Abraham Energy Report

Largest Cut in History. OPEC met in Oran, Algeria on December 17, 2008, and decided to cut 4.2 million barrels per day (mmbd) from their actual September production level of 29.045 for the OPEC 11 subject to production quotas, effective January 1. This amounts to an additional cut of approximately 2.4 mmbd from the October production quota level of 27.308, and a cut of 2.9 mmbd from estimated November production, if the cuts are fully implemented.

While this is a somewhat confusing way to present their decision, the Algerian announcement would imply a new OPEC 11 production goal of 24.845 mmbd from January 1. When combined with the October agreement, this latest cut represents a cumulative 4.0 mmbd decline from the September quota agreement, and a 4.2 mmbd cut (or 14.4%) in actual OPEC production from September levels.

The 2.4 mmbd additional cut is the largest the organization has attempted at one time in its history to date. Non-OPEC producers Azerbaijan and Russia, who attended the meeting as observers with great fanfare, declined the opportunity to join OPEC and did not make a formal pledge to cut production and exports. Mexico and Norway declined to participate, saying that their production was already declining as a result of depletion.

Even with these latest cuts, and with cooperation from everyone on compliance, OPEC President Chakib Khelil indicated that 2009 will be a very difficult year and that it may take six months or more to remove oversupply from the market.

Here are the operative words from the communiqué issued after the meeting:

Having reviewed the oil market outlook, including overall demand/supply projections for the year 2009, in particular the first and second quarters, the Conference observed that crude volumes entering the market remain well in excess of actual demand: this is clearly demonstrated by the fact that crude stocks in OECD countries are well above their five-year average and are expected to continue to rise. Moreover, the impact of the grave global downturn has led to a destruction of demand, resulting in unprecedented downward pressure being exerted on prices, which have fallen by more than $90 per barrel since early July 2008. Indeed, the Conference noted that, if unchecked, prices could fall to levels which would place at jeopardy the investments required to guarantee adequate energy supplies in the medium-to-long-term.

In light of the above, the Conference agreed to cut 4.2 million barrels per day from the actual September 2008 OPEC-11 production of 29.045 mmbd, with effect from 1 January 2009, with Member Countries strongly emphasizing their firm commitment to ensuring that their production is reduced by the individually agreed amounts.

Recap. OPEC really had little choice. They had to act and act forcefully. When OPEC met in September with an admonition to its members to “strictly comply” with their production quotas, WTI prices had already fallen from the $147 per barrel peak to a level of $103. Prices continued to slide on news of weakening demand and global recession, prompting OPEC to call an emergency meeting in Vienna on October 24, where they agreed to cut production by a further 1.5 mmbd. By this time, prices had already fallen below $65 per barrel.

Since they last convened formally in Vienna on October 24th, and again informally in Cairo on November 29th, the world economic outlook, prospects for global oil demand, and the price of crude oil have continued to deteriorate. The NYMEX WTI contract for January delivery fell to an intra-day trading low of $40.50 per barrel in the week before the meeting in Algeria, and the OPEC basket hit a four-year low at less than $38.00.

In the last few months, the downward momentum in prices provided a perfect set of circumstances for traders to short the market, putting additional downward pressure on prices in what became a self-fulfilling prophecy. This was just as true for all other commodities as it was for oil. The interesting point here is that the continued weakness of the dollar in the past few weeks has actually been contributing a mild boost to oil prices.

Low prices appear to have focused the minds of the ministers who attended the meeting; agreement was swift, with little apparent dissention. There was a lot of communication among the ministers and with the press in the days before the meeting, and most analysts felt that OPEC would cut by about 2.0 mmbd.

Demand Destruction. The International Energy Agency (IEA), the U.S. Energy Information Administration (EIA), OPEC, and many other oil market analysts continued to cut their oil demand and price forecasts for both this year and next. And there is no guarantee that the markdowns have caught up with reality. The financial crisis is continuing to morph into a global economic recession of uncertain magnitude and duration. Reuters recently reported that apparent oil demand in China fell 3.5 percent in November from a year earlier, the first decline in more than 3 years.

Global oil demand is now certain to shrink in 2008 for the first time in 25 years, and a consensus is developing around the notion that demand will fall next year as well. The only question is by how much. In the December round of monthly oil market reports by OPEC, the IEA, and EIA, only the IEA expects to see some small measure of oil demand growth in 2009, while most others expect further demand decline on the order of 0.2 to 0.4 mmbd. The investment bank Goldman Sachs expects oil demand to contract by as much as 1.7 mmbd next year. Nearly everyone expects the first half of 2009 to be weaker than the second half, especially given the large inventory overhang.

