OPEC’s folly

If, as suggested by Bob Woodward’s book on President George W Bush and Iraq, the Saudis pledged to keep oil prices down for the US election in November, they are not doing a very good job of it. The Saudis confirmed over the weekend that they would next month push for an increase of around ten percent in production quotas from Opec, as well as unilaterally raising their own output by around two million barrels per day in the months ahead, bringing it close to full capacity. But if this weeks’s renewed rise in oil prices was any guide, the markets were distinctly underwhelmed. Traders are right to be sceptical. In the face of strong global demand and a risk premium from instability in the Middle East and Iraq, Opec’s power is limited. The Group of Seven’s hopes for lower prices may well be disappointed.

The current oil price spike is unusual. It has taken place during an increase, not a sudden shortage, of oil supply. The main reason prices are at $40 a barrel is the thirst for oil from a recovering world economy, particularly China, outpacing production. Unlike the oil shocks of the 1970s, Opec’s placing of its thumb over the spigot has played little role. Indeed, its production is already about two million barrels per day above quota and world supply of oil has increased over the past year. With little spare capacity among Opec producers, the increase in formal quotas being pushed by the Saudis would probably have little effect on the amount of oil actually being supplied. Moreover, the supply problems that do exist are, sadly, not amenable to an easy solution by Opec.

Oil prices almost certainly already contain a substantial premium for the risk of a supply disruption — whether more setbacks to Iraqi output or, even more disturbingly, the possibility of a terrorist attack on Saudi oil infrastructure. It seems unlikely, given current uncertainties, that such a premium will disappear soon. In the meantime there is little that oil-consuming countries can do apart from prepare themselves for continued high prices and the possibility of a serious supply disruption if the security situation does deteriorate.. Oil prices are not yet at the level likely to inflict serious damage. But if they do rise further, it will be foolish to rely on the ability of the Saudis, or even Opec, to reverse them. (Guest Editorial courtesy the Financial Times)