Tightening Supply Picture Has Oil Companies Wondering What OPEC Will Do Next

OPEC is making promises it may have to break.

The cartel is vowing to continue its self-imposed production cutbacks through March, and possibly longer. But the group may have to increase its production before then to meet rising demand, say oil observers. And if OPEC members or its partners in the cutbacks, Mexico and Norway, backtrack now, it could wreak havoc with prices -- and energy-company confidence.

Belief in the group's ability to maintain oil-price stability is crucial for oil-company spending decisions. Although major oil companies take a multiyear view of prices, the recent volatility "makes it hard to plan to come up with the best probable estimates," says Marianne Kah, chief economist at Conoco (COC). Kah declined to discuss Conoco's price estimates.

Before the Asian economic crisis in late 1997, the price of oil was far from investors' minds as they rushed into oil-service and energy shares. But its importance became abundantly clear as prices tumbled and independents and oil majors slowed spending, crippling service-companies' growth and share prices. Although it's unlikely the market will soon return to the December and February lows, near $11 per barrel, the experience of 1998 and 1999 is not one investors want to repeat.

So OPEC is treading especially carefully. To date, the agreement to hold back more than 4 million barrels of crude oil a day has worked better than most observers dreamed in March. Prices soared briefly near $25 per barrel before skittishness set in late last month. Currently, prices are hovering in the low $20s.

OPEC, for its part, is vowing to keep the cutbacks in place. In Houston last week for an economic forum, Saudi Arabia's oil minister said a November meeting was unlikely to prompt any change in OPEC's output because stock levels were still too high. Then, Luis Tellez, non-OPEC Mexico's oil minister and one of the original architects of the agreement, told Reuters he would propose to keep the cuts in place into the second quarter.

Those pronouncements have come even though oil-market reports show the cartel's compliance with the agreement slipped in September.

How OPEC handles itself now will be crucial to its credibility. Since the cartel increased its quotas on the heels of the Asian currency crisis in late 1997, its every move has been scrutinized. When oil prices fell to historical lows, many felt the producing group had lost its power and credibility. That sentiment reversed dramatically as the disparate nations pulled together to enforce production cutbacks.

But, as Merrill Lynch analyst Michael Rothman has pointed out, what OPEC says is not always what OPEC does. Noting that OPEC is unlikely to actually "telegraph" its intentions to the market, Rothman recently wrote, "The same modus operandi has been vividly witnessed since the Riyadh pact in March 1998," the first of a series of OPEC cutbacks.

The question facing OPEC is how to accomplish a production increase without rocking crude markets. "OPEC doesn't know" when to increase production, says Kenneth Haley, manager of energy forecasting at Chevron (CHV). The market is "always looking at partial data that's old -- you're going to be faced with an uncertain situation."

OPEC produces roughly a third of the world's crude, but controls nearly two-thirds of the world's reserves, hence its power. In the third quarter, OPEC countries produced 26.2 million barrels per day, according to the International Energy Agency, down from 27.7 million barrels per day in the first quarter. World demand is expected to grow to 77.1 million barrels per day next year, up from the estimated 75.3 million per day we'll use this year, according to the IEA.

Although the IEA projects non-OPEC production will be flat next year, oil gurus, such as Matt Simmons, president of Simmons, a Houston-based investment bank, argue it will actually be down in coming quarters, due to decreased investment levels. OPEC production is the most likely source to meet overall demand increases.

One option for OPEC may simply be to cheat on its self-imposed quotas. The idea would be to gradually feed additional production to a tightening market. OPEC could then announce or confirm the changes when it meets in March, says Tim Evans, a senior energy analyst at Thomson Financial Markets.

"That is certainly one plausible way to work it out," says Chevron's Haley. But "psychologically it's probably not as good a way to do it," he adds. "That will convince people it has lost credibility or is beginning to unravel."

"The market really wants them to wait until April" to increase, says Conoco's Kah. "Right now we're really starting to draw down excess inventories."

Very true. Data from the American Petroleum Institute through Oct. 15 showed a small build in U.S. crude stocks, following news of a 7.1 million-barrel drop for the week ending Oct. 8. U.S. stocks are now just under 300 million barrels, the lowest levels since September 1997. Forecasters see another minidecline taking those stock levels back to levels last seen in January and February of 1997. Oil prices peaked then at more than $26 per barrel.

The problem with an April production increase is that it would coincide with a seasonal low-point in demand. But that might not matter, says Thomson's Evans, with the way the current inventories look. Yes, it would shock the market initially, he says, but "if the market gets tighter in the first quarter, it may be grateful for any increase."

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