February 12, 2004, 8:39 a.m.
Take OPEC’s Word on It?
What the cartel says is not what the cartel does.

OPEC ministers concluded their meeting on February 10 by agreeing to reduce production quotas by 1 million barrels a day to 23.5 million barrels, effective April 1. They also agreed to do a better job of adhering to quotas. In response, spot crude prices rose by $1.04 to $44.87 a barrel.

So now, after four years of high oil process, a period during which prices hovered within OPEC's targeted band much of the time, OPEC has credibility. OPEC ministers can say things and make the oil price rise even without taking any action.

It was the same case last December when oil ministers took no action on quotas, production, or even the ceremonial election of a secretary general, but merely mentioned that the dollar was weak, thus justifying a higher oil price. Speculators followed by promptly bidding prices higher.

But let's be clear about what's going on. OPEC has had a simple and straightforward message: It wants oil prices to stay high (at least for now). The question is: Will OPEC take action when it is required?

Most barrel counters agree that OPEC production has increased modestly since last July, even though production quotas were lowered in November by 1 million barrels a day to 24.5 million barrels. January production is estimated to be as much as 1.7 million barrels above quota, with every OPEC member cheating except Indonesia, which has been unable to reach quota for several years, and Venezuela, which still suffers from the effects of the 2002-03 oil-workers' strike.

So, OPEC members would have to cut production by 2.6 to 2.7 million barrels a day to be compliant with the new April quota. But why should anyone expect OPEC to abide by new, lower quotas when it ignores existing output restrictions?

One could argue that quotas are irrelevant and that OPEC is doing a good job of keeping oil prices high — even if by hap and circumstance. Truth be told, there is little incentive to produce within a quota today. Oil prices are already high. A production cutback might drive prices to levels that could harm economic growth and, consequently, reduce oil demand. Higher oil prices could anger oil-importing nations such as the U.S., Germany, Japan, and China. Also, why give up market share now when OPEC nations know that inevitably they will have to make room for higher Iraqi output?

But the true test for OPEC will come in the second quarter, when oil demand declines seasonally. Typically, the fall in world oil consumption between the beginning and middle of the year is about 2 to 2.5 million barrels a day. Also, Iraq is expected to resume exports through Turkey in the second quarter, which could lift that country's output by as much as 800,000 barrels a day.

If oil supply, demand, and inventory estimates are correct (a very big "if"), then OPEC faces a difficult task ahead. April looks to be too late for OPEC to start the cuts in quotas and production. Under normal conditions, production curtailments take at least one month to put in place, and transport time to move oil from producer to customer takes between one and two months. During this period inventories would be expected to build at a rapid pace.

The delay in instituting lower quotas appears to be a function of two things: reluctance on the part of OPEC to give up volumes and revenues, and confusion about the uncertainties influencing supply, demand, and inventories. The figures for these last three variables are notoriously inaccurate and estimates change frequently.

But the gap between supply and demand remains large enough that even errors within a normal range point to pressures building on oil prices. A price correction seems set for the second quarter.

— Frederick P. Leuffer, CFA, is senior managing director and senior energy analyst for Bear Stearns & Co. Inc.

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