How quickly things can change. In June, oil prices were spiralling up to a peak of $147 a barrel and speculation was mounting that $200 a barrel was not far off. The world’s major oil-consuming countries put intense pressure on oil producers to make a rapid and substantial increase in output from Opec to calm prices.

Riyadh responded by holding an emergency meeting of producers and consumers in Jeddah in June, and agreed to increase its oil production by 500,000 barrels a day (b/d) over two months. This came on the back of wider plans to boost its production capacity to a total of 12.5 million b/d by 2009.

However, in the past few weeks, these arguments have been turned on their head, as the price of oil has fallen sharply. In an effort to hold up prices, Opec decided on 9 September to cut production by an estimated 520,000 b/d. Output limits agreed a year ago would be reimposed and members were told that they must be strictly adhered to.

Even so, on 10 September, the price of the European standard Brent Crude dipped below $100 a barrel for the first time since 24 March, closing at $98.97 a barrel. On news of Lehman Brothers filing for bankruptcy and the takeover of Merrill Lynch, it fell further on 15 September to $93.75, while West Texas Intermediate, the US benchmark, fell to $96.31.

Swing producer

The turnaround says much about the reasons for the output increase earlier in the year. At the time, the word’s major oil consumers insisted that Opec should increase production to bring the market back into balance.

At the time, Saudi Petroleum & Mineral Resources Minister Ali al-Naimi argued against the increases, insisting that supply and demand were already adequately balanced, and that the reason for the inflated prices was speculation.

Riyadh was right. The dramatic rise in oil prices in the first few months of the year ran contrary to basic market principles. Under the normal rules of supply and demand, a declining dollar would be interpreted as a sign of US economic weakness, signalling a likely fall in oil demand.

As the largest oil consumer in the world, falling demand in the US should have had a deflationary impact on prices. Any increase in output should have done the same. But even as the dollar fell and Riyadh pledged to add more production, prices continued to climb.

The reason was a combination of the way investors reacted to the falling dollar and the sentiment that was driving oil prices. As the dollar fell, traders began to turn to commodities, chiefly oil, as an alternative investment, pushing up prices. “Debt was offering terrible returns,” says David Kirsch, manager of the market intelligence service at US-based PFC Energy. “And so were equities, so commodities became attractive.”

The reversal of this process as the dollar has started to recover has meant the unravelling of many of these investments. “The financial players who were putting money into the oil market are now taking it out,” says Kirsch. “There has been a dramatic unwinding [of oil market positions] on the Nymex [New York Mercantile Exchange], and a shift from futures to options that has taken the pressure off prices.”

Not everyone agrees that the slowdown of trading in oil futures is the principal reason for the rapid fall in prices. “There has been a reduction in interest on the futures market, but it started long before prices started to come down,” says David Fife, oil analyst at the International Energy Agency, which represents the interests of the world’s major oil consumers. “There has been a sell-off, but it was not the primary driver [behind the fall in prices].”

The balance of opinion, however, is that the huge rise in such trades in the first half of the year played a substantial role in artificially inflating the oil price. As such, Riyadh’s contention that speculation was the main reason for high prices has been borne out.

“It is difficult to find an argument against Riyadh being right,” says one London-based oil analyst. “There is evidence that it was the funds flowing in to the market that caused prices to rise so far. And there is still a downside risk as funds flow out during the rest of the year.”

The other reason for the market behaving contrary to basic principles was sentiment. “There was a very bullish sentiment in the early part of the year and the market ignored some bearish signals,” says Kirsch. “The psychology changed in early July and [the market] started to focus on the bearish side.”

Just as traders in the early part of the year were absorbed by the risk of there not being enough supply, now they are obsessed with weakening demand. This is happening even though there have been additional risks to US oil supplies from a series of hurricanes in the Gulf of Mexico.

“Regardless of what is going on on the supply side, it is the demand picture that people are focusing on,” says Erik Kreil, an oil analyst at the US’ Energy Information Administration. “People are fixated on negative demand news. The loss of 1 million b/d [due to hurricanes Gustav and Ike] has not fazed the market as it would have done a few months ago.”

