Commentary: OPEC Can't Keep Tightening the Spigot

By Stanley Reed

The July 25 announcement of its third production cut this year has had the effect that OPEC desired. Prices, which were moving downward, have at least temporarily blipped up $2, to $26 per barrel. Indeed, there is even worry that OPEC's gambit, headed up by Saudi Arabia's Oil Minister Ali Al-Naimi, could lead to $30-per-barrel oil again this fall if refiners in the U.S. and Europe cannot find enough crude to make heating oil for this winter.

But over the longer run, OPEC could be shooting itself in the foot. The slowing world economy is crimping demand for crude. Moreover, the high prices of the last two years have encouraged development of new supplies. By raising prices at this crucial point, OPEC could be choking off the economic growth needed to keep demand robust. Ultimately, it may be forced to pare production even more in an effort to keep prices at around $25 per barrel. That would make it difficult to hold the cartel together. "They are exacerbating the problem," says Adam E. Sieminski, an analyst at Deutsche Bank Alex. Brown in Baltimore.

BIG SQUEEZE. Low production capacity and high world economic growth worked in OPEC's favor for the last two years. Now those fundamentals have turned against the cartel. According to the International Energy Agency, growth in the world's thirst for oil will slow to an anemic 0.6% this year, vs. 0.9% last year and 1.9% in 1999.

At the same time, OPEC's success in keeping prices high has stimulated lots of activity. Drilling, for example, has soared. Baker Hughes Inc., the Houston-based drilling company, says there are now about 2,300 drilling rigs operating worldwide, 60% above 1999 levels. Some new production is starting to hit the market. Sieminski thinks nearly 1 million barrels a day of new non-OPEC oil will arrive next year alone. With demand only expected to increase by 800,000 barrels or so, OPEC's share looks likely to be squeezed.

The organization is already under pressure. If the September cuts go through, the 10 OPEC countries, excluding maverick Iraq, will have cut about 3.5 million barrels per day from their production ceiling of close to 27 million barrels. But as such cuts bite into revenues, they will be increasingly hard to enforce. In fact, some estimate OPEC is now producing about 900,000 barrels per day above its existing quota. Cash-hungry countries such as Nigeria and Indonesia are unlikely to start paying much attention to quotas as long as there is a market for their oil.

To offset such a scenario, you might think OPEC would let prices drift lower, in order to spur economic growth that would soak up that excess crude. But the cartel's leaders don't think that way. OPEC focuses almost exclusively on managing production to keep prices around $25 per barrel. If prices fall, they tighten supplies even more. "Everyone criticized us the first and second time we cut, but they proved to be wrong," says a Saudi source.

The bad news for consumers--and the global economy--is that OPEC could well prolong the high-wire act a few more quarters. Roger Diwan, senior analyst at consultants Petroleum Finance Co. in Washington, D.C. rates OPEC's chances of keeping prices in the mid-$20s at about 50% in 2001. Longer-term, though, he thinks it will be "next to impossible" to stave off a fall to $18-$21 per barrel in 2003.

Certainly, that's what the futures market is predicting. Yet Diwan says expensive oil has already done its damage, so OPEC has little to lose in trying to prolong the good times: "They are like an alcoholic who knows he is going to Alcoholics Anonymous soon, but says `give me one more drink."' Still, this drink could be one too many. If prices do spike up to $30 in September, the blow to the struggling economy could depress demand for the cartel's oil even further in later months.

London Bureau Chief Reed covers OPEC.

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