At the current juncture, it appears almost certain that the outlook for oil demand will continue to weaken well into the next year and possibly beyond. Assuming strict compliance, the newly announced cuts, when coupled with the old, now appear to be large enough to account for some additional deterioration in the demand outlook. After some months of relative inaction, OPEC now appears to be racing ahead once again in an attempt to catch up with a declining market.

Bringing supply and demand into better balance next year will still prove to be tricky, especially in the first half of 2009 when demand could be its weakest. In addition to the uncertain global economic outlook, the wild cards in this deck now appear to be the size of the growing inventory overhang, the degree of OPEC compliance with the agreed cuts, and the uncertain outlook for non-OPEC supplies.

As we pointed out in last month’s Abraham Energy Report (“The OPEC Meeting: Chasing Demand Downward”), OPEC did let the market get ahead of them to a large degree in the past few months, as demand fell away faster than supply could be cut. While there are many reasons for this, inventories ballooned as a result, and to a level that could become a further drag on demand in the future.

In part because of declining demand, commercial inventories of crude and products in the OECD industrialized countries swelled to near 57 days of forward demand coverage, well above the five-year average, and well above the 52-53 days of coverage preferred by OPEC. The extra inventory by itself (about 200 million barrels) will require fairly massive production cuts to correct, cuts well below what would be needed to balance supply and demand in 2009, even with some further deterioration in demand prospects.

Steep contango in the market has also provided an economic incentive to oil traders, producers and consumers alike to buy and store oil for future sale at a higher price. Algeria’s oil minister and current OPEC President Chakib Khelil said in a press conference before the meeting that oil stored at sea has swollen to almost a full day’s supply of around 86 million barrels. Other industry experts, however, put the figure closer to 50 million barrels.

OPEC cuts. While the market seems to be fixated on the speed and magnitude of demand destruction related to the global economic meltdown, OPEC has been moving to implement the production cuts agreed to at their last meeting in Vienna on October 24. The latest data on OPEC production in November (see table below) show output for the OPEC 11 subject to quotas at an estimated 27.8 mmbd, a decline of 1.7 mmbd from the August peak. However, even with these cuts, OPEC was still producing nearly 0.5 mmbd above the quota of 27.3 mmbd agreed to in October.

To be fair, it takes time to notify customers, rearrange shipping schedules, and otherwise implement production cuts. Several OPEC members have already notified their customers about further supply cuts in December and January, even in advance of the latest meeting and decision to cut output further in Algeria. In addition, while there is some discrepancy in the November OPEC production figures, especially for Saudi Arabia and Iran, early data showing OPEC’s output at the end of November and early December indicates that there have been some further reductions below the November averages.

It appears that OPEC was already well on its way towards fairly respectable compliance with the previous cuts agreed to on October 24 when this new decision to cut by an additional 2.4 mmbd was made in Algeria. December output by the OPEC 11 could show a large degree of compliance with the October agreement, but it will take some time to implement the additional cuts in the Algerian agreement.

TABLE 1 (mmbd)
	Production		Target
OPEC Member	Oct.	Nov. (est.)	Sep.	Nov.	Dec.***
Algeria	1.4	1.3	1.357	1.286	1.201
Angola	1.9	1.8	1.900	1.801	1.507
Ecuador	0.5	0.5	0.520	0.493	0.429
Iran	4.0	3.9	3.817	3.618	3.337
Kuwait	2.6	2.5	2.531	2.399	2.222
Libya	1.7	1.7	1.712	1.623	1.473
Nigeria	1.9	1.9	2.163	2.050	1.705
Qatar	0.9	0.9	0.828	0.785	0.730
Saudi Arabia	9.4	8.7	8.943	8.477	8.020
UAE	2.5	2.3	2.567	2.433	2.227
Venezuela	2.4	2.3	2.470	2.341	2.014
Total OPEC 11	29.2	27.8	28.808	27.308	24.845
Iraq *	2.3	2.3	(2.300)	(2.300)	(2.400)
Total Implied OPEC Output **	31.5	30.1	31.108	29.608	27.245
* Iraq is excluded from quotas ** Crude oil; excludes Indonesia *** Calculated as 85.6% of actual September output as reported by OPEC. Detail may not add to total because of rounding. Sources: EIA, IEA, MEES, OPEC, Reuters

As the table shows, full compliance with the cuts agreed to in Algeria would imply an OPEC 11 output level of 24.845 mmbd (or 27.3 mmbd for the OPEC 12 including Iraq) in 2009. These figures exclude Indonesia, which has suspended its membership in OPEC beginning January 1. This is well below the estimated output of 30.4 mmbd for the OPEC 12 in 2008, and in line with expectations that overall oil demand will shrink in 2009.

