OPEC's emergency meeting

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Oct 13th 2008
From the Economist Intelligence Unit ViewsWire

Falling prices mean a cut in oil production is likely


If oil prices continue to slide over the next month, it seems likely that OPEC ministers, who have decided to hold an emergency meeting in Vienna on November 18th, will approve a production cut. The main immediate question will be the extent of any such cut. Further ahead, there will also be questions about compliance and about the impact of the credit crunch on investment in both upstream capacity expansions and in pipeline and refinery projects worldwide.

Moving floor
At OPEC's previous meeting, in early September, the ministers described the market as over-supplied and issued a statement urging member states to adhere to the production levels agreed 12 months earlier—this, in effect, amounted to a cut of about 500,000 barrels/day, roughly the same amount of extra crude that Saudi Arabia had been pumping into the market in an effort to bring the price down from its mid-July peak of US$147/b. OPEC's action last month came after the oil price dropped below US$100/b for the first time in six months. The price has since fallen further, and on October 10th, the day after OPEC announced its plan for an emergency meeting, dated Brent slipped below US$80/b, its lowest level since September 2007.

The oil price has fallen as a result of a sharp contraction of demand in the developed economies, the strengthening of the dollar and the flight of funds from commodities futures markets. The challenge for OPEC now is to identify a realistic equilibrium target price and to calibrate its production accordingly.

The traditional hawks in OPEC, led by Iran and Venezuela, have made clear that they consider a production cut to be long overdue, suggesting that their view of an acceptable floor price is about US$100/b. Saudi Arabia, OPEC's largest exporter, has tended to take account more of the overall health of the world economy in its assessments of the oil price and production, and its own economy is better placed to cope with a lower oil price. Accordingly, Saudi Arabia is likely to argue for a more cautious approach. If OPEC were to react with a deep cut in production, this might eventually push prices up to a level that could endanger any nascent recovery of the world economy, and ultimately inflict more damage on oil exporters by choking off an eventual recovery of demand.

The International Energy Agency (IEA) has just lowered its oil demand forecasts by 500,000 b/d for the second half of 2008 and by 400,000 b/d for 2009. The agency is still forecasting a slight increase in total demand in both years—0.5% and 0.8% respectively—with increases in Asia and the Middle East offsetting lower consumption in Europe and the US. It is probable that OPEC will factor in a slightly more bearish demand outlook for 2009 to justify an immediate output cut of about 1m b/d. However, by the time the organisation's ministers meet, the market is likely to have factored in such a reduction, and there could be pressure from the hawks for tougher action.

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Supply chain
When the oil price wobbled in late 2006, OPEC managed to stop the rot through reducing its output by about 1m b/d. This time round it may be more difficult. Demand is much weaker, the impact of futures traders is much diminished and the start-up of a number of major new fields in Saudi Arabia has increased global spare capacity. OPEC's ability to comply with its revised production quotas was not severely tested last time round, partly owing to the involuntary shutdown of a large part of Nigeria's production capacity. If prices continue to slide, OPEC's compliance will face a stiff credibility test, as the market will no doubt assume that the more fiscally challenged member states will be strongly inclined to cheat.

Lower prices and the credit squeeze are likely to have an impact on investment in new production and processing, but probably more at the marginal end of the spectrum. Major oil companies may indeed see the fall in oil prices as an opportunity, as it will weaken the bargaining power of governments and national oil companies. The changed demand outlook may persuade Saudi Aramco, which has by far the largest investment programme currently underway, to put some of its long-term development plans on hold, but it will not affect its current crop of oilfield and refinery projects. Oil sector investment also stands to benefit from the fall in costs of construction materials, in particular steel.

EIU's new forecast
The Economist Intelligence Unit has lowered its oil price forecast (for dated Brent) to US$75/b in 2009 and US$82/b the following year. We expect the price to rise gradually thereafter as tighter market conditions recur.