Oil tumbles despite OPEC output cut

On Friday, US oil prices fell below the $65 a barrel level, heading for their largest monthly drop since crude oil futures started trading in New York in 1983. The fall came in spite of the decision by the Organization of the Petroleum Exporting Countries (OPEC) to decrease the current OPEC-11 production ceiling of 28.808 million barrels a day (b/d) by 1.5 million b/d, in an effort to stabilise the sharp fall in oil prices; Opec’s decision became effective on 1 November 2008. This article highlights the significant aspects of Opec’s decision and outlines potential future developments. Therefore it may be of particular interest to companies and investors within the oil energy sector, especially international energy groups working in Opec countries. The extraordinary volatility of the oil price and financial markets creates new opportunities and threats for international and national oil companies. The fall in oil prices from a peak of more than $147 b/d in July has been so rapid that executives and analysts have had little chance to assess the outlook.

Key aspects of Opec’s decision

The cartel, which produces 40% of the world’s oil, made its decision at a meeting on 24 October 2008. Opec convened the meeting to discuss the current global financial crisis, the world economic situation and their impacts on the oil market. During the meeting, Opec noted:

• that the financial crisis is having a noticeable impact on the world economy, dampening the demand for energy, in general, and oil in particular;
• that the slowdown in oil demand is exacerbating the situation in a market which has been over-supplied with crude for some time, an observation which Opec has been making since earlier this year;
• that forecasts indicate the fall in demand will deepen, despite the approach of winter in the northern hemisphere; and
• that oil prices have witnessed a dramatic collapse - unprecedented in speed and magnitude - falling to levels which may jeopardise many existing oil projects and lead to the cancellation or delay of others, possibly resulting in a medium-term supply shortage.

Given these factors, the cartel expressed a commitment to providing the market with crude oil volumes that consumers require.

Initially the group had widely divergent views on the depth of the cuts but as oil prices fell and put options indicated that traders were predicting a drop to $50 a barrel, Opec members agreed they had to act decisively.
Member Countries committed to ensuring that the volumes they supply to the market are reduced by the individually agreed amounts, as follows:

Country: Decrease (b/d)

Algeria: 71,000
Angola: 99,000
Ecuador: 27,000
I. R. Iran: 199,000
Kuwait: 132,000
Libya: 89,000
Nigeria: 113,000
Qatar: 43,000
Saudi Arabia: 466,000
U.A.E.: 134,000
Venezuela: 129,000
Total: 1,500,000

Saudi Arabia, which produces its oil without the help of international energy groups, has already cut its production. Other countries carry less of a burden because they produce fewer barrels of oil.

HE Abdalla Salem El Badri, OPEC’s Secretary General, made a keynote presentation at the opening ceremony of the International Energy Week, (22 – 24 October 2008) addressing the current oil market situation and the long-term challenges facing the oil industry. He acknowledged the concern, which some have voiced, that oil producers are not investing enough to be able to cater for future demand from consuming countries. However, he stated that the opposite is the case for OPEC countries; he noted that in the upstream sector, investments of more than $160 billion are expected to increase crude production capacity by around 5 mb/d by 2012 from current levels and spare capacity is set to grow. He also stated that downstream investment levels over the same period exceed $60 billion. Furthermore, the Secretary General highlighted that risks over possible future demand patterns are skewed towards the downside, due to a range of factors, including the current financial situation, recent energy and environmental policy initiatives and higher tax rates, which tend to drive a reduction in demand.

Effect of Opec’s decision

Despite its aim, Opec’s pledge to cut production failed to offset concern about shrinking global demand and failed to halt the slide in the crude price. The decision had little influence on the commodity market as investor confidence eroded in response to the threat of a deep global recession, which would force consumers and businesses to cut back on energy consumption.

One analyst noted that several countries could be running into a “nil-margin ” production scenario with oil prices sub $60 a barrel. Opec’s decision to cut production sparked criticism from the US and UK governments and the International Energy Agency (IEA), the western countries’ energy watchdog. They warned that it could aggravate the current economic crisis. Opec ministers, however, dismissed the criticism. OPEC’s Secretary General stated, at OPEC’s first session of the Oil and Money Conference 2008 (28-29 October), that OPEC “remains committed to adding net capacity of around 5 million b/d by the end of 2012, through investment of over $160 billion, and over $60 billion in the downstream sector over the same period”.

Some analysts warn that Opec’s decision to cut oil production would tighten the market in two to three months, resulting in higher prices in early 2009.

Next Steps

Opec’s review and monitoring

Opec’s adherence to its decision is likely to be a key signal for prices in the medium term. Some traders doubt that it will fully implement the cuts. However, Chakib Khelil, Algeria’s energy minister and Opec’s president, insisted that the group had “no other choice” because selling the oil was becoming problematic as potential buyers are not keen to buy or are unable to secure letters of credit.

The continuing fall in oil prices has led to talk that the cartel would try to reduce output further before the end of the year. Opec will review its decision at a meeting scheduled to convene in Oran, Algeria, on 17 December 2008. The oil cartel is open to the possibility of another emergency meeting before then if prices continue to fall. Meanwhile, OPEC officials aim to continue to closely monitor the market.

International meetings

Last week saw the cancellation of the international energy summit, planned for 19 December 2008, for heads of state of oil producing countries. However, Ed Miliband, UK Energy and Climate Change Secretary, plans to host a ministerial-level meeting to discuss energy matters in London in December. Gordon Brown, Mr Miliband and a delegation of business leaders began a four-day visit on Saturday to some of the world’s richest oil producing nations. The Gulf region, which produces more than half the world’s oil and an increasing proportion of the gas used in Britain and is likely to play a significant role in maintaining energy security. The investment decisions of national oil companies, many of which are in Opec countries, are likely to have a significant effect on oil supply during the economic turmoil.

World Energy Outlook 2008

The IEA is soon to publish its World Energy Outlook 2008 and plans to present the final results of the report officially at a press conference in London on 12 November. According to the IEA, the report will provide a full update of energy projections to 2030 and will cover questions such as whether the world is facing a supply crunch due to geology or to inadequate investment. The report will also provide an in-depth analysis of three key topics:

• Post-2012 climate change policy scenarios;
• Oil and gas supply prospects; and
• Energy poverty in resource-rich Sub-Saharan African countries.

Further reading

To read the speech delivered by OPEC Secretary General, HE Abdalla Salem El-Badri, at the 3rd International Energy Week, Moscow, Russia, 22-24 October 2008, please click here.

To read our law-now article entitled ‘Taking the strain - the impact of the volatile oil price on natural gas prices’, dated 8 October 2008 please click here.