Saturday, June 11, 2011

OPEC Holds the Line, Saudis Break Rank, Prices Will Remain Elevated

With oil prices hovering around $100 a barrel for the past few months, the resulting impacts are being felt throughout the global economy. Some OPEC members have even expressed concern that rising prices could hurt demand for their product.

Crude prices rose 25 percent from January to April, while US gas prices were up 28 percent in that period. Surveys show that Americans have already cut back on their driving in response.

Since OPEC supplies about 40 percent of the world's petroleum, it has the power to impact global oil prices.

Consequently, oil importing nations were hoping that OPEC members would decide to hike oil production quotas at their meeting in Vienna on Wednesday.

But it didn't turn out the way most had hoped and expected; divided OPEC ministers decided to leave production quotas where they are at present.

Higher oil prices lead to higher prices for food and all consumer goods, and they further constrain consumer spending. Higher oil costs result in less driving and traveling for motorists in the summer months. And higher oil prices also add the enormous US trade deficit, sending billions out of the country every month.

But in a bold step, Saudi Arabia decided to act unilaterally yesterday.

The world's biggest oil exporter reportedly plans to increase production from 9.3 million barrels per day to 10 million barrels, the highest level in 30 years.

This is a critical commitment because the fighting in Libya has taken 1.3 million barrels off the world market and the unrest in Yemen and Syria has subtracted an additional 300,000 barrels.

As a consequence, the Saudis need to raise output by 1.6 million barrels per day just to match former production levels. But even that won't balance global supply with a global demand of 89 million barrels per day.

Though any production increase will be welcomed, the Saudi decision will not solve the supply/demand problem.

OPEC says that world demand will exceed supply by 1.45 million barrels per day in the third quarter. However, the U.S. Energy Information Administration puts the shortfall at 1.81 million barrels per day.

That's significant enough to keep prices well over $100 a barrel. In fact, analysts now expect oil to average $130 a barrel for the rest of this year.

The tightness in global supplies is perhaps best illustrated by the following: among the 12 OPEC members, all but Saudi Arabia, Kuwait and the United Arab Emirates are said to be at capacity.

Is it any wonder, then, that they voted to maintain the status quo? Perhaps an increase wasn't even an option for most of them.

Under current OPEC production quotas — in effect since January of 2009 — 11 of its 12 members are allowed to produce 24.85 million barrels per day.

However, many of those members simply ignore their production quotas and pumped an average of 26.18 million barrels per day in April — more than 1.3 million above the set target, according to a Platts survey of OPEC, oil industry officials and analysts released in May.

That's a sign of a weak and divided cartel. Saudi Arabia's decision to act alone, and against the wishes of their fellow cartel members, only affirms this.

Interestingly, OPEC doesn't officially count the 1.3 million additional barrels that its members are pumping above the approved target.

Saudi Arabia, OPEC's biggest producer, doesn't follow production quotas and it is the only OPEC member that has any considerable spare capacity. But even that is the subject of much suspicion.

In his 2005 book, "Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy," oil analyst Matthew Simmons questioned Saudi Arabia's ability to raise production.

After much analysis, Simmons contended that Saudi Arabia may soon begin to lose production capacity. According to his research, the Saudi oil fields have matured, leading to their inevitable decline. As a result, Simmons concluded that worldwide oil production has already peaked and could in fact be less than it was in 2005.

WikiLeaks reinforced this contention just this year when it released secret US cables revealing that a senior Saudi government oil executive warned that the kingdom's crude oil reserves may have been overstated by as much as 300 billion barrels, or nearly 40%.

This indicates that Saudi Arabia does not have enough reserves to prevent oil prices from escalating.

Saudi Arabia's total production has been estimated to be as high as 12.5 million barrels per day.

However, the executive, a geologist and former head of exploration at the Saudi oil monopoly Aramco, told the US consul general in 2007 that Aramco could not reach a 12.5 million barrel-a-day capacity. The executive also noted that as early as 2012 global oil production would hit its peak.

Almost all of the new demand growth is coming from emerging countries, such as China and India.

Last year, global energy consumption rose at the fastest pace since 1973. That's a worrisome development considering OPEC's limitations.

China increased its energy consumption by 11.2 percent, moving ahead of the United States as the world's biggest energy consumer. China accounted for 20.3 percent of global demand compared with 19 percent for the U.S.

However, most of China's energy consumption was in the form of coal. The U.S. is still the world's leading consumer of oil, using 21 percent of the world's supply, double China's consumption.

Importantly, the top suppliers to the U.S. are Canada and Mexico. But since oil has a global market, and since the size of the pie seems to be fixed, any production constraints or demand spikes affect the U.S. as much as anyone else.

What is evident is that demand is continually rising and that all of the world's oil producers, including OPEC, may be unable to meet it. In the absence of a significant rise in production, oil prices will continue to increase, unsettling the global economy even further.

Unfortunately, higher prices are the new normal.

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