RGE: As anticipated, OPEC cut production in its October 24 Meeting. OPEC agreed to reduce production from its output ceiling by 1.5 million barrels a day from where it is currently set at 28.8 barrels a day. OPEC has been producing well over this quota for much of the summer and fall - so the reduction could be even larger. However as suggested in the piece below, written Oct 23, the prospect of even weaker demand as the economic climate worsens and the effects of wealth losses sink in, continued to push oil, other commodities and global equities downward. However now reduced demand and financial panic are pointing in the same direction - a lower oil price. We could see prices in the mid-$50s over the next few weeks, even if oil rebounds as it seems now to be doing.
However, first off, we will see how OPEC members implement the cuts - Saudi Arabia is responsible for about 1/3 of the cuts - 466,000 barrels a day, Iran 199,000 and UAE and Kuwait about 130,000.
The farther the oil price falls the greater the likelihood OPEC members might cheat on their quotas to maximize revenues as occurred in the 80s and 90s. Deeper production cuts might be needed for a real price increase which would be difficult for producers and an oil price much higher than current levels could exacerbate the economic crisis and delay the expansion and thus demand for its commodity.
There are no shortage of uncertainties pervading the market - uncertainties specific to the oil market include - how much demand has been destroyed and how OPEC members would react to persistently lower prices. The downward trend of oil prices (and those of most commodities) has been pretty unstoppable since investors finally realized that $147/barrel was too expensive in the face of a global recession. The belated recognition that this was a global and not a US centered crisis contributed to the initial turnaround and the escalation of the credit crisis has been marked by major losses in equity and commodity markets - and increased volatility. With credit markets still relatively frozen and the macro costs of the financial crisis still ahead, the outlook is gloomy for oil demand. And as mentioned before, it doesn’t take much of a reduction in demand, to trigger a big correction, especially when uncertainty abounds in global financial markets. With frequent news of foreclosures, flailing hedge funds, its no surprise that few want to take a risk in holding commodities.
The price for a barrel of OPEC crude is sitting at just over $60 a barrel - WTI is not much above $70. Some OPEC members have already suggested that the market may be oversupplied by as much as 2 million barrels a day.
OPEC faces several challenges 1) they don’t want to be blamed for exacerbating economic weakness 2) they want to maximize their revenues 3) they don’t want to overly encourage alternatives to oil or competition from non-OPEC suppliers. However, their biggest concern may be the continued panic in financial markets and mounting demand losses
Given the likely macro effects of the persistent freezing of the credit markets, economic output will continue to slow – and so should demand for hydrocarbons. Even if at a certain price point demand might rebound somewhat, particularly if the current surplus is removed.
The real wild card on the demand side is China. China accounts for the largest demand growth now and in the last five years. Its demand for oil is unlikely to follow the same large increases it experienced in recent years – meaning that its demand growth will fail to offset OECD reductions. The slowing of the Chinese economy and reduction in its imports of several commodities over the third quarter have confirmed the end of the current commodity super boom, if not the whole post 2003 boom. Already aluminum is piling up and inventories of several metals are on the rise. The question is whether this trend is temporary – ie how strong will Chinese demand be after some of the existing inventories are absorbed.
However, China’s torrid pace of commodity absorption is unlikely to return immediately– in part because it is trying to shift its economic sources of growth. However China’s fiscal stimulus will be partly channeled into infrastructure spending including to the railways and the construction sector, which could put a floor in prices – yet the expectations of Chinese demand growth that pervaded last year – and were a major justification for skyrocketing prices – seem overly optimistic in an environment where a figure like Gerald Lyons can suggest that China’s growth could slow to 4% next year. This may be overly bearish, but even at 7-8% growth, China will likely consume fewer commodities. and the combination of forces that led to the 2008 oil price boom seem unlikely to be repeated any time soon.
Many articles have been written over the last weeks about the reliance of OPEC countries (and some non-OPEC oil exporters) on higher oil prices which is likely adding to their concerns. Clearly they have gotten used to higher oil prices and on average budgets balance around 55-60 a barrel. Of course OPEC can’t just wish for higher prices and there is a risk that if prices keep dropping some OPEC members might break ranks and pump more (shades of the 1980s pricing conflicts).
There is a lot of uncertainty about the break-even points of some of these governments but a look at the range gives an indication of their respective “pain thresholds” to quote Russian Finance minister Kudrin. GCC countries prompt the most uncertainty. In fact estimates of Saudi Arabia’s breakeven point range from $30 a barrel to almost $60 a barrel. Its probably somewhere in the $45-50/barrel range. Estimates for the UAE also vary depending on whether one focuses solely on the rather small UAE federal budget or the broader spending that is directly or indirectly financed from oil revenues or the associated inflows. Bahrain and Oman, which have limited or declining oil output, have the highest breakeven prices – at or above $70 a barrel.
