The new realism

OPEC Bulletin Commentary February 2005.

OPEC’s decision to suspend its price band will send clearer signals to the market and investors.

At the recent 134th (Extraordinary) Meeting of the Conference, OPEC took two important decisions: to keep its output ceiling unchanged and to suspend its price band temporarily after prices had been trading out of the range for over a year.

The decision to keep output levels unchanged was not unexpected since, prior to the Meeting, prices were at eight-week highs, close to $50/barrel for Brent and WTI. The reason for these high prices was not a supply shortage — since strong demand had been met by increased supply from OPEC — but a variety of factors, including the cold weather conditions and high demand in key northern hemisphere regions, outages in Iraqi supply due to sabotage, uncertainty over the geopolitical ramifications of the post-election environment in Iraq, and the upward revisions to demand forecasts for crude oil in 2005. All of these factors were read as bullish signs by the market, despite the continuing build in crude oil stocks at the time.

But one should not forget that for all the talk of oil prices being around $50/b, many crudes from OPEC Member Countries are selling in a range of $35–45/b, lower than the benchmark crudes, but nevertheless higher than the now suspended OPEC price band range of $22–28/b.

This elevated price environment has persisted for quite some time now, making it apparent to the Member Countries that the price band, adopted amidst very different market conditions in 2000, was unrealistic and unfeasible. How could the Organization possibly defend prices in the $22–28/b range when the market has clearly been telling a different story with unprecedented oil demand growth in 2004, coupled with expectations of continuing, strong crude demand in 2005, amongst other things?

It had become abundantly clear that, in the current circumstances, OPEC could not continue to talk about the price band range, despite the fact that several of the major consuming countries had come to endorse it after it was adopted as being consistent with security of supply and demand. In the light of this, the Conference decided to clarify the situation, and for the time being suspend the band until further studies on the subject are completed.

Measures such as the price band make sense until market conditions change to a degree which necessitates a re-think about the way things are done. The decision to suspend a mechanism takes a lot of courage in a market which is hyper-sensitive. But making such choices demonstrates a realistic commitment to the stability of the crude oil market, and an increasing flexibility in the way OPEC takes decisions.

After all, the world is signalling that it will require more and more crude supplies in the coming decades. The developing world is growing at a rapid rate and developed countries show no sign of slowing at this point in time. What all of this highlights, most importantly, is the need for the security of both oil supply and demand.

And for oil security to be assured, capacity expansion projects need to be undertaken and, ideally, a recognition of the cost of this investment needs to be reconciled by all parties. Essentially, what this means going forward is that the price of oil needs to be sustainable not only for consumers, but also for producers to provide the volumes needed now and in the future. OPEC’s latest decision — which is in line with its commitment to maintaining market stability — will send the right signals to the market and investors in the industry.

This Commentary is taken from the February 2005 edition of the OPEC Bulletin, which can be downloaded free of charge in PDF format from the OPEC website.

OPEC Bulletin (February 2005)

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