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Economy

Can OPEC really call time on low oil prices?

In less than two years, OPEC, the 14-nation producers’  group that accounts for about a third of the world's oil supply, has swung from being written off as irrelevant to becoming the possible "savior" of a besieged market playing havoc with several economies and snuffing out upstream investment.

The 56-year-old organization was virtually cast aside after abdicating its role as a market-balancing force at a pivotal meeting two years ago. That could not have been easy to live down. But after its equally stunning about-face in Algiers in September, living up to its promise of rescuing oil prices from a stubborn bear market should be even more daunting.

Members at an extraordinary meeting on the sidelines of the International Energy Forum in the Algerian capital on Sept. 28 reached an understanding to try and agree to reduce their collective output to 32.5 to 33 million barrels per day from 33.24 million barrels, the level pumped in August, according to secondary sources.

Led by its most influential member, Saudi Arabia, OPEC now wants to bump up crude prices to a band of $50 to $60 through a coordinated output cut with non-OPEC producers, primarily Russia.

Benchmark Brent crude averaged $43.81 in the year to date as of Friday, having dangled between a low of $27.88 in January and a high of $53.14 earlier this month. U.S. light sweet crude averaged $42.20 over the same period.

Crude at $60 per barrel by the end of this year is "not unthinkable," Saudi oil minister Khalid al-Falih said on Oct. 10 in a keynote speech at the World Energy Congress in Istanbul. He cautioned against crimping supply too much, though, lest it "shock" the markets.

A price shock seems a bit incredulous in the current circumstances, especially when global oil inventories are sitting at historic highs and the U.S. has effectively built close to 1 million barrels per day of new "spare capacity," output that has been forced off the market from a peak of around 9.63 million barrels per day in April 2015.

OPEC members' economies are stressed across the board. Some, such as Venezuela, are in tatters. The fact that OPEC ministers within as well as outside the relatively rich Arab world in recent weeks have endorsed $50 to $60 as the new desired range suggests pragmatism more than any real fear of triggering a sharp spike by squeezing the supply too tight. Imposing and policing production caps on battle-scarred members that have been fighting for market share the past two years and have not had any "quotas" since 2009, is going to be a formidable task for the cartel.

However, cuts must come if oil-exporting countries are to have any hope of bringing respite to their finances. The International Energy Agency, the Paris-based energy policy adviser to the Organization for Economic Cooperation and Development, estimates that without any intervention, markets will likely balance only by the end of 2017. That would be too long a wait for oil exporters already gasping for air. Governments have been paring down spending, slashing previously generous subsidies for energy and utilities, siphoning from their sovereign reserves, juggling swollen budget deficits, and borrowing money from the domestic and international markets.

Saudi Arabia earlier this month closed its first ever international sovereign bond issue, borrowing $17.5 billion from investors that were willing to lend it $67 billion. Emerging market bonds offering positive returns have become attractive to investors in an environment of widespread negative yields caused by central banks' bond buying. The kingdom is also preparing to sell equity in its crown jewel, Saudi Aramco, in 2018, which would bring in much more in a higher oil price environment.

Fellow OPEC member Venezuela, in contrast, has been sucking wind. The Latin American producer has been servicing its sovereign debt by paying investors 46% returns, while its population grapples with 500% inflation and severe food shortages. State-owned oil company PDVSA has been fighting an uphill battle persuading investors to agree to a $5.3 billion bond swap and warning that it might default.

Nigeria, the other voice alongside Venezuela advocating for OPEC action for the past several months, is on course for its first annual recession in more than two decades.

But no matter how united Russia and OPEC now seem on curtailing output, internal and external threats loom large. It appears Iran, Nigeria and Libya are to be given a dispensation to reach their full potential, which means, in theory, an additional 1.88 million barrels per day could flow into the markets, wiping out any reductions by the others.

The group's unanimity seems to end at wanting crude above $50. Iraq, OPEC's second largest producer, is currently pumping more than 4.7 million barrels per day. It has previously rejected the "baseline" that would have been used to calculate its new production quota. On Sunday, its oil minister Jabbar Al-Luaibi, speaking at a press conference in Baghdad, demanded an exemption from a cut altogether, prompting fresh doubts over OPEC’s proposed output cut and sending crude tumbling down. 

Russia, which has surprisingly stood by OPEC since the failed production freeze initiative at the start of this year, also has been singing a slightly different tune of late. Its president and energy minister are talking about a freeze rather than a cut. A freeze -- members holding output steady at current levels -- can't lift prices, given that Russia, Saudi Arabia and some other OPEC countries have been pumping at record levels.

The single biggest external threat remains a U.S. supply response to higher prices. Shale didn't crumble under crude's slide as much and as quickly as OPEC had probably gambled in 2014, but U.S. output this year has slumped nearly 900,000 barrels per day from its April 2015 peak of 9.63 million barrels. A $50 to $60 barrel target band seems sensible, but OPEC would need to impose strict discipline and fine-tune its ceiling through a dynamic rather than a static, one-time cut, adapting to any increments in U.S. production or that of its exempted members.

Some in the market believe the global oil inventory buildup of the past two years has started to ease, signaling the start of market rebalancing. If true, the conditions couldn't be more conducive for OPEC to be effective. Disunity, geopolitical strains and mutual suspicion could still force it to snatch defeat from the jaws of victory.

Vandana Hari is founder of Vanda Insights, which tracks energy markets.

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