Even Libya and Algeria which had been relatively conservative now apparently have break even points at $45 and $54 a barrel respectively. And Nigeria recently scaled back its oil estimate for 2009 to $45 a barrel from the previously planned $62.5.
All of these countries have either saved a significant portion of their windfall – even Nigeria – or have almost eliminated government debt – providing them with some cushion. But lower oil prices may mean that their sovereign funds are called on for their stabilization and not investment objective. These funds are already being called on to invest more at home in the short-term and their savings or at least generated income could be tapped to finance next years consumption.
Iran and Venezuela likely have the highest breakeven points of OPEC members – as high as $90 a barrel for Iran. (Iraq which may need $100 a barrel according to some estimates, is not bound by OPEC quotas). Iran has a presidential election next year. (These 3 countries are most fragile. To me, a last ditch strategy might be to just go to war if you cannot balance the budget. War or creating uncertainty will give rise to a hike in oil prices. Its a simple strategy but one which has been employed more times than you think when economics-politics-oil are mixed in.)
Outside of OPEC, Russia and Kazakhstan may be most vulnerable in part because their accumulated savings are being used to shore up their domestic banking and construction sector. Their banks (and other corporations) borrowed abroad cheaply - net borrowings by Russian corporations start to make the rapidly shrinking savings of Russia's central bank seem small ($515 billion in reserves compared to $460 billion in private borrowing). Russia’s current spending requires about $72 a barrel. (Even Russia is not beyond using their military might to drive oil price higher, beware. Hence the key moving forward could be a huge carrot for the destabilised nations to wage war unnecessarily to boost oil prices. The longer the global slowdown continues and the longer we have weak oil prices, the higher the propensity for these nations to try "things".)
These numbers indicate two things 1) OPEC’s determination to stem the tide of oil price decrease may be great 2) the rate of growth of oil wealth abroad may slow sharply next year as the levels at which these countries run current account surpluses is not so far away from where their fiscal spending balances.
Ultimately, Saudi Arabia still is the key one to watch. As OPEC largest producer by far, it is likely to bear the brunt of most cuts and already has pulled back most of the additional supplies it added this summer. It has been reluctant to sign on to cuts advocated by more ‘hawkish members’ like Iran.
Another country to watch is Russia. Russia has been talking more about cooperating with OPEC, being involved in discussions etc. While it might not join OPEC it will be interesting to watch if Russia matches any OPEC cuts. Already Russian oil output is down this year and new production has been delayed to come online. . Meanwhile earlier this week, Russia joined Qatar and Iran in calling for an “OPEC for gas”– a reversal from its past desires to have a looser grouping but it may be a desire to secure a place at the table for any coordination. But it is certainly something that raises concerns among Russia’s consumers in Europe. Yet so far, natural gas is still not commodified like oil.
So the real test of the cartel is ahead. especially since asset markets have a tendency to overshoot.
However, the combination of lower demand and credit contraction may sow the seeds for higher prices ahead, even if they are not as high some of the trends seen earlier this year.
The lack of financing and uncertainty about the oil price outlook might defer energy exploration for now, though companies with cash may be able to snap up assets at cheap prices. The lack of financing may freeze deals in progress, though it will privilege investors that have cash even if they wish to hold out until it is clear where the bottom is in the oil market. With oil (and other energy commodities like Coal and natural gas) still on a downward trajectory investors may want to avoid locking in too high an implicit price.
At this point there are still many uncertainties in the financial markets for major moves – we may well see delays and deferrals especially of expensive oil sources like unconventional sources which may need a price above $80 a barrel to break even.
In fact the combination of low or negative real interest rates, credit shortage and a cheaper and possibly declining oil price may defer energy investment for some time, possibly pushing the arrival date of new supplies further into the future. Companies may prefer to invest later when they hope to get higher returns on their investments. This could contribute to a rebound in oil prices after growth restarts in a year or two.
But much will happen between now and then and for now, the downward trend could continue. And that may be something that scares OPEC even if falling commodity prices are one of the few positive signs in the global economy – the current account and fiscal positions of several emerging markets like India are improving.
The one saving grace for OPEC members – at least their petro”dollars” are worth more even if they are now getting fewer of them.
p/s photo: Daphne Iking
