed prices before the OPEC meeting, but they dropped off sharply to about $23.00 per barrel for the OPEC basket. That is what prompted OPEC Sec. Gen. Ali Rodriguez to say on March 21 that OPEC might call for yet another production cut if prices remain weak.

Yet slashing away at production will only serve the Saudis' interests up to a point. Already their production is set to dip below 8 million barrels per day, after hitting around 8.7 million last year. If OPEC continues cutting output, more and more of the burden will fall on the Saudis to manage the drop in production--and that will hit Saudi revenues.

There's another risk: Despite recent price weakness, the Saudis' move to cut the oil flow could repeat last year's shortages and, perhaps, even the politically sensitive price spikes that resulted. As of now, U.S. crude and gasoline inventories are below their five-year averages, creating the potential for problems this summer. "We just don't see the fundamentals for a rebuild in stocks," says Joanne Shore, senior analyst for the Energy Information Administration, a U.S. government agency. "That will keep prices high."

Maybe the Saudis figure the Bush administration slyly welcomes OPEC's moves, which smoothe the way for the increased oil and gas development in the U.S. that President George W. Bush favors. On March 19, Bush even praised the Saudis for saying that they would not let prices rise above $28 per barrel. "That's very comforting to the American consumer, and I appreciate that gesture," he said.

The Saudi gamble is that consumers will accept a higher price range as long as it doesn't get out of hand. "One has to live within a price range that is acceptable to everybody," says Ray R. Irani, Chairman of Occidental Petroleum Corp. "OPEC has so far come up with a formula that has worked."

Has it, though? There are already indications that high prices have contributed to economic weakness in the U.S. The Washington-based National Association of Manufacturers estimates that high oil and natural gas prices in 1999 and 2000 cost the U.S. economy $115 billion--equal to 1% of GDP. OPEC is dreaming if it thinks it can play the price game with impunity.

By Stanley Reed

With Chris Palmeri in Los Angeles and Laura Cohn in Washington

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