OPEC’s own forecast, which came out the day before the meeting in Oran, expects demand for OPEC 12 crude oil to average 29.3 mmbd in 2009. If there is full compliance with the new quota, and if demand doesn’t deteriorate any further (two big ifs), the OPEC cuts just announced could eventually bring the market into better balance.

The question remains if the new cuts will be enough to account for still shrinking global demand and a return to more normal stock (inventory) levels. The problem is also complicated by the fact that the first half of 2009 could be much weaker than the year as a whole, especially if the inventory overhang comes into play.

Compliance. Will compliance with the Algerian agreement be as respectable this time around? With prices and revenues already pinching the budgets of most OPEC members and many non-OPEC supporters, like Russia, there may be reluctance on the part of some members to cut further, especially if prices remain weak. It’s easy to agree to production cuts in a cohesive group setting of an OPEC meeting, but actual production cuts are taken on an individual basis where national politics holds sway.

If the latest round of cuts succeeds in shocking the market and nudging prices upward, revenues will improve and possibly make compliance an easier pill to swallow. On the other hand, higher prices could prove to be a strong temptation to produce more, and lead to quota busting. This will be especially true for Venezuela, Iran, Nigeria and Ecuador, as well as Russia, who are all facing difficult political choices at home.

As a result, its possible that we could see a considerable amount of seesawing in prices and OPEC output over the course of next year. OPEC also has to be wary of the world’s fragile economic condition. Some in OPEC view the drop in oil prices as their contribution to economic recovery, and some may be better prepared and able to live with relatively low prices for a year or two.

Too rapid a rise in oil prices, even to the level of $75 per barrel often mentioned by several OPEC ministers as a “fair” price for oil, could choke off any anemic economic recovery and prolong the recession. Too rapid a price rise could also shrink the demand for oil further and raise the prospect of additional production cuts. This is something many in OPEC do not want to confront.

OPEC may have some limited success in preventing prices from falling much further, but it seems doubtful that they will succeed in raising prices to $75 per barrel anytime soon. Sustained higher prices may only be possible when the global economy shows definite signs of recovery and renewed growth.

The picture is far from clear. There are a lot of uncertainties out there that could radically alter the picture and the market’s perception of balance. Economic meltdown and falling oil demand has been the big story and the main focus of the market. OPEC’s production cuts to date and the almost daily anecdotal evidence of delayed, postponed, and canceled investment in new supplies, have been largely ignored by the market. At some point in the next few years, especially when economic recovery gets underway, the supply side will come back into focus.

The recent production cuts announced by OPEC would provide the world market with a comfortable margin of spare capacity to offset any unforeseen disruptions in supply for the next few years, and this is generally a good thing. It will also provide us with a cushion of supply for a few years if and when demand begins to recover. But the impact of low prices on investments in additional capacity for the medium and longer term could be disastrous.

While the speed and magnitude of the decline in demand have mesmerized the market, the outlook for non-OPEC supplies may be deteriorating almost as rapidly. The latest round of forecasts by OPEC, the IEA and EIA have non-OPEC supplies rising by 0.5 to 0.7 mmbd in 2009, an outcome which is by no means assured. Other forecasts show non-OPEC supplies falling next year by 0.5 mmbd or more, a difference of almost 1 mmbd. A drop or minimal growth in non-OPEC supplies next year will help make the OPEC production cuts more effective.

Who is right among these forecasts remains to be seen, but total non-OPEC liquids production, including natural gas liquids (NGLs), could take a hit from lower prices and recession-induced lower demand for natural gas. OPEC and non-OPEC NGLs have made an important contribution to supply in the past few years, and a global recession could affect natural gas demand and adversely impact NGL supplies.

Key Findings

• OPEC hoped to deliver a dose of shock therapy to the market in an attempt to stem the decline in oil prices but, for reasons largely beyond their control, they may have fallen short.

• 2009 will be a very difficult year. Without some clear signs that the global recession and ongoing markdowns in oil demand are bottoming out, the supply overhang could persist well into the new year and possibly beyond. The inventory overhang could be especially troublesome.

• OPEC may have some limited success in preventing prices from falling much further, but it appears doubtful they will succeed in raising prices to $75 per barrel anytime soon. Sustained higher prices may only be possible when the global economy shows definite signs of recovery and renewed growth.

Analysis by John Brodman, contributing eidtor of the Abraham Energy Report
Dec. 17, 2008

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