Barclays Capital predicts demand among members of the Organisation for Economic Co-operation & Development (OECD), a club of 30 mainly rich countries, will fall by 850,000 b/d this year. OECD demand is expected to drop by a further 130,000 b/d in 2009, as the impact of high food and fuel prices takes effect.

While analysts agree that non-OECD demand will continue to rise, the marginal increase will drop from 1.4 million b/d in 2008 to 1.16 million b/d in 2009, according to Barclays Capital.

“There has been a realisation that the slowdown in US economic performance will last longer than expected, and people are looking at the potential for demand destruction in the OECD that food and fuel inflation are bringing about,” says Kirsch. “But it is the notion that [inflation] is threatening demand growth in China and other emerging markets that has really spooked the oil market.”

Increasing supply

Supply growth from non-Opec producers is expected to rebound next year after a poor 2008, although it is unlikely to be sustained in later years. “There was virtually no production growth outside Opec this year, whereas next year could be the last year that there is a large net year-on-year increase of non-Opec supply, as a number of delayed projects come on stream,” says Kreil.

Under the circumstances, Opec’s recent decision to rein in production is understand-able. But for the moment, it is unclear how effective it will be. Opec members are divided over what action the organisation should take in response to falling prices. “Some producers may be keener to cut back [oil output] than others,” says Fife. “The more hawkish members want $100 as a floor.”

Iran and Venezuela appear to want to defend an oil price of $100, whereas Riyadh, fearful of what that could mean for longer-term demand, is probably happier with a double-digit price, and has made it clear that it is prepared to supply what the market needs.

The way Opec sets its target is not straightforward. Opec president Chakib Khelil says the reimposition on 9 September of a target production of 28.8 million b/d is equivalent to a cut of 520,000 b/d. But there is considerable confusion about how the figures have been arrived at.

“If you look at the numbers for September 2007 [that include Indonesia, which has since left Opec, but not Ecuador and Angola, which have since joined] they don’t come close to 28.8 million b/d,” says Kreil. “The closest you get is by using figures from October 2006, when individual allocations were last specified, which gives a total of 28.97 million b/d.”

Compliance with the targets is also an issue. “It is very hard to work out what the individual members are actually doing,” says Kreil. “ The only people who really know what is happening are the Saudis.”

In light of these difficulties, Opec’s decision to reimpose last year’s production quota is seen as a statement of intent rather than a specific production target that the organisation will meet. “Opec is trying to get agreement from as many members as possible and show that it is going to take oil off the market without offending anyone,” says Ed Morse, an oil markets analyst at the now defunct Lehman Brothers. “It is a politically induced solution to show they accept that they should be doing something, while actually doing nothing.”

With oil field maintenance programmes due to start in Abu Dhabi, the reality is that Opec production was likely to be cut in the short term anyway. But most observers have reserved their judgement on the impact of Opec’s policy announcement until they see how much is actually coming out of the pumps, and there are reasons to believe Opec may want to cut production further.

As traders continue to exit their oil market positions and focus on demand weaknesses, many believe that the oil price could fall as low as $80 a barrel, a price generally thought to be below the target range of any Opec member. With this in mind, there is already speculation that a formal Opec production cut will be announced in the next few months to keep prices closer to $100.

“The next question is whether there will be an extraordinary meeting, or even whether a cut can be co-ordinated by telephone,” says the London-based analyst. “The next Opec meeting, in Algeria in December, is potentially a bit late.”

Whatever happens in the next few months, the events so far this year confirm one thing: oil prices have entered a new paradigm. Only last year, when Brent Crude prices averaged $72.70 a barrel, the market was still in awe of the possibility of prices reaching as high as $100. Now, $100 is becoming an increasingly accepted benchmark.

While it remains possible that prices will return to the $80-90-a-barrel range in the short term, they are expected to climb again in 2009. Barclays Capital predicts an average Brent Crude price of $108.10 a barrel in 2008, rising to $114.20 in 2009 and $121.30 in 2010.

Nor is there likely to be any respite for oil consumers in the longer term. “In 2009-10, we expect there to be spare production capacity of 5-6 per cent,” says the London-based analyst. “But from 2011 onwards, we expect it to fall to 2-3 per cent, or a couple of million barrels, which does not insulate the market well from oil shocks.”