Commentary: Forget About Cheap Oil

OPEC's discipline and global recovery could well keep prices high

When the topic of rising oil prices comes up, an easy explanation leaps to mind: a gathering global recovery, boosted by surging demand from the U.S. and especially China, is behind the runup. That's true -- but it's not the whole truth. There's a lot more going on behind the scenes in the global oil market. The factors at play involve everything from hedge-fund activity to the needs of Persian Gulf economies to the unexpected strength of OPEC. Taken together, they could spell a new era in oil pricing.

The ability of OPEC to stand firm has been the most surprising development. Ever since the cartel rediscovered discipline in 1999 and reversed a price collapse, analysts had predicted it would soon lose its grip and send prices tumbling back to their $20-per-barrel long-run average. Five years later that retreat still hasn't happened, and, with prices for U.S. benchmark crude stuck at about $35 per bbl., some industry experts are starting to talk about a new paradigm, where the price will average closer to $30 than $20. "We are becoming more convinced that some profound changes have happened in both supply and demand," says Paul Horsnell, head of energy research at Barclays Capital Inc. in London.

Energy prices are, of course, volatile, and predicting where they're headed is a fool's game. But not only has the average price of West Texas Intermediate kept above $25 per bbl. for four years running, but the whole oil price futures curve has moved up. The price for delivery as far away as Dec. 31, 2010, is $27.31 per bbl. That's a clear sign, Horsnell reckons, that the "long-held belief in a long-run price fixed between $18 and $21 has been abandoned."

Besides global demand, a convergence of forces is working to keep prices up. Under the tutelage of Saudi Arabia's Oil Minister, Ali Al Naimi, OPEC officials have become a lot more adept at managing the oil market. Naimi is acutely aware that low inventories translate into higher prices. And in recent comments he has signaled his determination to keep supplier stocks at bottom-scraping levels. That's how the powerful Saudi oil minister is succeeding in keeping prices up, especially in the pivotal U.S. market, where inventories are at near-record lows.

A change in Saudi attitudes is also apparent. It seems hard to believe now, but the Saudis -- by far the most influential OPEC member -- used to worry that costly oil would drive their customers to try alternative energy sources. In the age of the ubiquitous gas-guzzling sport-utility vehicle, the Saudis now appear to have abandoned those concerns. How could one draw any other conclusion from OPEC's Feb. 10 announcement of a production cut -- at a time when prices were at a high $33 per barrel? Al Naimi says the cut was to head off a future glut and that the OPEC target is now $25 per bbl. But Roger Diwan, an analyst at Washington consultants PFC Energy, says Saudi behavior is more indicative of a $35-per-bbl. goal.

What else has driven the attitude shift? Some analysts point to the influence of Crown Prince Abdullah, who is far less inclined to please Washington than was his ailing brother, King Fahd. Then there is the theory that the Saudis are angry over the fall of the dollar, to which their currency, the riyal, is pegged. That increased Saudi import costs by about $3 billion last year alone, according to Brad Bourland, chief economist at Saudi American Bank in Riyadh.

HEDGE FUND ACTIVITY. But the explanation may be simpler. Saudi Arabia and other OPEC countries have youthful, exploding populations, and they need all the money they can get to pay for imports, government entitlements, and job-creation programs. "The bottom line is export revenue. Everything else is marginal at best," says Anthony H. Cordesman, an analyst at the Center for Strategic & International Studies in Washington.

Further sparking the market are investors, particularly hedge funds, which have been piling into oil and other commodities, pushing up prices. Hedge funds are attracted by the volatility of the oil markets. Investing in oil also offers a way to diversify portfolios away from the securities markets. As of Feb. 17, so-called noncommercials, which include hedge funds and other financial players, were net long 67,673 futures contracts -- representing almost 70 million barrels of crude oil -- on the New York Mercantile Exchange, according to the U.S. Commodity Futures Trading Commission. "In the last few months the funds have been much more active in commodities and the oil market in particular. This activity creates additional demand," says Marc Mourre, managing director in commodities trading at Morgan Stanley in London.

OPEC is well aware that investment by hedge funds is a two-edged sword. If they suddenly get spooked and liquidate their contracts or go short, they can drive the price down several dollars a barrel in a wink. For now, the fundamentals are working in OPEC's favor -- and preventing any panicky sell-off from the funds. With economic recovery kicking in and the U.S. shuddering through a cold winter, consumers are burning all the $30-per-bbl. oil they can get. China, where oil consumption grew at an 18% clip in early 2004, and the U.S. lead the guzzling leagues. At the same time, growth in supply from non-OPEC countries outside of the former Soviet Union is looking weak, as older producing zones such as the continental U.S. and the North Sea decline and oil companies struggle to find new prospects.

The real test of OPEC's strength comes soon. The always-difficult second quarter is approaching. That's when demand plummets with the end of the winter heating season. Concern that prices will fall was heightened by the Jan. 16 release of a bearish report from the International Energy Agency, a Paris-based consumer countries' group. The IEA forecasts that demand for OPEC crude will dwindle in the second quarter to 23.3 million bbl. per day -- far less than January's estimated production of 26.4 million per day. OPEC insiders think the IEA estimate is too low, but they're taking it seriously. By announcing a big production cut in mid-February, OPEC sent a loud signal that it is determined to keep prices high. So far the gambit has worked. "OPEC has shown once again that it can manage expectations," says Adam Sieminski, an oil analyst in London.

Some analysts think the organization is playing with fire. David Fyfe, supply analyst at the IEA, worries about what an unforeseen disruption could do to global supply. "It is very difficult to micromanage the market the way they are doing," he says. If OPEC miscalculates, a spike in oil prices could come right around the time of the November U.S. Presidential election, heightening tensions with OPEC's most important customer. "Unless there is a fairly significant buildup in inventories in the second quarter, the possibility of a real price breakout is high," says Edward L. Morse, senior adviser at New York energy trading firm Hetco. But don't bet on OPEC loosening its grip just yet. It may well take a global recession before the new model shows any strain.

By Stanley Reed

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