By Carola Hoyos
Simple economics would dictate that the Organisation of the Petroleum Exporting Countries’ move to cut the cartel’s production by 1.2m barrels a day would put upward pressure on oil prices – as happened in early Friday trading.
But might the output cut in fact prove to be a drag on prices?
This question was posed in a recent report by Neil McMahon and Benjamin Dell, who head Sanford Bernstein’s energy team, and the suggestion has vexed at least one important Opec delegation.
McMahon and Dell argued that, ultimately, an Opec cut is bearish – and not only because it signals that the market is oversupplied (something that traders may be slower to realise than the world’s biggest oil producers).
Dell put it this way: “The interesting thing about the oil market is that the pricing structure is now being driven by spare capacity…This is very similar to the drilling market with prices going exponential when effective spare capacity falls to zero or in this case spare capacity falls to 1m b/d.”
He added: “What this relationship also suggests is that an Opec cut is bearish for prices. If Opec does cut 1m b/d, then spare capacity will be 3m b/d, suggesting that prices should fall to around $40 a barrel, plus any risk premium.”
What the Bernstein bears are saying is that Opec cutting production simply shifts the oil from the market to the group’s ‘”emergency cushion” – the spare capacity it holds and can turn to for oil at almost a moment’s notice.
This means there will be more crude oil available to fill any sudden gaps in supply. When there is more oil available, the risk of getting caught short by failing to buy oil diminishes.
The market has been concerned about Opec’s oil cushion ever since it began to drastically shrink as booming demand from China and the US pushed the cartel to open its spigots full throttle.
The correlation between price and spare capacity is a strong one, the Bernstein analysts argue.
In the past two years, the more oil Opec offered the market in an attempt to cool prices, the higher international oil prices climbed as traders worried about the shrinking cushion.
As spare capacity shrank to a narrow 1m b/d, oil prices hit records. As it began to grow again, oil prices eased.
The reason the price has been so sensitive to emergency stock levels is illustrated by the so-called ‘geopolitical premium’. No one knows exactly how large this premium – the gap between real market supply and demand fundamentals, and the benchmark oil futures price - is. But analysts believe it has shrunk as the fear of war or sanctions against Iran, Opec’s second largest oil producer, has subsided.
The Bernstein analysts also claim to have history on their side. “Opec production has historically shown a positive correlation with crude prices, with cuts being followed by a 20-30 per cent drop in the oil prices,” they note.
(FT.COM, 20/10/06)