Expect OPEC to Cut Production

In the past, OPEC's production decisions have often failed to influence prices. Many have opined that OPEC's policies were aimed at price manipulation. My belief is that OPEC's decisions have had more to do with keeping production at levels where supply matched demand to protect against price declines through over-supply.

This time is different.

OPEC has a hard job - on the one hand, cutting production too deep will lead to price increases which will ultimately cause demand destruction. On the other hand, not cutting production allows prices to fall to levels which will cause under-investment and major price escalation and demand destruction in the future.

The president of OPEC has already indicated that cuts will be deep; deeper than the market expects. The aim is to remove supply to an extent that will surprise the market. Why then inform markets of a surprise ahead of the intent? I believe the intent is to gain an insight into market expectations; and then cut marginally ahead of those expectations! Or else, it is to prepare the market so the impact of the shock is spread over a week instead of a day.

My view is that OPEC will have learned from the last downturn when it failed to cut production and the result was oil priced cheaper than mineral water. This time OPEC will cut deep. It will force a sharp draw down of inventory. OPEC will not supply cheap oil to build and maintain inventory levels; instead production cuts will force a sharp draw down of inventory. Once inventory is down, prices will rise and at that stage enhancing production to allow inventory to return to normal levels will make sense.

In the immediate term, energy prices may decline as inventories are drawn down and non OPEC oil is used in an attempt to break OPEC. Short term, it is likely that oil prices will escalate once more. Oil trading needs strong regulatory over-sight, otherwise price levels will rise on rampant speculation once again; this can derail prospects for recovery from amongst the longest recessions in US history - it could be the straw which breaks the camel's back.

To price oil, there is demand which comes from users, and supply which comes from producers; there need be nothing more. Demand is created by users with a desire together with the willingness and ability to pay. Similarly, supply is created by producers willing and able to deliver at a price. A supplier will never increase supply if the price for that unit of supply falls below the cost of production of that additional unit; to do so would be an economically irrational decision. The equilibrium price is what the user is willing to and able pay the producer for that last additional unit of production; it is the point where marginal revenue equals marginal cost; this is where the price of oil must be and it is my belief that a reasonable estimate of the marginal cost of production is $60.

Oil needs to be priced rationally; in my view a price substantially below $60 means the needs of future generations will not be met. A price substantially above $60 is damaging to the present generation.

Why then are bubbles created? When oil prices were at $147, I wondered how speculation could occur without an inventory build by hoarders; everything produced was getting consumed at the price without an inventory build, so speculation seemed unlikely.

Here is how I think it works. This bubble was created because the relationship between users and producers became obscured. In the very short term, because demand destruction takes time, a user's "willingness & ability" to pay can exceed the producer's marginal cost of production. This spread between user willingness and ability to pay and the marginal cost of production creates an arbitrage opportunity. It is fairly easy to exploit the arbitrage opportunity through the futures market in a manner which allows today's production to continue at capacity with no inventory build up. The only problem is that real users end up paying tomorrow's potential prices today.

As long as demand continues to grow as expected by financial investors, everyone is happy. But once prices go above that user "willingness & ability" to pay, future demand falls as demand destruction occurs. The last financial investor owning the futures instrument holds "the can" as the cookie crumbles. And prices rapidly fall back towards marginal cost of production; then prices fall below the marginal cost of production as losses are limited by the can holder. Then the producer response occurs and we have come a full circle. All this occurs because the user and producer relationship has been obscured by intermediaries and arbitrageurs.

The futures market has an incredibly important role to play. It allows better pricing and provides producers and users information which will permit both better planning. However, when the market is distorted by a chain of financial investors with no underlying demand for the physical commodity, things start to go wrong. In truth, the futures market should reduce volatility; in fact, since it has obscured the relationship between users and producers, it has enhanced volatility and economic risks. This market should not be abandoned, but I believe it requires strict regulatory over-sight; it should be a market operational only for parties with real demand for the physical commodity.

Comments

[Pipo:]

Oil had its Biggest weekly drop since the Persian Gulf War in 1991. Is a short covering rally ust around the corner?

www.oiltradersblog.blo...

2008 Dec 07 11:49 AM

[yank:]

Agree with author. We will see a 2 million bbl cut on the 17th. More importantly OPEC leaders will "read the riot act" to its members. They will underscore the imperative not to cheat on quotas. I think everybody from Iran to Venezuela now knows that quota cheating simply results in lower oil prices. They have now figured out that they have to accept temporary pain now (lower oil revenues) in order to support prices. Let' s see if they actually follow through. Should be interesting.

