Time for OPEC to plump up its cushion

Mar 16th 2005
From The Economist Global Agenda

OPEC has agreed to boost production by 500,000 barrels per day in order to cool oil prices, which rose to within a whisker of all-time highs last week. But if the oil producers' cartel wants to keep its grip on the market, it will have to widen the gap between the amount it pumps and the amount it can

IN SAMUEL JOHNSON’S novel “Rasselas”, a reclusive meteorologist, unnerved by the accuracy of his forecasts, becomes convinced that he controls the weather. The oil-market forecasters at America’s Department of Energy could be forgiven for the same delusion. Last week, they released their latest monthly predictions for energy prices, warning that “imbalances” in the market for light, sweet crude could drive the price “well above $50 per barrel”. Their prophecy promptly fulfilled itself: the price of a barrel of West Texas Intermediate oil rose to within two cents of the all-time record of $55.67 set last October, though it subsequently fell back a bit as speculative buyers decided to quit while they were ahead. On Wednesday March 16th, Texan crude was changing hands for around $54.60 per barrel.

If predicting the oil price is like forecasting the weather, it might be because the former often depends on the latter. A relatively mild winter in America and Europe has recently turned bitter, which is raising demand for the oil distillates that heat people’s homes. Last winter, the average household in America's north-east spent $953 on heating oil, according to the Department of Energy. This winter, it is expected to spend 29% more.

When the winter passes and spring arrives, Americans leave their hearthside and take to the roads for the so-called “driving season”, which stretches from April to September. This year, however, filling the tank may empty the wallet rather faster than usual. Drivers will have to fork out $2.15 per gallon this spring, predicts the Department of Energy. Last April, they paid no more than $1.80. Air passengers will suffer as much as road travellers.

America’s drivers and frequent fliers are used to being the undisputed kings of oil consumption. But they must now share increasing amounts of space with the Chinese, who have accounted for a third of the rise in global oil consumption since 2001. The International Energy Agency, which monitors the oil market on behalf of rich oil-consuming nations, reckons the growth in China’s demand should slow this year, but not by as much as it originally thought. On Friday it said that China, which consumed about 6.4m barrels per day (bpd) last year, would add another 500,000 bpd to this total in 2005. Last month, it thought China would add only 400,000 bpd.

The rainmakers

The people who really aim to govern the winds and rains of the oil market are of course the 11 members of the Organisation of the Petroleum Exporting Countries (OPEC), the cartel of oil producers which met this week in the Iranian city of Isfahan. OPEC’s members can shore up flagging oil prices by agreeing to cap their production; in theory, they can also restrain soaring prices by tapping into the extra pumping capacity they hold in reserve. But this margin of spare capacity dwindled to historically low levels last year. With oil demand outstripping expectations, and supply struggling to catch up, there was little the cartel could do to stop prices rising past $50 per barrel.

OPEC maintained that fears of a supply shortage were “unwarranted”. As Simon Hayley of Capital Economics, a London research firm, argues, the oil producers always find a way to increase supply “if the price is right”. Sure enough, Saudi Arabia went to great lengths to bring new oilfields onstream and delay the retirement of old ones. Kuwait, among others, also stretched itself to increase supply. By the end of 2004, Mr Hayley says, OPEC had reasserted control. Supply caught up with demand, prices fell back sharply, and OPEC even saw fit to cut its official production quotas by 1m bpd in December.

Before the meeting in Isfahan, on Wednesday, OPEC's swing producer, Saudi Arabia, had called for the cartel to agree an output rise of 500,000 bpd (to 27.5m bpd) to cool oil prices. Other members, such as Iran, Venezuela and Indonesia, wanted to keep production at its current level, arguing that demand will soon ease, as the northern hemisphere's winter ends. But by lunchtime on Wednesday they had buckled: OPEC announced an immediate rise of 500,000 bpd and pledged to double that if prices remain high. The Saudi oil minister, Ali al-Naimi, told al-Hayat, a London-based newspaper, that he wanted to see prices fall to between $40 and $50 a barrel.

However, OPEC has learnt that oil prices above $50, though painful, are not debilitating for the world economy. Indeed, it can justly argue that the high oil price is a natural consequence of the global economy’s strength, not a cause of economic weakness. Besides, America’s stocks of oil are now rising healthily, and its currency is falling, meaning that the dollars OPEC members earn from their oil exports do not go as far as they once did.

OPEC has decided that it needs to pump more oil, but does it also need more oil wells? That may be the more interesting question broached this year, if not this week. According to some estimates, the cartel is currently using all but 1.5m bpd of its full capacity. It will need a cushion at least twice that size, analysts reckon, if it is to insulate the oil market from the shocks felt last October and in the past week. According to reports in the Financial Times, the International Monetary Fund’s next World Economic Outlook, due next month, will urge OPEC to raise its margin of spare capacity to as much as 5m bpd. Without more slack, the cartel’s grip on the oil price may prove as illusory as that of Johnson’s meteorologist.

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