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THE WALL STREET JOURNAL: Oil-Price Rise Poses OPEC Conundrum

By NEIL KING JR. in Washington and GUY CHAZAN in London
February 29, 2008; Page A3

Oil prices finished at a new high for the second time this week, bolstering the likelihood that OPEC will sit on its hands at next week’s meeting in Vienna.

The Organization of Petroleum Exporting Countries, which supplies about 40% of the world’s oil, had signaled it was considering a production cut to compensate for economic softness and a slowdown in major consuming markets. But oil’s recent surge has made a production cut politically tricky, market watchers say.

Oil’s rise flies in the face of many of the indicators OPEC watches. Crude-oil inventories in the U.S. are swelling, while gasoline stocks are at 14-year highs. Still, the Energy Department is warning of record prices at the pump this spring. Other market watchers are eyeing thin oil inventories elsewhere in the developed world.

U.S. benchmark crude yesterday jumped $2.95, or 3%, to finish at $102.59 on the New York Mercantile Exchange, continuing a run that has pushed oil up 12% this month. Oil could soon test its all-time inflation-adjusted high of $103.76 a barrel, reached in the spring of 1980.

The prospect of another U.S. interest-rate cut is helping to push oil and a raft of commodity prices higher. The Federal Reserve’s rate cuts typically weaken the dollar; oil futures offer a hedge against inflation and a falling dollar, which established a new low against the euro yesterday.

OPEC ministers have made clear in recent days that they aren’t likely to respond to bullish prices by boosting supplies. It seems equally out of the question that the cartel will agree to a formal output cut — which would drive prices higher — even if two or three producers within the 13-member group back such a move.

Looking further down the road, OPEC faces a potentially daunting challenge: The group may have to begin acting like an actual cartel again if world-wide oil-demand growth continues to cool, as nearly all forecasters believe it will. That means OPEC would have to agree to reimpose internal production restraints to try to keep supply in line with slackening demand, even at a time of triple-digit prices.

Since 2003, with a few brief exceptions, nearly all OPEC countries have produced flat-out to meet soaring demand in Asia and the Middle East. This year, the cartel believes world-wide demand could grow by about 1.2 million barrels a day, to just shy of 87 million barrels a day.
 
The unexpected twist is that most of this new demand could well be slaked by boosts in non-OPEC supplies, mainly in increased amounts of natural-gas liquids, biofuels such as ethanol and nonconventional oil such as Canadian tar sands.

Analysts say that all those sources, together with an expected bump of about 200,000 barrels a day in conventional non-OPEC production, may more or less match the world’s increased thirst for oil. OPEC ministers flagged this possibility when they met a month ago. Analysts within the cartel forecast that the demand for OPEC supplies this year may be 400,000 barrels a day less than last year.

But imposing a new set of quota limits would be a highly contentious matter. The group scuttled its system of formal caps, which had been set at 28 million barrels a day, in September 2006. The group is now producing about 32 million barrels a day.

“This is the first year in some time that OPEC may have to start acting like a cartel again,” said Larry Goldstein, an economist at the Energy Policy Research Foundation.

A move to rein in OPEC production would come as several of its key members, including Iraq and Angola, are looking to boost output. The cartel’s de facto leader and largest producer, Saudi Arabia, is also set to bring nearly two million barrels a day in new capacity online over the next 18 months. “Many of these producers are going to have to start cutting back,” Mr. Goldstein said.

At the International Energy Agency, the Paris-based watchdog for developed oil-consuming countries, the picture is less than comforting. The IEA says that “forward cover” — a way of measuring inventories that accounts for expected use — is down to about 51 days of supply, well below the five-year average and the lowest it has been since the end of 2004.

Looking toward next week’s Vienna gathering, some OPEC officials are expressing dismay at the continued surge in prices. At its last session, the group signaled that slumping demand in the developed world could trigger a formal output cut, especially if prices began to fall sharply.

“The feeling right now is that the price is very high, but not because of fundamentals,” said one senior OPEC official, who estimates that at least a third of the price run-up over the last year is due to what he calls “pure froth” — basically, speculative flows of money into the oil market.

OPEC’s dilemma now is in some ways similar to the one it faced in the late summer of 2006, when the group was also fretting over slumping demand and a potential glut in supplies. Then, the group decided to scrap its formal quotas and trim output informally. But that decision sparked a heated debate within OPEC over which country should trim output, and by how much.

The cartel then decided twice in the following three months to formally cut production by a total of 1.7 million barrels a day. The big difference between now and then, though, was that prices were falling precipitously in the late summer and fall of 2006.

•  Pushing Higher: Oil prices’ continued rise has made an output cut by OPEC less likely.

•  Mixed Signals: The rise has confused OPEC officials, who point to indicators that suggest oil prices should be facing downward pressure.

•  Market Concern: An energy watchdog group points with concern to dwindling stocks in developed countries.

Write to Neil King Jr. at neil.king@wsj.com and Guy Chazan at guy.chazan@wsj.com

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