Is It Time to Bet on Oil Again?

With the next meeting of the Organization of the Petroleum Exporting Countries (OPEC) scheduled for May 28th, everyone is asking the same question – will they or won’t they?

Make more production cuts, that is.

If you had asked me this two or three weeks ago, I would have said production cuts were likely with the price of crude seemingly stuck around the $50 a barrel mark. But once Bernanke and the Fed started telling everyone who would listen about “green shoots” of economic recovery taking hold in the US economy, oil has been on an steady upwards trajectory. Two days ago it broke the previous resistance level of $60 and yesterday, a greater-than expected decline in US crude and gasoline inventories pushed crude over the $62 a barrel mark and some analysts predict $70 to be the next price ceiling.

Unless of course investors driving up the price of crude stop to really think this through.

Realistically, what is there in the fundamentals that points to a real and prolonged recovery? The Federal Reserve actually downgraded their earlier predictions yesterday afternoon saying that retail sales and factory production could start to rebound late in the year, but unemployment meanwhile could yet go as high as ten percent! If this prediction comes true, there will be a lot fewer people with the means to buy gasoline and demand will surely wane – and don’t forget that the US still remains the number one consumer of oil in the world It is unlikely that any additional shortfall will be made up elsewhere.

Which brings us back to the OPEC meeting and the question of cuts. On April 26th, Abdullah Salem al-Badri – OPEC’s Secretary General – said that while $50 a barrel was too low and prevented further investment in the industry, $70 a barrel would be more appropriate. If there is indeed the beginnings of positive growth taking root in the US, a sharp rise in energy costs will be just the thing to cut it off at the knees further delaying a meaningful recovery. Such a move will serve no one – neither the consumer nor the oil producing countries.

OPEC has the opportunity to send a strong and supportive signal at the upcoming meeting by pledging to maintain current output levels. This will do much to sustain the emerging demand for oil, likely pushing crude to $70 a barrel within a few weeks. Announcing further production cuts right now however, could be the shock that kills any further talk of green shoots and puts the kibosh on any growing optimism that the worst of this crisis is behind us.

One thought that could throw a spanner in the works however, is that compliance amongst OPEC producers for the previous round of cutbacks last January is estimated at 83 percent. This shows that some dissension remains within the OPEC ranks – certainly Iran would like to drive prices up by reducing output while Saudi Arabia is seen as the most moderate of the OPEC members and often resists production cuts.

My best guess is that OPEC will not introduce more cutbacks so long as oil prices remain strong next week leading up to the summit meeting but there could be a token reference to working towards full compliance of the January cutbacks. Even meeting the full January targets only reduces daily output by another 722,000 barrels so it should have little impact on optimism yet still sends a signal to the markets that OPEC is willing to reduce production if necessary to ensure higher oil prices.

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