Iran-Saudi Price Pact Helped OPEC Ride A High Wave; Now Taking A Difference Course.

*** OPEC No Longer Can Control Oil Pricing; It Has Two Options: Either To Curb Output When The Price Of Its Basket Of Seven Crude Oils Falls Below $35/Barrel (Meaning Below $25 In Late '02 US Dollars), Or To Produce At Capacity When Its Basket Price Is Above $40/B -

*** But Some Hawks Want A Higher Price Ceiling & A New Basket To Include A Big Share For Sour Crude Oils 

*** The Crude-Long Moderates Are Worried That, If Conventional Oil Becomes More Expensive, Other Sources Of Fuels Will Receive A Preferential Treatment Such As Tax Incentives At The Expense Of The Former -Not Only Because The Latter Is Nearer, But...

ISFAHAN - With OPEC having just held a ministerial meeting in this Iranian city for the first time in 34 years and the oil ministers of Iran and Saudi Arabia having celebrated the outcome of their 1999 price defence pact, the organisation has begun to reverse course to defend the share of conventional oil in world energy. The new course will have major implications for both the oil market and the petroleum producers of the Middle East.

OPEC's ministerial meeting on March 16 raised its official oil output ceiling by 500,000 b/d to 27.5m b/d immediately and decided to hold similar meetings in Vienna on June 7 and Sept. 19. But as crude oil kept rising to record levels, on March 8 OPEC's current president and Energy Minister of Kuwait, Shaikh Ahmad Al-Fahd Al-Sabah, said he will consult with fellow members on raising the limit to 28m b/d - excluding Iraq - within ten days if prices have failed to come down.

In effect, at Isfahan ministers realised that the oil price defence pact struck in early 1999 by Saudi Arabia and Iraq - following intensive talks behind the scenes with prices below $10/barrel - had enabled OPEC to ride on a wave of prices which now has become too dangerously high for conventional oil to withstand. Its share of global energy, relative to alternative sources of fuel, is at stake. WTI on March 17 hit a $57.5/b record before settling a lower level, but people now are talking of a $70-100/b range in the next two winters. At such high levels at lot of alternative fuels will price OPEC oil out of many markets before long.

High oil prices reflect two big structural changes: (1) low oil stock-ing since 1996, with IEA states still unwilling to release strategic reserves when supplies are short; and (2) a natural decline of non-OPEC output due to a depletion of reserves, water incursion into oilfields, and a fall in reservoir pressure.

The impact of these changes is amplified by two factors: a strong global economy, and the move of speculators and investors from equity and securities to commodity markets (see Oil Market Trends 11 of last week's APS Review, omt11IndnsExprtMar14-05). In this tight supply/ demand environment since late 2002, high oil prices will not only persist but will also get NYMEX/IPE speculators to perceive additional reasons for the upward spiral to continue, particularly when risks of tighter supply appear, such as a refinery accident here or pipeline sabotage there.

The most important message from Isfahan was not OPEC's communique, but rather the hints some ministers including Saudi Arabia's and Kuwait's gave in their statements: "stock up as much oil as you can while it's available, to use it when we [OPEC] won't be able to pump more". And the other hint was that OPEC, including Iraq, was going to produce more than 30m b/d through the coming months.

OPEC capacity is slightly over 31m b/d. But almost 2m b/d of this consists of heavy/sour crude oils in Saudi Arabia, which only a limited number of OECD refineries can turn into profitable fuels.

An important part of oil's price is a risk premium, some of the risk being imaginary. Conflict and terrorism pose threats not only to current oil output, but also to investment in future production. With the focus now being on the Middle East, western oil supplies have become more dependent on sources like Russia, Venezuela, Nigeria, Angola, Sudan and the Caspian. Oil production from the US, UK and Australia is in long-term decline. Norway, Russia and possibly Mexico are likely to see falling output within the next five years.

The US Market's Out Of OPEC Hands: In terms of fuel prices, an unprecedented coupling of market emphasis on heating oil and gasoline is taking place in the US as the cold in the north is not over. As on NYMEX the price of front-month WTI - a light/sweet crude oil rich in gasoline and distillates - nears $58/b, the price of regular gasoline at the US pump may soon exceed $2.40/gallon. If WTI crests above $60/b, Americans could be paying $2.75/g even before the summer driving season peaks. Already the US market is beyond control where OPEC is concerned - not to mention China and India whose combined oil consumption growth this year is expected to exceed 850,000 b/d, and this is a conservative estimate by APS Energy Group.