2008 Dec 07 12:13 PM

[eric2802000:]

we will see a huge short covering rally that might last for weeks. it may not be obvious at first but it's pretty much a sure thing

2008 Dec 07 02:00 PM

[smurphny:]

OPEC will "announce" cuts that never happen. and that no one who matters takes seriously...as usual. The price of crude will fluctuate a little and then continue on down because anyone who trades this commodity KNOWS OPEC is too diverse, political, and dysfunctional. Sell oil plays on this rumor (probably tomorrow) because oil is still rapidly heading south to the $20s before finally stabilizing at about $45 IMO.

2008 Dec 07 03:45 PM

[doubleguns:]

There is no honour among thieves. At these prices the thieves in the mix will sell thier grandmothers oil to make a buck. They have to eat today to stay in power and avoid riots etc.; to keep thier necks out of the noose. They will cheat every chance they get and prices will head south. Only an increase in demand will save them and that has been crushed, with thier help I might add. Those that do cut production will have oil at a later date while those thieves selling now are just depleting thier assets faster and cheaper. Kinda puts a smile on my face.

2008 Dec 07 04:12 PM

[doubleguns:]

There is no honour among thieves. At these prices the thieves in the mix will sell thier grandmothers oil to make a buck. They have to eat today to stay in power and avoid riots etc.; to keep thier necks out of the noose. They will cheat every chance they get and prices will head south. Only an increase in demand will save them and that has been crushed, with thier help I might add. Those that do cut production will have oil at a later date while those thieves selling now are just depleting thier assets faster and cheaper. Kinda puts a smile on my face.

2008 Dec 07 04:12 PM

[Greg Pinelli:]

Saudi Aarabia and Kuwait are the only swing producers that matter..and they win no matter what the announced cut is or whether any of the other OPEC members cheat or not...
IF a 2 mbd cut is announced an adhered to by all (you would have better luck finding a 25 year old virgin on the Las Vegas strip) the price moves up (a $5-6 pop..nothing more) and the Saudis/Kuwaitis bring home a little more cash...that $47 price does little to help the Iranians or anyone else..
IF the Iranians and all the other neer do wells cheat (imagine that!) and oil stays at the current level for several more months even better for the Saudis...they can survive quite well at this price while the Iranians sell precious product and barely survive.
NOW..heres the outcome..Come May/June the massive liquidity being piled up works its way into world economies..the price of oil goes to $60-70..VERY LIKELY..there has been no new product development and the Irans..Venezuelans..et... have made NO real profit todevlop reserves and rebuild infrastructure to provide product..The Saudis/Kuwaitis control the last barrel (the marginal barrel)..which is god's gift to those who have but don't need.....voila!
Everyone whose talking trash about $25 oil looks even more stupid than they are....and the chump players in this game come begging with hat in hand for money to do waht they never have..invest in their reserve bases.

2008 Dec 07 06:14 PM

[Steven Hansen:]

"The futures market ..... should be a market operational only for parties with real demand for the physical commodity."

i agree it would have prevented the last bubble - but take an additional step. if you take an additional step of not allowing re-selling of the futures contracts, and requiring the holder of the contract to take physical delivery - it eliminates speculators period. even oil company speculation is diminished.

all oil is not sold on the open markets, the solutions are complex.

2008 Dec 07 07:14 PM

[samerca:]

not as informed as most on these boards so a quick question--I've been curious, what would a dollar collapse/depreciation do to the $ price of oil? Thanks.

2008 Dec 07 10:55 PM

[NOWHEREMAN:]

Samerca: IMO,

As oil rises the dollar will drop not the other way around, the other developed industrialized nations are not as dependent on oil as we are.

The Saudi's, Kuwait and Russia are the swing producers. Russia, Iran and Qatar produce some 60% of the worlds Natural Gas and are in talks to create their own mini-cartel for NG.

Sometime within the next 3 months, Iran will activate the first Nuclear Reactor in the Arab world. They will literally be the Power to deal with in the Gulf States after this activation.

The analyst who made the $25 oil prediction stated in a CNBC interview that it presuppossed a condition which he did not believe would occur. It was a worst case scenario which required a worldwide negative GDP and which assumed a negative GDP in China and India as well. As an analyst, he said he felt a worst case scenario was justified with the current economic conditions.

