OPEC Announces 1.2-mil.-b/d Output Cut; Now Must Convince Markets

OPEC ended a week of uncertainty with a firm statement of intent early Friday morning in Doha (Qatar) when the organisation announced it had agreed to cut production by 1.2 million b/d from September output levels. With OPEC claiming total production of 27.5 million b/d in the month of September (excluding Iraq), this means that official quotas will drop from 28 million b/d to 26.3 million b/d. The cut is also to be widely distributed with Saudi Arabia set to reduce output by 380,000 b/d from 1 November to 8.7 million b/d. Other OPEC members will be counted on to trim a total of 820,000 b/d of production between them, with Iran and Venezuela set to take the biggest individual hits to output at 176,000 b/d and 138,000 b/d respectively. Saudi had been talking up a 1 million b/d cut from September production levels earlier in the day, but with market reaction to this muted the Saudis pressed for a bigger than expected cut and managed to get this. The question now is whether OPEC members will comply with the new quotas or whether history will repeat itself and OPEC members over-produce. The markets appear to be betting on the latter as prices have risen in light electronic trading, but not significantly. Early today NYMEX crude was trading up just US$0.13/b at US$58.63/b, while ICE Brent was on US$59.00/b, a rise of just US$0.25/b.

OPEC Credibility on the Line

It was a messy week for OPEC. As the Saudis looked to talk prices up with suggestions of a large production cut, other members broke ranks and indicated that they were happy to continue production at current levels. Nigeria and Venezuela took unilateral, and largely symbolic, action to implement cuts on their own, but the small reductions were widely seen by the markets as an effort to cast falling output levels as voluntary cuts. With such widely divergent views within the organisation, yesterday's emergency meeting was a rare occasion where genuine discussion occurred at, rather than prior to, the formal gathering. Saudi Arabia continues to be the dominant member, but it did need to bring other members along with a widespread and deep cut if it was to defend prices at US$55/b. This has now been achieved on paper, but will it carry through to the physical supply?

Expectations of a well-observed cut are not high. While the Saudis can be counted on to trim the 380,000 b/d they have committed to, the same cannot be said for other members. Venezuela and Nigeria, although the first to announce unilateral cuts, have seen production falling for reasons other than a desire to control prices. Nigeria's troubles have forced significant shut-ins while Venezuela's failure to re-invest adequately in state producer PDVSA has hit overall output. With both countries struggling to meet previous production levels, the combined 238,000 b/d of production that the two countries are set to cut cannot be fully counted on. Iran has been producing below quota and was pressing for a cut from current quota levels rather than actual production. The aim was to bring Iran's quota in line with actual output, thereby requiring no actual output reduction. Iran's willingness to cut over 130,000 b/d of production is open to question.

With the big three after Saudi Arabia rather less reliable, the bulk of the cut will be forced on the Gulf States of Qatar, Kuwait and the United Arab Emirates. Between them they will be asked to reduce output by 236,000 b/d. Much of that can be counted on, if past history is a guide. That leaves Algeria, Libya and Indonesia. It is clear that Indonesia is not a factor, but the two North African states may ultimately hold the key to whether the OPEC cut proves successful in defending prices or not. With Gulf producers set to cut by 550,000-600,000 b/d between them, and a further 100,000 b/d counted on from Nigeria. Iran and Venezuela, the balance will be set by Libya and Algeria. The two are set to reduce output by 131,000 b/d between them, but notably this is lighter, sweet crude. In tipping an overall OPEC reduction much closer to its stated quota, compliance with the cut would also have a greater price effect given the shortage of lighter crude volumes.

History does suggest that OPEC members do over-produce when prices are relatively high. The organisation has had only limited success in defending a price floor prior to 2000. Assessing the members one by one it looks as though an actual cut of between 500,000 b/d and 800,000 b/d is possible, depending upon how committed producers are outside the Gulf to defending US$55/b. A 500,000-b/d cut would leave OPEC producing at 27 million b/d overall in November and December against a call on OPEC (according to the International Energy Agency, IEA) of just under 27.5 million b/d (excluding Iraq). This assumes current OPEC production data is accurate. This would help trim global inventories slowly, but is not likely to be enough to have a significant impact on the market. Prices may be slower to fall, but they would likely edge lower in the US$50s. A cut in excess of 800,000 b/d would see OPEC producing at somewhere between 750,000 b/d and 1 million b/d below expected demand levels. This is not unusual for the time of year, but would have a more substantive impact on depleting global inventories. Such a move would help defend prices above US$55/b over the course of the next two months and into the first quarter of 2007, but would be unlikely to send prices soaring.

Outlook and Implications

OPEC's 1.2 million b/d is a statement of intent, and the organisation is well aware that its actions now will have a major impact on its ability to control prices through 2007. A good portion of this cut can be counted on, but the ultimate success will depend on those members that were reluctant to cut in the run-up to the Doha meeting. If Saudi Arabia has convinced them that some pain now will have beneficial effects, then OPEC's move will help to support prices at the apparently desired level of US$60/b for WTI. If the organisation reverts to type and over-produces, prices will continue falling through the fourth quarter and into the first of next year. What should be expected is something of a compromise – an actual cut of approximately 800,000 b/d. This will help to solidify prices, but given current inventory levels the drawdown will be slow. The wild card is how severe the northern hemisphere winter is. A mild winter will put more pressure on OPEC to cut again when its members meet in December.