AZERBAIJAN - The Global Petroleum Perspective.

OPEC has just raised the average level for its price defence effort by $10/barrel to $35/b. There is no formal decision for this as yet, but it is what Saudi Arabia wants and to what the other 10 OPEC member-states will agree. The next OPEC ministerial meeting is scheduled to be held in Vienna on July 21. The previous price defence band, $22-28/b, was adopted in 2000 and was abandoned quietly in late 2002 as general strikes in Venezuela caused that country's oil exports to stop and oil prices to rise.

In announcing the new oil price level and saying OPEC should not raise production by 500,000 b/d from Aug. 1, Saudi Arabia gave one of the causes for market speculators to let world crude oil prices shoot up on July 1. August WTI surged $1.69 to $38.20/b, bringing the advance in the two previous days to more than $3/b. August Brent jumped $1.52 to $36.02/b. Both contracts leapt the previous day, also, because of a weekly snapshot showing a decline in US commercial crude oil inventories.

These factors stopped a decline in prices. By June 30, market fears had begun to switch from supplies of gasoline for summer to supplies of heating oil for the winter, which had not been replenished as much as usual. Because of high prices for natural gas, US power generators had switched from gas to low-sulphur fuel oil thus draining heating oil inventories. Compounding the price swings, speculative funds had returned to the oil futures market as well.

The US Department of Energy on July 1 said American crude oil stocks had fallen by 500,000 barrels to 304.9m in the week to June 25, while the API said they had dropped 4.2m barrels to 304.6m. The Energy Department said gasoline stocks had held steady at 205.1m barrels; the API said gasoline inventories had dropped 2.1m barrels to 204.12m. Traders were on alert for a rise in gasoline demand over the US Fourth of July weekend.

Announcing the new price defence level for OPEC on June 30 was Saudi Oil Minister Ali Naimi, who was speaking to reporters in Riyadh. Asked whether OPEC would proceed with a scheduled 2m b/d rise in output from July 1, Naimi said: "Actual oil prices are fixed by the market and not by OPEC. The price (for world crudes then averaging about $35/b) is fair and there is no reason to take a measure to reduce or increase production".

There are four reasons for this position: The value of the US dollar relative to the euro and the Japanese yen has fallen by about 30% in the past two years. World oil demand has been much stronger than expected, with the US and China being the main drivers for the growth in consumption. Worldwide, the spare capacity for oil supply has fallen to less than 1.5m b/d, with most of this being in Saudi Arabia. And the Middle East now is more unstable than at any time in recent decades: a still chaotic situation in Iraq with violence continuing despite a June 28 US handover of sovereignty to the Iraqis, civil war in Saudi Arabia, an endless cycle of violence between the Palestinians and Israel, and uncertainty in most other countries in the region including Iran (see Recorder of this week's Diplomat Package).

Although crude oil prices have fallen from a peak of $42.75/b for WTI in early June, mainly due to a big increase in OPEC supply, they could rise again in mid-August if in Venezuela President Hugo Chavez provokes violent unrest that might affect the country's oil exports to the US. Apart from high gasoline consumption in the US, demand for low-sulphur fuel oil needed for power generators (for air-conditioning) in the American market has risen by almost 25% since mid-2003.

Minister Naimi's statement followed a debate among OPEC oil ministers who, after their June 3 conference in Beirut which decided to raise production by 2m b/d from July 1, held a long-term strategy discussion in the Lebanese capital on June 4. Venezuela and Iran were in the lead among members calling for a higher price defence level.

Venezuela and Iran, trapped by huge budget deficits, demanded a sharp increase in the price target, pushing the floor up to $28/b. But Saudi Arabia wanted to adjust it for inflation and dollar depreciation in the last four years, to a floor of around $26/b.

The Saudi message means that, given the strength of current fundamentals and the capacity needs of the oil market in the future, $35/b should not be considered a high price.

APS Energy Group estimates that OPEC's actual production, including 2m b/d in Iraq, in July could exceed 29m b/d. OPEC has not pumped such volumes since the second oil shock caused by the Iranian revolution 25 years ago. AEG says Saudi Aramco in early July was already producing 9.2m b/d (while non-OPEC Russia was producing about 9.3m b/d).

This means Saudi Arabia only has about 1.3m b/d of spare production capacity. Spare capacities anywhere else, including Kuwait and Abu Dhabi, is less than 200,000 b/d.

The fear premium that has helped boost oil and gold prices this year contracted on June 29 as commodity markets factored in the latest political developments in Iraq and Saudi Arabia. Gold prices dropped $8 to $392.00/$392.75 a troy ounce in London trade, down from its late quote in New York of $400/oz. August Brent fell 59 cents to $33.11/b in London trade, extending the $1.24 decline from June 28. August WTI fell 58 cents to $35.66/b, extending the $1.31 fall from the previous session. Fears of attacks on Saudi oil infrastructure have subsided, with some Wahhabi militants giving themselves up during a month-long government amnesty.