The Media took it out of context.

A recent energy association study concluded that currently producing oil fields were being depleted at an annual rate of 6.7%. This translates into 5 million barrels daily if production rates are not curtailed. This is a supply issue. It doesn't matter whether demand for it materializes now or later. Supply is depleted even as oversupply is created driving the price down. An additional cut of around 3-4 million barrels is needed to offset this annual depletion in worldwide supplies.

At this point in time, the dollars strength is hurting the purchasing power of the Asean Zone. Meanwhile, Recssions in the developed world are hurting Asian exports as well. They can purchase less with their own currencies and are unable to sell what they produce even if they can sell for less than other developed world producers.

IMHO, the only thing which can counter the deflationary spiral in progress is a large inflationary dose in the form of oil which would affect all aspects of our economy.

2008 Dec 08 01:24 AM

[Shiv Kapoor:]

Conventional wisdom says that when a fiat currency devalues, commodities tend to outperform. A fiat currency is backed not by hard assets but by the full faith of a nation. When the full faith becomes suspect, people flee the currency for hard assets capable of generation of future cash flows and so commodities tend to outperform. But in my view, playing commodities as a financial hedge against a $ is a past story; play it on fundamentals, for those are strong.

One reason for falling full faith is rising deficits. As it happens, US deficits are now reaching record levels; excluding 1944-1951 (WW2 impact), when the US deficit peaked at nearly 120% of real GDP, we will be at all time highs.

Now remember, the market is forward looking. Oil prices traded at irrational levels as the $ weakened in response to a rising deficit expectation. I feel the deficit will rise further throughout 2009. But now it has reached levels from where the expectations will lean towards falling deficits over time - particularly in an Obama government. So $ should remain firm and strengthen - this does not mean commodities will fall in value; all it means is the reason for rising commodities will not include a falling $!


On Dec 07 10:55 PM samerca wrote:

> not as informed as most on these boards so a quick question--I've
> been curious, what would a dollar collapse/depreciation do to the
> $ price of oil? Thanks.

2008 Dec 08 01:31 AM

[Ferdinand E...:]

Really good article and very good comments. Of course, the contention about the futures market was wrong. That market is NOT distorted by financial speculators who - quite simply - are gambling on the futures market rather than places on the Strip that someone mentioned. Without those speculators there might not be enough liquidity to allow producers and consumers to hedge the oil price. And as for the statement about the futures market being reserved for transactors in physical oil, no no no.......

2008 Dec 08 10:25 AM

[Steven Ward:]

Saudi's have 2 fields comming on stream with a total of 45 billion barrels. Not easy to cut back. Politically, the Saudis want to push the Iranians to the wall.

I'll go with smurphy right now. Georealist maybe in 18 months.

2008 Dec 08 01:51 PM

[User 232593:]

the saudis are opec.they will control the situation only for their own benefit.they are now investing in solar power to sell electricity.who has more sun than their desert?

2008 Dec 08 03:41 PM

[PatientInve...:]

Thank you for the very informative article. I am also wondering why OPEC is telegraphing a large upcoming production cut. Could it really be a game changer?

2008 Dec 08 08:08 PM

[Shiv Kapoor:]

I sort of agree with you; but in my view everyone except for the user & producer is a speculator. Essentially, a financial investor projects future demand; he speculates on what might be required tomorrow. But you are very right in pointing out that without financial investors it would get difficult to hedge positions.

Excess liquidity from financial investors is what drove oil prices up. Demand & Supply play a key role but when future demand expectation is unrealistic, the price rise (& subsequent fall) is damaging. I think the whole derivative space needs regulation so that risks undertaken by financial investors is responsible in the context of their capital. I think a financial investor transacting with a producer or with a user is fine; but for a financial investor to have a counter party who has no interest in the physical commodity is dangerous.


On Dec 08 10:25 AM Fred Banks wrote:

> Really good article and very good comments. Of course, the contention
> about the futures market was wrong. That market is NOT distorted
> by financial speculators who - quite simply - are gambling on the
> futures market rather than places on the Strip that someone mentioned.
> Without those speculators there might not be enough liquidity to
> allow producers and consumers to hedge the oil price. And as for
> the statement about the futures market being reserved for transactors
> in physical oil, no no no.......

2008 Dec 09 11:28 AM