OPEC: Production Hike To Meet Short-Term Demand

In something of a surprise move, the Organization of Petroleum Exporting Countries (OPEC) on September 11 agreed to raise collective output by 500 mb/d above August 2007 actual production. The move, which takes effect from November 1, will see OPEC's cumulative official output targets increase some 1.4 mmb/d, as the Secretariat also acknowledged that the Organization's existing output was some 900 mb/d above nominal targets in place since February 2007.

The proposal for the increase was first raised by Saudi Arabia, albeit late in the day. Riyadh has been concerned by the recent run-up in oil prices, reflecting perceptions of crude oil tightness in coming months as the peak winter demand period approaches. But offsetting these concerns are longer-term question marks surrounding the health of the US and global economy - and with it the continuing prospects for oil products demand growth beyond the coming winter - something that other OPEC states thought should be of greater overall concern.

OPEC's move not only underscores that it is able to respond to short-term market needs, but more significantly that it has returned to a key role in world oil markets. As oil markets bumped up against global crude production capacity constraints in 2004 and global refining constraints in 2005 and 2006, OPEC's importance in setting world oil prices was eclipsed. However, by late last year the prospects of an emerging crude oil glut seemed readily apparent, and in part accounted for the precipitous fall in oil prices from records above $70/b in July to prices near $50/b by mid-January 2007. In fact, oil's recent strength is largely attributable to OPEC's market management enacted through two production cuts agreed to late last year, with the impact of taking nearly 1.0 mmb/d of world production off markets.

These production cuts have helped to trim worldwide commercial inventories of crude oil throughout the OECD (although levels in the US market remain well above the five-year average level. According to PFC Energy balances, the increase will help mute the expected continued drawdown in global crude inventories through the first quarter of next year, but still leave OPEC well-positioned should adjustments to output levels be necessary.

Certainly part of OPEC's recent reasoning has been that a too strong oil price could add to current economic malaise in the United States, and potentially threaten growth in global oil demand. But in general, OPEC will continue to pursue a strategy of defending steadily higher oil prices. This stems not in part from the core group of OPEC producers' needs to earn increasing revenues from oil exports in order to finance expanding populist spending measures (exemplified by the policies of Venezuela's President Hugo Chavez and Iranian President Mahmoud Ahmadinejad) or ambitious investments being undertaken in the non-oil infrastructure, particularly in the states of the GCC. But greater impetus to a stronger oil price strategy comes as a response to the Federal Reserve easing monetary policy which is resulting in further dollar depreciation-and seeing an evaporation of the purchasing power of dollar-denominated commodities.

Thus OPEC's current situation puts the Organization in a position to meet increased short-term demand, but also prevent an unmanageable build in global crude inventories. This situation will allow the producing states to revisit production decisions early next year to either guard against lower-than-anticipated global economic growth - and oil demand - or to further increase supplies should the situation warrant.

Key Conclusions

OPEC will be able to successfully continue its strategy of active crude oil market management to defend steadily higher prices over the next several years.

By keeping markets in relative balance or even slightly tight, OPEC also guards against significant price pressures in the event of worse-than-expected global economic performance.

Although OPEC is currently concerned about risks stemming from upside price increases, over the longer-term the Organization will continue to adopt a more conservative approach emphasizing downside risks of uncertain demand.

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David Kirsch is the Manager of the Market Intelligence Service, a PFC Energy client service examining the key fundamentals, political, and economic factors influencing global crude oil markets. For further information on this article contact Enews_dkirsch@pfcenergy.com.