Weekly Offshore Rig Review: OPEC's Big Flex

With its output cuts over the last six month and its meeting this week, OPEC has been doing much to affect the price of oil around the world lately.

Climbing Prices
As is obvious to even the most casual industry observer, oil prices have climbed steadily and consistently over the last five years. In February 2002, NYMEX light crude oil futures traded at just just over $20. By two years later, in February 2004, that average trading price had risen almost 70% to $34.25 and was just warming up. Through the next twelve months, the average monthly NYMEX light crude oil price rose another $14 to $48.26 in February 2005. That was the last month where NYMEX crude averaged less then $50 per barrel.

Through the summer of 2005, crude prices continued to rise, peaking at an average monthly price of $65.55 in September when Hurricanes Katrina and Rita pounded the US Gulf Coast. Thanks in part to OPEC assurances, crude prices subsided in the latter months of 2005, dipping back into the upper $50 range before the end of the year.

2006 saw prices jump back up and then rise to new levels that were sustained for months on end. From April thru August 2006, NYMEX crude oil prices averaged over $70 per barrel based largely on supply concerns related to Iran's uranium enrichment and subsequent stand-off with western nations. As 2006 drew into the third quarter, it quickly became apparent that oil stocks had grown significantly and that demand appeared to be cooling slightly. These two factors eased supply concerns and helped to bring oil prices down nearly 20% from their July peak.

OPEC Can't Slow the Climb
One of the key realizations that comes out of this look at climbing oil prices is that OPEC can do very little to stop, or even slow, rising oil prices. In fact, when prices reached all-time highs in 2006, OPEC officially did nothing at all (although its individual member nations were very much involved in generating the tensions that drove those new records).

Even in times of crisis, particularly in the aftermath of the 2005 hurricanes, OPEC was essentially helpless to affect the rising oil prices around the globe. Saudi Arabia's offers to pump all available crude to meet demand and cover for damaged infrastructure in the US GOM helped to soothe nerves. However, the organization ultimately made only modest increases in production that in and of themselves had little impact on prices.

What is also apparent is that OPEC nations quickly grew used to the increased price levels and became ready to defend price levels that just a few years earlier had seemed unsustainable. For instance, when the average NYMEX crude price dipped $3 (almost 10%) between August and September 2003, OPEC was quick to announce output cuts of nearly 1 million bpd. In February 2004, OPEC announced a further 1 million bpd cut even though oil prices had risen each of the previous four months and had been well above the $28 price threshold for more than two months (more about the price band below).

Useless Price Band
As part of its response to the oil price collapse of 1997-98, OPEC took steps to create clear guidelines for when production adjustments should be made in order to try to offset changes in the market. At its March 2000 meeting, OPEC set up a price band mechanism, triggered by the OPEC basket price. According to the price band mechanism, OPEC basket prices above $28 per barrel for 20 consecutive trading days would result in production increases. Prices below $22 per barrel for 10 consecutive trading days would result in production decreases in order to maintain prices within the band. This adjustment was originally automatic, but OPEC members changed this so that they could make production adjustments at their discretion.

Since its inception, the price band mechanism was activated only once. On October 31, 2000, OPEC activated the mechanism to increase aggregate OPEC production quotas by 500,000 barrels per day.

Since December 2, 2003, when the OPEC basket price crossed the $28 per barrel threshold, the OPEC basket price has traded above that threshold for well over 800 consecutive trading days. Apparently recognizing the futility of the unused price band, OPEC decided to temporarily suspend the price band mechanism at its January 30, 2005 meeting.

OPEC's Current Moves
In the last six months, OPEC has flexed its muscles once again and shown that while it cannot (and apparently has no desire to) influences oil prices downward, it can push them up. As mentioned above, during the third quarter of 2006, oil prices began to fall as the Lebanon-Israel conflict cooled and oil inventories built. In fact, oil inventories of the world's leading economies had built to their largest levels in nearly 10 years, and had grown larger than the levels reached before the halving of oil prices in 1997-98. This prompted an immediate reaction from OPEC, even though NYMEX oil futures were still trading well above $60 per barrel. With a series of two cuts totaling 1.7 million barrels, OPEC tightened the taps and has been able to dry up much of the excess inventory and push prices back up. After dipping momentarily below $50 per barrel in January, NYMEX prices are back up near the $60 mark.

When looking at the numbers behind these cuts, it is easy to see the reasoning of the OPEC members. A 1.7 million barrel reduction in OPEC production quotas was expected to result in about 50 to 75% compliance, thus producing an actual decrease of 850,000 to 1.2 million barrels per day. A decrease on the order of 1 million barrels of oil per day is generally expected to result in about a $10 increase in the price of oil. In total, OPEC members have increased their overall revenue by approximately $260 million per day ($10 increase times 26 mmbopd) by sacrificing about $60 million in revenue per day (1 mmbopd times $60/bbl) resulting in a net increase of $200 million per day.

If the market would sustain higher prices, OPEC would likely try to tighten the flow of oil further and increase revenues even higher. However, the world economy has shown some signs of weakness, with large drops in stock indices around the globe being just one of the more noticable signs. So, OPEC likely does not want to try to push prices any further for fear of a recession that would cause damage to world oil demand. At price levels near $60, OPEC is in well tested territory where prices are high, but consumers are still willing to buy.

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Brent Crude Oil : $54.94/BBL 0.88%
Light Crude Oil : $51.79/BBL 0.21%
Natural Gas : $3.65/MMBtu 6.10%
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