OPEC's Cuts Signal Pricing Worries

With a bigger-than-expected production cut and the threat of more to come, the cartel shows a strong desire to stop the fall in oil prices

OPEC delivered a stronger-than-expected message to skeptical oil markets at its "emergency" meeting in Doha, Qatar, on Oct. 19. The 11-nation cartel said that it would cut production by 1.2 million barrels per day—some 200,000 more than the oil ministers had been tipping to the market in recent weeks.

In an attempt to convince traders that it was serious about slashing output, OPEC said that the cuts would come from current production of around 27.5 million barrels per day (plus 2 million in Iraq) rather than from quotas, which have become somewhat fictional. OPEC also published a detailed list of cuts down to the nearest thousand barrels. They range from 380,000 barrels per day for Saudi Arabia to 39,000 in Indonesia.

The move shows that OPEC is very worried about the sharp fall in prices of around 25% from the July peak of more than $78 per barrel for West Texas Intermediate (WTI) crude. Many analysts think that unless OPEC slashes production substantially, inventories will build up rapidly in the coming months, further depressing prices. So far, OPEC's unexpectedly hard-line position has not had much impact on the market. Prices for WTI, the benchmark U.S. crude, were at $58.75 per barrel on Oct. 20.

In the face of such bearish sentiment about the lifeblood of its members' economies, the cartel wanted to make a display of toughness and solidarity for the benefit of hedge funds and other speculators, who have become big factors in the oil market over the last two or three years. To underline the point, Saudi Oil Minister Ali Naimi, by far the most important OPEC spokesman, said that further cuts of 500,000 or so barrels per day might be necessary when OPEC next meets on Dec. 14 in Abuja, Nigeria.

$60-Plus Oil Expected

The Saudis could live with a lower price than the current level of around $60 per barrel but agreed to go along with the plan to achieve consensus on both prices and production levels (see BusinessWeek.com, 10/4/06, "Why Are Saudis Approving Cheaper Oil?"). Yet the Saudis don't want to have to absorb the bulk of the cuts, as they have at other times of weakening demand. In this case, they are only pledging to cut 380,000 barrels per day, bringing their total production to about 8.7 million barrels per day, or roughly one-third of OPEC output.

All of the OPEC members (except Iraq, which doesn't observe OPEC rules) are sharing the pain. But because Saudi Arabia can weather prices in the $50-per-barrel range, while Iran and Venezuela will have fiscal problems at much below $60, the Saudis have leverage to encourage others to stick with what they have agreed. Otherwise, the threat is they will overproduce, as well.

There are, of course, many variables that will determine prices in the next few months, including the severity of the winter in the Northern Hemisphere and the resilience of consumption in the U.S. and major emerging markets such as India and China. But analysts think that OPEC has a reasonable chance of holding the line in the $60-per-barrel range. "We expect OPEC will eventually succeed in pushing oil prices back over $60 per barrel," said Michael Lewis and Adam Sieminski, analysts at Deutsche Bank (DB), in a note following the meeting.

Mistake Could Catapult Prices

In fact, there is even some risk that OPEC is misjudging how much current supply is outstripping demand, which could set the stage for a new price run-up. This is what occurred the last time OPEC cut production in 2004.

Deutsche Bank points out that OPEC has succeeded in defending prices seven of the 10 times it has cut production since 1993. The key variable will be the world economy. If economic growth brakes sharply, no amount of OPEC cutting is likely to keep prices at $60 per barrel. Oil-industry insiders consider that price very high, even if the public has become accustomed to such levels.

Of course, no serious analyst takes OPEC pronouncements as an exact blueprint. The cartel's positions are more a statement of intent than a precise set of marching orders for what oil producers will do. Most likely, the cuts in the coming weeks will fall short of the 1.2 million barrels per day that OPEC is promising.

But the cartel, led by the Saudis, is already removing oil from the market. The Saudis are believed to have cut 200,000 to 300,000 barrels per day by pegging their heavy crudes at unattractive prices. Most OPEC countries have built up large financial reserves in recent years. Those stashes of dollars and euros may make it easier for them to go along with cuts today.

Before it's here, it's on the Bloomberg Terminal.