Basking in Higher Prices, OPEC Holds Output Level

At the Vienna summit, the oil cartel left production quotas unchanged, betting that recovering economies will lift demand—and prices

Fire and smoke rise as an Iraqi oil worker observes at an oil field in the southern Rumaila area of Iraq ESSAM AL-SUDANI/AFP/Getty Images

By Stanley Reed

It's a warm spring day in Vienna, and OPEC delegates meeting in the former imperial capital seem more relaxed than they have been in months. There is less behind-the-scenes skullduggery than usual. Instead, it's an opportunity to hold leisurely dinners with colleagues, or even take time out to watch Barcelona beat Manchester United in the European Champions' League soccer match on TV. And why not? The oil market, deathly ill just three months ago, has recovered faster than just about anyone—including OPEC—expected, with prices now above $63.50 per barrel. "They are jubilant," says Kamel Al-Harami, a Kuwaiti oil analyst.

It came as no surprise that with prices moving up OPEC saw no reason to change production levels at its May 28 parley. "Stay the course," the Saudi Oil Minister Ali Naimi shouted cheerfully as he left OPEC's glassy blue and white building to take in the sunshine. OPEC's medicine for weak markets announced late last year—a series of cuts amounting to 4.2 million barrels per day—seems to be working, even though demand remains limp and inventories are near record highs. "We worry less when prices are improving," says the Algerian Energy Minister Chekib Khelil. He added that he thought rising prices were sustainable if the European economies follow what OPEC sees as signs of improvement in the U.S.

$60-a-Barrel Floor

The OPEC kingpins were extremely worried a few months back. But now they are confident—or at least acting as if they are—that the gentle rise toward the $75 to $80 per barrel range favored by some OPEC producers is likely to happen over the next few months. Naimi, the Saudi oil minister and OPEC's key decision-maker, says the world economy now looks healthy enough to support prices at that level. And OPEC delegates argue that a floor has been drawn under oil prices at $60 per barrel, even though oil traded as low as $33.98 per barrel just three months ago, on Feb. 12.

Is the upbeat talk realistic? After all, the fundamentals of the global oil market are still pretty awful. In the first quarter of this year, world consumption was down by about 3% from the year before, or an estimated 3.6 million barrels per day, according to the Center for Global Energy Studies, a London think tank. Given that demand almost always increases year-over-year, that's a huge drop.

Stockpiles in the OECD countries have built to a high 61 days of consumption, and it will take several quarters to drain them to normal levels. "Despite the improvement in price, the outlook for oil markets remains very much uncertain, with most ministers concerned that the bullish market sentiment is not warranted by the poor physical market fundamentals," says David Kirsch, an analyst at PFC Energy, who regularly attends OPEC meetings.

Despite the cheery atmosphere in Vienna, a decline in oil prices is quite possible if the economic outlook darkens again or something else changes the big picture. Kirsch notes that traders have recently stepped up buying of puts, or options to sell oil, at the $40 to $50 per barrel level. Another oil analyst, who asked not to be named, said flatly: "The fundamentals don't justify a price of $60 per barrel."

Many analysts think that prices are higher than they should be because OPEC is getting help from an old bête noire, the financial markets. The huge drop in oil prices from the $147 peak last July didn't kill investors' appetite for energy and other commodities. In fact, there has been a buying spree this year, as some $4.3 billion has flowed into exchange-traded oil and gas funds alone. "With the sharp fall in prices, a lot of people saw the opportunity to lock in long-term positions," says Amrita Sen, an analyst at Barclays Capital (BCS) in London.

Declining Dollar

Investors are betting that the tentative signs of recovery in China and elsewhere mark the beginning of a global turnaround that should lift demand for oil. Some believe that given the annual decline in the output of existing oilfields and ever-growing demand from China and other emerging markets, today's prices are likely to look cheap over the long term. "The market is thinking $60 per barrel is a fair price," says Kamel Al-Harami, the Kuwaiti oil analyst. "It has nothing to do with fundamentals."

There are even tentative concerns that prices could once again spiral out of control, as they did in 2008. After all, if prices can nearly double in the space of three months, as they did this year, what's to keep them from surging again over the rest of 2009?

Prices could be further spurred by fears that the U.S. dollar may weaken in the face of heavy U.S. government spending and the Federal Reserve's buy-up of debt. David Woo, a currency analyst at Barclays Capital, notes that like last year, oil prices are rising when the dollar falls against the euro, as investors look to hedge against the weakening greenback. "The re-emergence of this fundamental correlation appears to be driven by a combination of improved investor sentiment toward global economic growth and increased concerns about the medium-term inflation consequences" of the Fed's actions, Woo wrote recently.

But the betting right now is that further price rises, if they occur, will be modest—at least until a recovery is well under way. The collapse in demand after last year's spike showed that there are limits to how far oil markets can distance themselves from economic reality.

Reed is London bureau chief for BusinessWeek.

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