OPEC's Relevance

Some of the headlines about the OPEC meeting in Qatar today give the impression of an organization in disarray, as the oil market falls off a cliff. I think we could use a bit of perspective, here. OPEC functioned perfectly well, from their perspective, while prices rose steadily. Discipline was unnecessary, as members sold every drop they could produce--barring civil unrest, pipeline accidents, or running short of the grades of oil the market actually needed. In effect, from 2003 until recently, OPEC was irrelevant to both consumers and themselves. Things are shifting back into a more normal mode for OPEC, as demand slows and inventory creates a bit of headroom. I suspect that they and we are unaccustomed to that, after three years of ascending on auto-pilot.

Putting prices into their proper context, yesterday's closing level of $57.70/barrel on the New York Mercantile Exchange, while $20 lower than this summer's highs, is still roughly twice the historical average nominal oil price. It is also higher than the averages for 2005, 2004, 2003, or any previous year you care to examine. Even in real dollars, you have to go back to the tail end of the last energy crisis, in the early 1980s, to find a higher real price.

Of course, that's what's on OPEC's minds. They remember the price collapse of 1985-86, when sellers had to come up with creative ways to induce buyers to take their oil, and one of those clever mechanisms--the netback price--created a positive feedback loop that accelerated the collapse. They also remember the 1990s, when prices dropped from $20 in November 1997 to bottom out under $11.00 a year later. They know that after several years of very high prices, consumers start to adjust their habits, and non-OPEC producers find new ways to eke out more production. The market is moving off auto-pilot, and the cartel must think about trying to set a new course.

Watching this from the vantage point of the gas pump, it's easy to magnify OPEC's problem. We've seen US average gasoline prices drop by 80 cents per gallon, or almost $34/barrel, but roughly $15 of that has come from the collapse of refining margins, which doesn't affect OPEC directly--but has hammered pure-play refiners such as Valero. The real story here is that crude oil and petroleum product inventories are well above their seasonal averages, and the risk of war with Iraq over its nuclear program has apparently receded. OPEC needs to trim by a million barrels per day or so to bring supply and demand back into balance. If they can't achieve that now, prices will fall farther and they risk needing a larger cut later, just when the winter demand really kicks in. That could produce a very nasty whipsaw in the market.

In any case, no matter how much they might wish to be seen that way, OPEC is not the Federal Reserve Bank, and the measure of an OPEC meeting isn't in its concluding press release, but in the reports of actual deliveries four to six weeks later.