Thursday, October 19, 2006

What is OPEC Thinking?

It wasn't very long ago that OPEC used to have a price target for oil of about $25/bbl. Today it seems like OPEC's target for the price of oil is closer to $60/bbl. From CNN/Money:
OPEC's big gamble

NEW YORK ( -- If OPEC follows through on the talk that it will cut oil production by a million barrels a day, it will send a clear signal that the cartel feels the world can handle $60 oil.

...Analysts had long predicted OPEC would cut production if crude oil sank into the $50s, especially since autumn is typically a season of low demand. The decline has come as economic growth has slowed and supplies swelled to levels above or well above average for this time of year.

Analysts said the biggest reason OPEC, which currently supplies better than a third of the world's 84 million-barrel-a-day habit, will likely cut production is because it can. The global economy has continued to grow despite oil's record run. And demand, while slowing, continues to rise.

"They are all enjoying the largesse" of higher prices, said John Kilduff, an energy analyst at Fimat in New York. "And they see the global economy can handle it so far."
But actually, I think the dynamics of oil prices are much more complicated than this. Suppose that you believe that the price of oil right now includes a "risk premium". Traders are willing to pay a little more for their oil right now because they worry that in the future something bad could happen in the oil markets (a terrorist attack, civil disturbances in a major oil-producing country, etc.) which could drive oil prices up sharply. Thus today's oil prices are higher than they would be, because of this risk.

If that's the case, then OPEC putting aside some productive capacity could actually be a move on their part to try to reduce that risk premium, in an effort to keep oil prices low enough that people don't substantially change their oil consumption behavior. The CNN/Money piece mentions this possibility as well:
"Potentially, [having some reserve capacity] will take away some of the fears," said Kilduff. "This is taking a significant production cushion and putting it just offstage."

Not everyone agrees with that view.

While OPEC will no longer be pumping at full capacity, there is still little room between what the world consumes and what it is able to produce.

"We still have that fundamental issue," said Brian Hicks, co-manager of the Global Resources Fund at U.S. Global Investors. "If we had a supply disruption it would really tighten up the markets in a hurry."
Where I disagree with the CNN/Money piece is whether this means that the production cut may "come back to haunt" OPEC. I tend to think that OPEC has a lot of smart people working for it, and so I am pretty easily persuaded that OPEC's goal is not to drive prices higher, but rather to keep them low enough to discourage conservation efforts. After all, consumers in the US now seem perfectly happy to pay only $2.25 for a gallon of oil...

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