OPEC Output Cut Seen as Key to Oil Prices in 2007

NEW YORK Jan 02, 2007 (Dow Jones Newswires)

For oil traders returning to trading pits on Wednesday, the new year begins with something that hasn't preoccupied them in years: OPEC production cuts.

After years of maintaining an open-taps policy, the Organization of the Petroleum Exporting Countries has started restraining production to keep oil prices high in the face of a faltering global economy and an unseasonably warm winter in the Northern Hemisphere.

With a military confrontation with Iran and other geopolitical concerns receding to the back burner, analysts say the extent to which OPEC complies with its output restraint will go a long way in determining whether oil prices stay above $60 a barrel this year after ending last year flat for the first time in five years.

"This is the first time in years that OPEC compliance will be a big story," said Peter Beutel, president of trading advisory firm Cameron Hanover in New Canaan, Conn.

For much of the last five years, OPEC members pumped all they could as rapidly rising world oil demand and geopolitical worries - from the war in Iraq to the nuclear dispute with Iran - lifted oil prices from below $20 to a record high of more than $78 last summer. But as prices tumbled below $60 following a quiet Atlantic hurricane season and swelling U.S. oil inventories, OPEC moved to cut production for the first time in two years.

OPEC's first production cut, of 1.2 million barrels a day, went into effect Nov. 1. The second cut of half a million barrels a day is due to take effect in February.

OPEC says it has cut output by as much as 1 million barrels a day and remains committed to implementing the second cut. But analysts believe that compliance from OPEC nations that are dependent on oil revenues has been less impressive, with only 700,000 barrels a day to 800,000 barrels a day cut thus far. As a result, OPEC may have to cut output further to keep prices above $60.00 a barrel, which some OPEC members say is crucial to their economies.

With oil demand slowing in the face of sluggish global economic growth, it is "increasingly likely that additional OPEC production cuts will be required during 2007 to avert a further slide in the oil price," Deutsche Bank said in a recent research note.

Compliance Closely Watched

Compliance with those cuts will be closely watched by the market during the first quarter, said Tony Rosado of floor brokers MW Futures in New York.

"There are a lot of bears out there, and if they don't see cuts being made, the market is going to head lower," Rosado said.

Not that OPEC output cuts haven't worked in the past. Deutsche Bank studied the response of oil prices to the 10 OPEC production quota reductions between 1993 and 2004 and found that OPEC has had a 70% success rate of defending or pushing prices higher during a three-month window. On the two occasions OPEC cuts did not prove effective, in 1998 and 2001, the bank concluded, the cartel did not cut output fast enough in the face of global economic growth falling below 3%.

With global economic growth expected at 4% this year, "OPEC is in a strong position to defend the oil price via production cuts," Deutsche Bank said.

Nevertheless, the bank expects oil prices to average $62.00 a barrel this year, down from an average of more than $66.00 a barrel in 2006.

While bulls such as Goldman Sachs see the return of $70-plus oil this year, most analysts are looking for flat to lower prices.

"Right now, I don't think records are in the cards," said Mike Zarembski, an analyst at Chicago-based retail brokerage Xpresstrade. "Barring any kind of military confrontation, prices will stay in the $60 to $70 range through most of 2007."

That is not to say prices won't jump to new highs if any one of the oil producers experiences a major supply disruption. But analysts say supply and demand forces appear to have reasserted themselves for the first time in years, with consumers reining in demand and producers, including non-OPEC members, increasing output in response to higher prices.

"Basically, what we've done is we've returned to a more typical crude oil market where prices are dependent on OPEC restraint for support," said Tim Evans, an energy analyst at Citigroup in New York.

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