After protracted and often acrimonious discussions, both the 'hawks' and the 'doves' within OPEC finally agreed to compromise on an oil production level that will leave them flush with funds and yet allow the global economy to continue growing. Rafiq Ahmed reports.

World oil markets reacted cautiously to the Organisation of Petroleum Exporting Countries (OPEC) decision to increase collective output, preventing even greater price increases. The OPEC cartel, during its March meeting in Vienna, agreed to production increases of 7%, or 1.7 million barrels per day (mbpd), effective from 1 April.

The decision makes the new ceiling 24.676mbpd (excluding Iraq, which has been outside the OPEC quota system limits since the Gulf war in August 1990). The agreed increase also took into account the current over-production by some OPEC states. OPEC has been exceeding its April 1999 ceiling of 22.976mbpd by up to 1mbpd during the first quarter of 2000. Thus actual new OPEC oil produced will be about 850,000bpd.

But there will be other sources of oil in the coming months. A recent United Nations motion will allow Iraq to boost export volumes to 2.25mbpd and further increase the amount by up to 700,000bpd within a few months.

Meanwhile non-OPEC output is expected to increase by an extra 400,000bpd, Norway, the world's second-largest oil exporter after Saudi Arabia, is increasing production by 100,000bpd and Mexico by 150,000bpd. Angola and Oman are also expected to boost production, bringing the total addition to world's output to l.8mbpd.

However, OPEC's increase fell short of major importers' expectations. The US had lobbied for a hike of 3mbpd, in order to return the oil markets to equilibrium. The European Commission had hoped for a 2mbpd increase, while the Paris-based energy watch dog, the International Energy Agency (IEA), called the Vienna deal, "a step in the right direction" but expressed concerns about low crude oil and refined product stocks. The IEA said that OPEC needed to sanction an increase of 2.3mbpd in order to replenish inventories to normal levels.

Over the past year, crude oil has confirmed its reputation as a volatile commodity. Within a span of 13 months, prices soared from a cyclical low of $10 a barrel (bbl) in February 1999 to a 10-year high of $32bbl for Brent blend - an international bench-mark - in March. Not surprisingly, there were immense international pressures, led by the US, on OPEC to relax its policy of supply-tightness.

The IEA warned that some developing countries could suffer huge trade deficits if oil prices continued at current high levels until year-end. This would harm global economy and place a burden on a still fragile Asian recovery.

Effects on future prices and energy demand

The direction of oil prices in the near-term will depend on whether OPEC's 10 members exceed the new ceiling. The new Vienna accord, supported by Mexico and Norway, should prevent oil prices from soaring above $30bbl, but the size of output increase is not enough to lead to a significant build-up of global stocks, or risk a precipitous fall in prices, as in late 1998.

Preserving financial stability

On balance, prices might not fall much below $23-25bbl over the next six months. Such a level is seen as essential for preserving financial stability in some of OPEC's economically weak members, such as Nigeria, Iran, Venezuela and Indonesia. The Deutsche Bank says, "The oil price is going to be stronger than people realise."

The market's fundamentals are still favouring producers and not oil-consuming countries. There is a current gap of 2mbpd between global supply and demand. The world is producing about 74mbpd, while total consumption is nearly 76mbpd, although as the northern hemisphere enters summer, oil consumption traditionally drops. OPEC accounts for 40% of the world's production.

The market is expected to remain in supply-deficit throughout this year. Growth in global demand in 2000 is estimated at 2.5mbd. Meanwhile, according to the IEA, petroleum stocks in the OECD area are currently at a 20-year low and are equivalent to 46 days consumption.

The OPEC hawks - Iran, Libya and Algeria - were strongly opposed to any increased quotas during the second quarter of the year. They argued that OPEC risked undermining prices through increasing supplies, when seasonal energy demand in North America and western Europe is usually subdued. According to energy analysts, global oil demand in the last ten years during the spring and summer months fell by an average of 2.7mbpd across the developed northern hemisphere. But others point out that conditions this year will differ because of a growth revival in south-east Asia which has become a major energy importing region. They also argue that US refineries will need to rebuild supply stocks ahead of the summer's 'driving season'. Consequently the IEA predicts a small decline of 1.5mbpd in the second-quarter demand. The London-based Centre for Global Studies (CGES) also reckons that fears of a seasonal down-turn are "entirely misplaced".

Gulf producers, chiefly Saudi Arabia, the UAE and Kuwait (supported by Nigeria) maintained that global oil demand is strong enough to justify opening the taps and that this was unlikely to cause a price collapse.

By autumn, the OECD petroleum stocks may fall again, increasing the pressure on OPEC to open their taps once more, perhaps by a further 1.5mbpd. Recently, Venezuela's oil minister, Ali Rodriquez said that OPEC would probably agree to increase output in the second half of the year to meet growing demand.

Soft landing

Observers argue that this time around OPEC has attempted to engineer a soft landing for the world's markets. It has adopted a new reference price of $20-25bbl linked to the Brent blend. A stabilisation mechanism is being put into effect, with aims of preventing sharp fluctuations in crude prices as there were in the 1990s.

The cartel would cut output by half a million barrels per day of Brent should the price fall below $22bbl or conversely, if the price rises above $28bbl, output will rise automatically by the same amount, without a ministerial meeting.

OPEC has pledged to protect the $22-28 band. One encouraging piece of news for the market's stability is that speculative hedge funds, which largely fuelled a 10-year surge in the price of West Texas Intermediate ($34.20bbl) in New York in early March, have now bailed out from the futures markets.

Medium-term outlook

Technical indicators suggest that a downside correction is inevitable by next year, with the futures markets pointing to lower prices. International oil majors are saying they believe that $18bbl is a more sustainable long-term price, while the Bank of England also envisages oil prices correcting to $18bbl by early 2002. Such a level is sustainable for producers by providing reasonable returns on fixed investments and underpins a steady growth in importing countries' energy consumption.

A principal reason for lower futures prices is the expectation of higher non-OPEC production and a continuous surge in Iraq's capacity to 3.5mbpd, assuming a greater inward foreign investment into the Iraqi oil industry. Most analysts believe that a Brent price of $20-25bbl will encourage exploration and development of higher-cost non-OPEC production this year and next.

On balance, given the mostly fragile economic situations of key OPEC producers, a complete breakdown in the cartel's discipline as during 1990s, is unlikely. The world may have to live with slightly firmer oil prices in the medium-term. The financial pains of 1998, when OPEC members collectively lost over $50bn in revenues, were too severe and they will be cautious of raising output substantially.

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