OPEC has a dilemma

Por Venezuela Real - 13 de Diciembre, 2006, 11:16, Categoría: Petróleo/Energía

Prof A.F. Alhajji
Ohio Northern University
December 11,  2006

OPEC has a dilemma: It cannot have it all. Any action by OPEC would produce results that OPEC does not like.  Converting oil revenues from the dollar to the euro would lower the value of the dollar and consequently reduce the purchasing power of OPEC's oil exports.  Yet some OPEC ministers want to cut production to compensate for the depreciation of the dollar! A production cut would increase oil prices, which might reduce the demand for oil, increase the demand for oil substitutes, and increase non-OPEC production.
 
OPEC is on the verge of announcing a cut in production, but this decision would carry positive and negative consequences.  The net effect of a production cut remains to be seen.  Each cut is unique, and the current market situation will make this cut unique in several ways.  If OPEC members cut production in order to trim swelling inventories and to compensate for the declining dollar, they might not achieve these objectives.  Simply put, OPEC does not control all the factors that affect oil inventories, let alone the value of the US dollar, yet it behaves in a way that makes it looks like it does.

Several experts believe that the contango-where the forward oil price is higher than the prompt price-has fueled an increase in oil stocks.  Several factors contribute to the current contango.  These factors include the continued decline of the US dollar, the expectation that the dollar will continue to decline, the mismatch between the growth in production capacity and the growth in world oil demand, and limited storage capacity.  In this environment, the impact of a production cut on inventories, even if all OPEC members adhere to their quota, is very limited.  The only way OPEC can influence the market is to surprise the market by unexpected actions.  It seems that OPEC policy in recent years has focused on "signals" and "surprises."  OPEC sends signals to the market.  If traders do not react to the signals as OPEC desires, OPEC could shock the market by cutting production when traders do not expect a cut, or cutting more than expected when traders expect a cut.
 
If OPEC shocks the market with a deep cut, it might increase prompt oil prices significantly, which would change the magnitude of the contango or change it to backwardation.  Such a change would reduce demand and spur inflation.  Even if OPEC increases production at later date, these changes will put OPEC credibility at risk and increase price volatility.   For now, if OPEC cuts production as expected by traders, the contango will continue.
 
Ironically, OPEC members are contributing indirectly to the sustainability of the contango, and therefore to the rise in oil inventories in the consuming countries.  Recent reports have indicated that several oil-producing countries have shifted some of their foreign reserves from the dollar to the euro and other currencies.  This shift has contributed to the decline in the value of the dollar in recent weeks.  In response to a decline in the dollar, OPEC members harm themselves when they cut production, raise prices, earn extra revenues in US dollars, and then covert those dollars to other currencies.  This conversion will only promote a further decline in the dollar.
 
The switch from the dollar to other currencies will fuel the contango, which will in turn increase inventories.  Investing in oil inventories will be a safe haven for investors and speculators. Therefore, the impact of a cut that match trader's expectations would be temporary at best.  It will not reduce inventories.   OPEC members, even if they adhere to their quota, cannot continue cutting production to reduce inventories that are built by a contango.
 
In a market with contango and a declining dollar, OPEC must search for an optimal policy that balances production, the real value of oil exports, and the value of its foreign reserves. In the absence of such a policy, a decision to cut production might not be the optimal policy for OPEC.  In short, OPEC's current problems are not the price of oil or swelling inventories. They are the "dollar" and the lack of clear policies to deal with various market situations such as the current one, where oil prices, inventories, the value of the dollar, and the value of foreign reserves are all linked together.





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