OPEC Shuts Off the Spigot

Many analysts think the new cuts may be overzealous restrictions of supply that overshoot OPEC's target oil prices

At its meeting in Abuja, Nigeria, OPEC on Dec. 13 announced another output cut of 500,000 barrels per day beginning Feb. 1, 2007. U.S. oil prices rose sharply by $1.20 per barrel to $62.57 on the news. It was the second announced cut in a matter of months. In October OPEC called for cuts of 1.2 million barrels per day to halt a 25% price drop.

OPEC is promising to make more production cutbacks because it detects a "continuing supply overhang" despite the earlier cuts. But a substantial body of analysts disagree and think that OPEC is playing a dangerous game that could damage a slowing world economy and, ultimately, hurt the organization's own interests. "OPEC appears on the verge of potentially killing the golden goose that lays the golden egg," said Lehman Brothers (LEH) Energy Economist Edward Morse in a recent note.

Such analysts think that OPEC could be repeating the notorious mistake it made in 2004 at an Algiers meeting when it cut output just as demand from China and elsewhere soared. That move sent prices higher than even OPEC wanted, to a peak of $78.40 per barrel last July. "The danger is that OPEC is being more proactive than it needs to be," says Kevin Norrish, director of commodities research at Barclays Capital (BCS) in London.

Gauging Inventories

Norrish thinks that prices could rise to much higher levels than the $60 per barrel or so that OPEC ministers have suggested they are targeting. Indeed, Norrish, a longtime oil bull, thinks that there will be at least one quarter in 2007 when oil prices will be above $80 per barrel.

The difficulty for OPEC in trying to manage the oil markets is that data is sketchy and open to debate. Only the U.S. has timely and reliable data. OPEC, for instance, worries about recent U.S. inventory for crude and products that have been running above the range of the last five years. But inventories have been shrinking rapidly in recent weeks, and many analysts question the validity of the last five years as a benchmark. The last half-decade was characterized by unusual circumstances including the 2005 U.S. hurricanes, a decline of OPEC spare capacity to near zero, and a concerted effort by OPEC to drain world inventories in an effort to raise prices.

OPEC also said in its communiqué that output from non-OPEC oil producers is likely to outstrip the growth in world demand by 1.8 million barrels per day to 1.3 million barrels per day—hence the justification for a 500,000-barrel-per-day cut to prevent a glut. But non-OPEC production has consistently come in on the low side in recent years as mature fields declined more rapidly than expected and new projects were delayed in coming on stream. At the same time some analysts think that demand growth from China and elsewhere may be recovering after two sluggish years.

A Short Reprieve

Still, OPEC seems to want its customers, rather than the organization, to assume the risk of misjudgements. The organization may also want to recoup some of the purchasing clout lost by the recent fall in the dollar. OPEC producers earn oil revenues in dollars but spend a lot of euros and yen on imports. "A lot of things influenced our decision, including the dollar," said Saudi Oil Minister Ali al-Naimi.

The silver lining could be the delay until February. That will allow the big consuming countries such as the U.S. to get through the peak heating season. It also will give OPEC time to reflect. If world inventories continue to fall or prices remain above $60 per barrel, "OPEC may elect to forgo the additional February cuts," Washington-based consultants PFC Energy say. What is sure is that after years when prices were so high that OPEC became almost irrelevant, the cartel is resuming active efforts to manage the market. The coming months, OPEC said from Abuja, will require "extreme vigilance in assessing the market." Oil consumers beware.