OPEC will be holding its meeting this Friday, October 24, 2008 to establish a cut on oil output in an attempt to stabilize the oil prices. I don’t believe anyone would doubt OPEC will end the meeting with no cut on oil output. The market is estimating OPEC will announce a cut between 1M to 2.5M barrels a day. Today, the price for a barrel of crude dropped to $66.75, losing $5.43. One wonder what could be the reason for oil prices to fall if an impending cut is coming. Here is a possible scenario that the market might be anticipating ahead of the meeting, and might explain why the price of crude continues to drop.
There is no doubt that OPEC will announce some level of output cut this Friday. But it really doesn’t matter what level of cut OPEC will announce, the actual output will remain the same if not more than what it is today. The cause for the actual output to be unchanged is the ‘not in my backyard’ attitude. It’s similar to all those people favor nuclear power, when a nuclear power plant is proposed to be built in their city or state, they will object and tell you that “you can build it anywhere as long as it is not in my backyard.” Similarly, every OPEC members want to cut output level to maintain the price of crude to be above $70 a barrel, but none of them (except the Saudi) are willing to take the cut because they need the oil revenue to finance their country’s expenditures. Therefore, no matter what the cut OPEC agreed upon, the Saudi has to shoulder the actual cut because it is the only member country that can afford it. Iran and Venezuela will be the most aggressive countries demanding a bigger cut in output to ensure higher prices, and they will be the least willing countries to absorb the cut. The Saudi is well aware this is not the right time to cut output and force a higher oil prices to a weakening global economy. In order to satisfy OPEC’s demand to cut output in an attempt to halt the drop on oil prices, the Saudi will agree to take the cut if the output reduction is 1M barrels a day instead of the more aggressive cut proposed by more radical OPEC members such as Iran and Venezuela. The Saudi also understand the demand destruction will be greater and quicker than it is now if the price of crude is kept too high. So at the end of all the talk about output cut, the announced number will only be symbolic, a show of desires but not wills. The 1M barrels cut agreed by Saudi Arabia will only bring the supply and demand closer to balance. But as Iran and Venezuela keep pumping more oil exceeding their quota onto the world market to generate the necessary revenue to meet their country’s needs, they will continue to put downward pressure on prices. As prices continue to decline, the supply of oil will continue to rise due to those OPEC countries that need to sell more oil to make up for the lower prices in order to maintain a level of revenue. Their action will push the price to the $30-$35 a barrel. At this price level, which is near the Saudi’s breakeven level, the Saudi will then exert its power to force the OPEC members to cut production or it will glut the market with oil and drive down the prices that will cause great economic and political pains for other member countries. I believe this could be a scenario the market is anticipating, and that is why the price of crude will continue to fall until it reaches that critical price (whichever it may be.) This scenario is not new. It has happened before, and it will happen again in the future. Let's wait and see if this scenario will play itself out once again.
