The strong recovery in oil prices since mid-year provides solid evidence that the OPEC supply cuts are working. Already at $18 a barrel, prices are expected to reach at least $20 later in the year - if the production discipline holds. Peter Kemp reports on the dramatic turnaround

There have been so many previous false dawns in the oil market that it may be tempting fate to suggest that the sunny forecasts are real this time. Oil prices are not only rising steadily, they have entered the desired target range of most Middle East producers and have a good chance of remaining there. That is the consensus of analysts and observers who have been impressed by the effectiveness of the latest OPEC supply cuts. As inventories start to decline, there is palpable relief across the industry that reasonable prices have been restored and look set to be maintained next year. 'It's a great time to be OPEC,' says George Beranek at the Petroleum Finance Company (PFC) in Washington.

The turnaround has been remarkable. From a low of under $10 a barrel in late 1998, dated Brent had rebounded to more than $18 by early July. 'There's a high level of probability that it will continue to a peak of $20 a barrel, even as high as $22 a barrel, maybe around September,' says John Tolster, an analyst with SG Securities in London.

Barely two months ago the rebound in prices was widely dismissed as premature, unjustified by the fundamentals which still pointed to excessive supplies and an immovable mountain of stocks. Speculators were blamed for the skyrocketing prices. Since then, OPEC compliance with its latest round of cuts has proved decisive.

'It has been a lot higher than expected,' says Irene Himona, analyst at ABN AMRO. 'Stock levels are being drawn and the whole thing is going a lot faster.' Not only has OPEC compliance achieved rates of nearly 90 per cent, far higher than expectations, but demand has proved surprisingly perky. Says Tolster: 'OPEC compliance was the primary driver, helped by flat non-OPEC, Asia-Pacific recovery and strong demand in the US.'

The cuts agreed by 10 OPEC members to come into effect on 1 April were intended to slash group output, excluding Iraq, to 22.975 million barrels a day (b/d). By June, production by the 10 was down to about 23.25 million b/d, with three laggards - Nigeria, Indonesia and Qatar - accounting for most of the discrepancy. Observers are impressed. 'If they retain that level of compliance, prices could go much higher,' says Himona at ABN AMRO, which is assuming only 75 per cent compliance in its current oil price forecasts for the year (see above).

The other big boost has been demand, with forecasts of higher economic growth in the OECD countries and a more rapid recovery in Asia. 'The news flow on world economic growth has been positive,' says Adam Sieminski at Deutsche Bank Alex Brown. 'Worldwide demand will probably be up at least 1 million b/d this year.' Others predict that demand could be ahead by 1.2 million b/d, with demand growth of 1.5 million b/d pencilled in for 2000. As demand picks up again, OPEC has brought production down by 1 million b/d and non-OPEC supply, responding to the low prices of the past year, is down by 200,000 b/d.

The combination of stronger demand and tighter supplies is having a dramatic impact on inventories, which had risen to historic highs on the back of the oil glut of 1998. Industry stocks in the OECD that were around 58 days forward cover earlier in the year had come down to about 54-55 days cover by early July. Given the current rapid rate of depletion, the now legendary overhang could be completely mopped up by the end of the third quarter. Sieminski believes that forward cover could be down to 50 days by year-end. 'We're back into the normal range,' he says. 'If the trend in the IEA and API data of the last few weeks continues, we'll be at [stock] levels that we haven't been at since the lows of 1996.' Confirming the trend, the IEA predicted in its July market report that the drawdown in the third quarter could be one of the largest ever, 'hypothetically over 3.2 million b/d, a level which has been seen only once in the last 20 years.'

With so many factors running in OPEC's favour, are there any risks of an upset and a reversal of the current trend? There are areas of uncertainty. One worry is the Asia-Pacific region, where some observers are questioning the recent economic rebound. 'Is Asia really on the up or not?' asks Sieminski. In the US, where demand remains robust, an upward adjustment in interest rates trailed by the Federal Reserve could slow the economy after years of strong expansion. Another mild winter may reduce the stockdraw, while a cold one could send demand soaring, driving prices up as well.

At least Iraq's capacity to rock the boat by driving up production against the OPEC trend has been exhausted for the time being. Production peaked at an average of 2.7 million b/d in May and exports are about 2.2 million b/d, but both production and transport systems will need major new investment to take the figures any higher.

Resisting temptation

OPEC discipline is another issue. 'OPEC really outperformed everyone's expectations,' says PFC's Beranek. Whether they can stick to it remains to be seen. Adherence to the cuts has been remarkable so far but it is early days and the temptation to cheat on quota observance to boost revenues may prove irresistible if prices are over $20 a barrel. The pact can be reviewed at the OPEC meeting in September but one of its chief architects, OPEC President Youssef Yousfi, insists it will stand until March 2000 as agreed. He says stocks are still too high and equilibrium will not be achieved before the end of the year at the earliest. 'They [producers] should not be tempted by the present situation not to apply the agreement very strictly,' he said in early July.

There are dangers in high prices too unless OPEC can use its new influence to stabilise the market. Prices in the desired $18-20 a barrel range could be sufficient to trigger another investment cycle by the industry, returning OPEC to the familiar predicament of having excess capacity while non-OPEC supplies are expanding. If the current price strength continues as expected, OPEC will have a difficult balancing act later in the year. Asks Sieminski: 'At what point and which OPEC members will want to respond to higher prices, either by cheating or by revising production levels?' In the present heady atmosphere, it's a question better left unanswered.