Time to deliver

09 April 1999
SPECIAL REPORT OIL & GAS

Another round of supply cuts to try and mop up the oil glut has reversed the decline in prices and hopes are high that a rebound has begun. OPEC has restored some of its lost credibility but compliance will have to improve if the recovery is to be sustained, Peter Kemp writes

The oil industry is enjoying a rare moment of optimism in the wake of the latest OPEC meeting. Three months ago, a deal to slash supplies further was a remote possibility as OPEC's big guns bickered about why the previous agreement wasn't working. It took a disastrous winter for oil prices to bring them to their senses. As even larger revenue losses loomed, something had to be done.

The response was The Hague pact which was rubber stamped by the OPEC ministerial meeting that followed on 23-24 March. Oil prices gained more than $3 a barrel in March, largely in the expectation that drastic action was imminent. The latest agreements promise to reduce supplies by another 2 million barrels a day (b/d), starting from April. OPEC is taking out another 1.7 million b/d with Mexico, Norway and Oman chipping in with the rest. The 10 OPEC producers involved will have cut supply by an average of 15.8 per cent from the February 1998 baseline if they comply fully with their new commitments (see table).

Compliance holds the key to the pace and scale of the recovery. The Centre for Global Energy Studies (CGES) in London calculates that 100 per cent compliance would propel Brent over $20 a barrel by the end of the year, from just above $13 at present. In reality, nobody expects such an outcome because compliance is certain to be less than complete. OPEC managed an average of only 70 per cent compliance with its July 1998 cuts but appears to have ironed out the main problems with Iran and Venezuela that weakened the agreement (MEED 26:3:99, Cover Story).

Credibility remains an issue. OPEC oil ministers put a predictably positive spin on their new accord but discipline has a nasty habit of unravelling as prices pick up. The temptation to cheat by pushing a few more barrels into the market to bump up revenues has in the past proved irresistible. And it could do again. Despite the new buoyancy of spot prices, forward markets are factoring in significant leakage later in the year.

This could come from several fronts. Notwithstanding the pledges, the cuts are certain to be controversial in Venezuela, which was unable to deliver on the last round in full because of domestic opposition. Chaotic conditions in Nigeria makes full compliance equally doubtful. Indonesia is in acute economic distress and may prove reluctant to cut production by a further 7 per cent. Iran has been brought back into the fold, having disputed the previous agreement from the outset, but it will have to prove its commitment by delivering on this one. CGES says that futures prices to the end of the year imply compliance of only 50 per cent, rather than the 100 per cent that will be needed to drive prices to $20 a barrel and keep them there.

The immediate challenge is to sustain the recovery and the high expectations it has raised. Although the anticipation of a new OPEC accord urged it along, the price rise in March was helped by other factors. After an exceptionally warm winter, there was a bout of cold weather in Europe and the US in late February and a surprise drop in US inventories. Far East demand was also picking up amid signs of a return to growth in some of the economies worst hit by the financial crisis of 1998.

That recovery is still shaky and could be knocked off course by a sharp rise in oil prices, slowing the rate at which demand from the region rebounds. South Korea has shown the most dramatic recovery in percentage terms but it is from a low base after the collapse of imports in 1997-98. Asian customers were the first to be notified of supply cuts from Abu Dhabi and Saudi Arabia for April and prices have already picked up in response. More than half the growth in global demand this year - likely to be about 800,000 b/d - will come from Europe and the US, with the buoyant US economy accounting for the lion's share. Asia is likely to account for about a quarter of the projected increase.

OPEC supply cuts have also been supported by the withdrawal of some marginal, high-cost production, particularly in the US, because of the low oil price. By the same token, higher oil prices could bring that capacity back into production. Non-OPEC additions to global capacity have been repeatedly overestimated in recent years and are likely to be negligible this year as any gains will be offset by closures. But higher prices could revitalise some of the non-OPEC exploration and development that has been slowed down or suspended altogether in recent months.

Recovery also depends on a steady erosion of inventories. During the mild winter, stocks actually rose - against the historic trend - as buyers took advantage of the supply glut. This merely compounded the problem created by the huge stockbuild in 1998. The global inventory build of 1.4 million b/d in 1998 is still there and will take a lengthy period of tight supply to bring down to a level that will sustain higher prices. Analysts forecast at the start of this year that inventories would begin to decline by the second half - a process that will be brought forward by a few weeks if the latest OPEC cuts kick in quickly - laying the ground for a solid recovery in the third quarter. Most estimates point to prices of $16-18 a barrel, possibly higher, by the fourth quarter.

Excluded from the OPEC cuts, Iraq is still a rogue factor that could undermine the new optimism. Its exports have doubled over the past 18 months to about 2.4 million b/d. Despite damage to pipelines and occasional interruptions, they are nudging 2.5 million b/d at the moment and could rise by a further 300,000 b/d this year if repairs are carried out as planned.

The initial euphoria created by The Hague agreement is based on the belief that cuts of this magnitude will mop up the oil glut quite quickly. It has been bolstered because the cuts are slightly bigger than anticipated and were agreed without any obvious rancour once Iran's views on the baseline from which to measure its contribution had been accepted.

The recovery cannot come too soon for cash-strapped Arab producers. On current trends, Saudi Arabia would earn $4,000 million less in 1999 than last year, which may explain its willingness to abandon the 8 million- b/d production floor and drop to 7.438 million b/d. Iran also faces a massive hard currency shortfall unless prices turn around. Without a recovery, CGES estimates that the OPEC countries would stand to lose another $13,000 million in revenues in 1999.

Faced with such a prospect, desperate remedies were required. In defiance of the sceptics, the agreement at The Hague managed to more than meet expectations and prices are rising. The challenge will be to make sure the accord is honoured so that prices keep on moving in the same direction.

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