OPEC Speaks, Nobody Listens

The cartel announces it will pump more oil, yet prices hit a new record. The reason: Skepticism, speculation, and fear of worse spikes to come

By Stanley Reed

OPEC's Mar. 16 decision to raise its production ceiling by 2%, or 500,000 barrels per day, has done little to calm the overwrought oil market. Hedge funds and other traders, the key players in today's speculation-driven market, just don't believe that OPEC can do much about prices in the near term.

Despite the cartel's statement, U.S. crude prices rose more than $1 per barrel, hitting a new record of $57 on Mar. 17, after the release of data showing a sharp drop in U.S. gasoline supplies. But they remain near all-time highs, despite the fact that supply fundamentals are in respectable shape. "The oil market is currently dominated by participants who doubt [OPEC's] ability to control the upward spiral in prices," says Kevin Norris, an analyst at Barclays Capital in London, in a note following the decision.

Last year, surging demand, especially from China, helped make oil prices in the $40- to $50-per-barrel range a fact of life. Yet the situation has only worsened this year, even though the increase in demand in 2005 is expected to be somewhat less -- around 1.8 million barrels per day, vs. 2.7 million barrels per day in 2004. Still, 1.8 million is a big number, and forecasters, including the U.S. Energy Dept. and Paris-based consumer watchdog International Energy Agency continue to revise forecasts upward.


  The market is skeptical that supplies can grow fast enough to keep up with -- let alone outpace -- consumption. "People are afraid that by the end of the year there won't be enough spare capacity," says Roger Diwan, senior analyst at PFC Energy in Washington. More important, traders are exhibiting a lack of confidence in the ability of OPEC and market forces to exert their traditional influence over oil prices.

Diwan describes today's oil market as schizoid. Industry players can't understand why prices are so high. They point out that supplies of oil are no problem to secure. No shortages have cropped up. But such old-fashioned fundamentals are not determining prices.

Instead, he says, the market is being driven "by a perception of future tightness." OPEC ministers have a valid point when they say more than market fundamentals are behind the high prices. Yet their impact on trader sentiment in the short term is virtually nil, most experts say.


  The good news is that as OPEC gets more and more uncomfortable with prices above $50 per barrel, its motivation to take more aggressive action in reining them in becomes stronger. Despite raking in well over $300 billion from oil revenues last year -- and the likelihood of gaining even more this year -- OPEC knows it needs to do something about the situation. The Saudis, who have finally started investing in additional capacity, were threatening to increase production on their own if OPEC declined to go along. What the Saudis want, the Saudis usually get.

Still, OPEC's firepower is limited on the upside. The group is already pumping pretty close to flat-out -- as it was doing in the fall of 2004. OPEC's spare capacity, excluding Iraq, is just 1.5 million barrels per day, figures Adam Sieminski, an analyst at Deutsche Bank in London. That's a pretty slim margin, considering that it's less than the production of Venezuela or Iraq -- countries that have experienced severe disruptions in the recent past. With spare capacity this low, a major outage could send prices to $70 to $80 a barrel.

But supply-and-demand fundamentals should work in consumers' favor over the next couple of months. Prices should ease somewhat -- if the Middle East and other oil regions remain relatively calm. Consumption tails off sharply in the second quarter with the end of the winter heating season. That should mean increases in inventories, which are now moderately low, especially with OPEC pumping at high levels.


  Not long ago, the cartel was mulling cuts to head off stocks building to a point where prices could have been knocked down. But markets are already focusing on the fourth quarter, when consumption is expected to rise by about 2 million barrels per day above the current 84.4 million.

No huge price drops are in sight, however, and 2005 could well see the highest average prices ever. Moreover, current prices so far aren't producing the huge production increases that economists say should be occurring. Supply from non-OPEC countries could well disappoint this year. Growth of new output from Russia, the main source of new oil in recent years, looks to have at least temporarily peaked -- not least because of President Vladimir Putin's meddling in the industry. Sieminski pegs overall non-OPEC supply growth in 2005 at 1.2 million barrels per day, while other estimates range down to 600,000 barrels.

While OPEC is cautiously adding capacity, in recent years it has shown the will to cut output when needed -- and sometimes when not needed. The cartel's policy is to err on the side of too little production. Now perhaps it needs to risk slipping up on the side of too much production -- rather than letting consumers bear the cost.

Reed is BusinessWeek's London bureau chief

Edited by Beth Belton

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