This sudden spurt, frustrating both OPEC and anyone in the US filling up their tank, reflects heavy speculation in oil futures, and a combination of big demand and limited spare capacity on both sides of the supply and demand chain. The Christian Science Monitor on March 18 quoted John Felmy, chief economist at the American Petroleum Institute (API), as saying: "The market is pretty tight right now".

With April WTI at a $57.50/b high before settling at a lower level on March 17, gasoline hit a record at $2.05/g nationally. The CSM quoted Mike Fitzpatrick of the commodities trading firm, FIMAT USA, as saying: "Who knows where it will go? Speculation [in oil futures) is running rampant... Now, we're seeing pension funds, equity funds, people who feel they need a commodity component in their portfolios. They are unencumbered by numbers, by history".

Despite the high prices, US energy demand continues to be strong. Some of this is weather-related: Cooler than normal temperatures have kept demand for home heating oil strong in the North-East, by far the world's biggest oil market. Felmy of API said: "It's been a long, cold end of winter". At the same time, Americans are driving more. On March 16, API statistics showed a 1% gain in gasoline demand in February. Some of the rising demand is the result of a healthy economy, says Felmy.

Globally, demand remains strong as well. The main forecasters continue to predict that China will represent over a third of the growth in world oil demand. Some of the Chinese appetite comes from work on filling a strategic petroleum reserve of up to 750m barrels.

Mark Baxter, director of the Maguire Energy Institute at Southern Methodist University in Dallas, says OPEC cannot help much even as it pumps at capacity, as most of the demand growth is for the lighter and lower sulphur end of the barrel. "Unfortunately", he says of Saudi Arabia's spare capacity, "it's the heavier grade, not the sweet stuff [which is better for making gasoline]". Baxter predicted on March 15 that, if the WTI price remained at its level, the national average price of gasoline in the US could soon hit $2.40/g. However, if the WTI price rises to $60/b, he says the price of gasoline at the pump could move as high as $2.75/g.

The price spike comes as the US Congress is focused on energy. Last week, the Senate, in a budget bill, moved to open up drilling in the Arctic. The legislation must now pass the House. On March 16 President Bush told a press conference: "I'm concerned about what it means to the average American family when they see the price of gasoline going up". The price of gasoline then was 33 cents/gallon higher than it was in mid-March 2004. On an annual basis, this means US consumers spent an additional $40 bn at the pump. "It's a lot of income spent on gas[oline] that could have gone to other goods", Felmy noted. In fact, now that the price of gasoline is above $2/g and rising, Baxter thinks Americans will start to change their driving habits, saying: "They will become more efficient, make fewer trips. How high will it have to go before consumers start to trade in their SUVs for more efficient or hybrid types of vehicles?"

Some of those moves may be happening already. General Motors and Ford, which make many of the large SUVs, report significant increases in inventories. Felmy said: "The most recent numbers indicate some pretty dramatic declines in the sales of SUVs, particularly the larger ones".

At the International Petroleum Exchange (IPE) in London, Brent crude on March 17 hit an all-time high of $56.15/b in early trading, but fell back slightly later as dealers took profits from the surge. The jump was to feed into higher pump prices in the following days even though the UK Chancellor of the Exchecker Gordon Brown froze fuel duties in the March 16 budget in response to the high oil price.

OPEC blames speculators for the price rise rather than a genuine shortage. Unice, the pan-European employers' body, on March 17 warned that a $10 rise in the Brent crude oil price would knock 0.3% off the European Union's already "feeble" economic growth prospects.

The Isfahan Event: The Isfahan meeting on March 16 took place near the muddy waters of the city's Zayandeh Rood River. The gathering was a testimony to a consensus which has shaped a rare unity among the Gulf oil producers in OPEC over the past five years. This rapprochement, based on the Saudi-Iranian price defence pact struck in early 1999, helped set in motion OPEC's most successful period since its creation in 1960. Cordial inter-state relations featured a resumption of diplomatic relations in early 2000 between Iran and Algeria, with the rapproche-ment arranged in late 1999 by APS Energy Group President Pierre Shammas. These and other efforts culminated in OPEC's summit conference held in Caracas in September 2000 and in OPEC's adoption of a $22-28/b price and for its basket of seven crude oils. This band was dropped quietly in late 2002 as Venezuelan production and exports stopped because of national strikes.

The Isfahan meeting also came at a time of acute diplomatic tension with the US over Iran's nuclear programme. The potential for a confrontation over Tehran's alleged development of nuclear weapons was raising concerns in oil markets. With most OPEC members producing close to full capacity, traders worry that any disruption in supplies, either through war, a blockade or accident, could send prices surging to $70-100/b.