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OPEC: A discussion of crude oil prices and the balance between supply and demand faced by OPEC at the June 21, 2000 meeting. The following is excerpted from WTRG's recent newsletters and interviews.

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June 21 , 2000: Pre Meeting Report
 Note most of the comments in the March report are still valid please refer to it for background.

There have been various reports of the last few weeks ranging from doubts that there would be any increase to as high as a million barrels per day. In our opinion there will be an increase and that it will be in the 1/2 to 1 million barrel range. The if OPEC is to preserve market share the number should be at the higher end of that range. The question face by OPEC is will a million barrels per day cause a price collapse. There have been some signs of reaction in consumption to the high price of crude. IEA has revised its last two consumption forecasts downward. We think that there will be an increase and that it will be close to one million barrels per day.

Here's the logic: 

According to the most recent data  U.S. and European crude oil stocks are 70 million barrels below last years inventory. It would take two months of a million barrel increase just to restock. Therefore, there is little reason to fear a total price collapse. 

Add to the stock situation the fact that the highest consumption worldwide is in the fourth and first quarters.  See OPEC's March 27, 2000 meeting.  We are are less than a month into the third quarter which typically has the lowest level of consumption. It takes almost a month for the U.S. to receive crude from the Persian Gulf. As a significant portion of any increase would come from Saudi Arabia this relieves some of the timing problems. If OPEC is truly concerned about the timing, an increase of a million barrels or more phased in over two to three months could be a solution.

However it is done, OPEC, if its is to maintain market share, needs an increase large enough to move prices down significantly.  The reason for this is production costs outside of OPEC. The marginal cost of non-OPEC production is $14 to $18 dollars per barrel. In the long run prices tend to the marginal cost of production. Price uncertainty adds a little to the exploration and production decision. For this reason we think that a slightly higher range $16-$20 would reduce the growth in non-OPEC production and maintain OPEC's market share. This range should be understood as a constant dollar range. By that we mean that the range can be expected to grow with inflation. OPEC members are well aware of the risk to market share of high oil prices. Every month OPEC delays a production increase increases the probability of more non-OPEC production.

The key to understanding the process is the typical industry cycle. It takes time to find oil, make a decision to drill and then put the production online. In periods of high prices, non-OPEC producers make decisions to drill. By the time the decision bears fruit ( months to several years ), the additional production puts downward pressure on prices and prices often collapse. A collapse can be avoided if OPEC is willing to be proactive in production cuts. In general, they are too late in their decision to cut back. 

When the price collapses non-OPEC drilling suffers almost immediately. Production does not production suffer an immediate downturn. The market eventually comes back into balance because there is little new non-OPEC oil coming online and existing wells have declining production. Then the cycle resumes. 

To give you an idea of the sensitivity of prices to a supply demand imbalance.  A one million barrel per day imbalance can move the market 3-5 dollars per barrel. That is only a little over a one percent of world production. With that kind of price sensitivity it is easy to see why a consensus within OPEC is difficult to obtain.

Returning to the price range whether it is the current range or something lower it has yet to be tested. The market will have much greater confidence in OPEC if there is an automatic adjustment mechanism in place and it it survives a test at the low end of the range. We believe that one of the major reasons that the "automatic" adjustment did not take place was the combination of the proximity of an OPEC meeting and the need for more than a 500,000 barrel per day increase. Had the increase been implemented it would have been virtually impossible to get a consensus on additional barrels at the June 21 meeting.

We will post the results of the meeting when available.

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Copyright 2000 by James L. Williams 
 
James L. Williams
WTRG Economics 
Phone: (501) 293-4081
 
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email WTRG at wtrg@wtrg.com