With OPEC Planning to Cut Production, the Decline in Oil Prices May Not Last

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By Jason Simpkins
Associate Editor

Oil prices have plummeted 24% from the record high levels achieved in July, but the sell-off that sparked a stock-market rally over the last four weeks may not last since the Organization of Petroleum Exporting Countries (OPEC) is already gearing up to cut production.

OPEC, the cartel that controls roughly 40% of the world’s oil supply, pushed its production to the highest level in its 48-year history in July after being criticized for doing too little as the oil bull went on a year-long rampage – causing oil prices to reach an all-time high of $147.27 on July 11.

The production increase was led by Saudi Arabia, which – after a visit from U.S. President George W. Bush – boosted its production from 9.4 million barrels per day (bpd) to 9.7 million bpd, the highest level in 30 years. Higher production from Iran also helped push OPEC’s total output to 32.8 million bpd.

However, as economic growth stagnated in the developed world and cash-strapped American consumers cut back on expensive gasoline purchases, that production increase turned into a glut and oil prices plunged by more than $30 a barrel. Now that crude is down significantly from its record peak, OPEC is getting ready to take some of the excess supply off the market.

In its August Monthly Oil Market Report, the cartel lowered its global demand forecast to an average of 32.05 million bpd. In July, OPEC said demand for 2008 would average 32.64 million bpd.

“The softening economic situation has led to a further slowdown in oil demand growth,” the cartel said. “Oil demand growth will be on the decline in 2009 which will make the world demand growth the lowest since 2002.”

This bleak outlook could foreshadow a series of production cuts, not just for this year, but in 2009, as well. Here’s a key reason why: Falling oil prices are expected to cost OPEC about $176 billion in lost export revenue over the next two years, the International Energy Agency reports.

Net oil exports from the 13-member OPEC nations are projected to hit a record $1.172 trillion this year, the IEA said. While the total dwarfs the $671 billion the cartel raked in last year, it’s still $79 billion less than the EIA forecast in July. The IEA said OPEC would bring in $1.225 trillion in 2009, $97 billion less than last month’s prediction.

Emerging Markets Keep the Oil Bull Alive

While the IEA also lowered its demand forecast for members of the Organization of Economic Coordination and Development (OECD), the group said that demand in emerging-market countries – many of which subsidize the cost of gasoline for their inhabitants – remains strong.

"Demand is coming from emerging markets. As long as the [United States] doesn’t collapse, it doesn’t really matter if the mature economies are slowing," IEA analyst Eduardo Lopez, recently told The Independent

Chinese consumption rose above 8 million bpd for the first time in June, hitting 8.3 million bpd. Chinese demand is expected to grow by 5.6% this year and 5.7% in 2009. The IEA sees demand more than doubling to 16.5 million barrels a day by 2030.

Also in the short-term, the Chinese government has closed hundreds of factories and kept more than 1 million cars off Beijing roads as part of a massive effort to clean up the city for the ongoing Summer Olympic Games. There’s also a growing suspicion among many analysts that, after the games, the factors that are suppressing demand will be removed, meaning energy consumption will climb back to prior levels.

Meanwhile, India is expected to overtake the United States, Japan, and China as the world’s leading net oil importer by 2025. Still on track for robust economic growth, India’s demand for oil is expected to grow by 8% to 10% this year alone. That’s good news for OPEC, as India imports about 76% of its crude oil.

Despite the challenges posed by slowing economic growth, the IEA still expects world energy consumption to rise by 0.9%, or 86.9 million bpd, from 2007.

Given the relative strength of demand in emerging markets, the IEA was less eager to pronounce the oil bull dead than was OPEC.

“While OECD demand could still surprise us on the downside, non-OECD prospects, particularly for China and the Middle East Gulf, could be subject to upside adjustment,” the IEA said. “Add in customarily ever-changing sentiment over Iran, and it looks too early to cite definitively a sea change in the market.”

Political instability remains a global problem. Uncertainty and unrest remains a given in the Middle East and Africa. But with its Aug. 7 attack on neighboring Georgia, Russia has essentially positioned itself as a geopolitical wild card among oil producers, as well.

“We continue to stress the supply uncertainty that’s out there. The events over the past week in Georgia and Turkey have only reconfirmed that,” IEA analyst David Fyfe told The Wall Street Journal, referring to Russia’s incursion into the Georgian province of South Ossetia. [For a Money Morning investment research report on Profit Opportunities From the New Cold War, please click here. The report is free of charge.]

Oil and the Market Rally

Whether OPEC intends to stand back and watch as oil prices continue their decline – costing the cartel hundreds of billions of dollars in foregone export revenue – will become clear at the group’s next meeting, set for Sept. 9. That meeting, at OPEC’s Vienna headquarters, is where the group will have its first opportunity to combat oil’s ravenous price decline.

If OPEC does cut production, it will be bad news for investors. Oil's long slide has been part of an overall decline in commodities prices that has been cheered by investors who are hoping the falling prices will provide a boost to a sputtering U.S. economy that’s been afflicted by the one-two punch of soaring inflation and sagging consumer sentiment. [For more detail on U.S. consumer sentiment, please click here to see a related story in today’s edition of Money Morning.]

Since oil began its decline in mid July, the Dow Jones Industrial Average is up more than 5%. The Standard & Poor’s 500 Index is up 6.5%.

"Commodities continue to fall off a cliff and the market likes it," Greg Church, chief investment officer of Church Capital Management, told The Associated Press.

Of course, if oil prices resume their upward trend, the rally of the past month will have been short-lived, indeed. Crude prices fell $1.30 to settle at $113.71 a barrel Friday.

“It looks like crude oil prices will find support at $110 per barrel,” Xu Jiashun, an analyst from Yong'an Futures, told Interfax.

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