Meltdown 101: Why OPEC moves aren't hitting prices

[December 18, 2008]  HOUSTON (AP) -- To understand why OPEC's largest single production cut ever failed to lift oil prices, look no further than today's headlines.

OPEC and other oil-producing countries can't cut production fast enough to stay ahead of plummeting demand as millions of people lose their jobs and stop driving, factories shut down and the world settles in for the worst economic slowdown in a generation.

In other words: Even if OPEC talks about cutting the supply of oil, those cuts are nothing compared to the way the slumping economy is pushing demand downward. So prices keep sliding.

Is there anything more to it? Here are some questions and answers about OPEC's influence over oil prices.

Q: Doesn't OPEC pretty much dominate oil production -- and can't it control how prices go up and down?

A: The 13-nation Organization of Petroleum Exporting Countries controls about 40 percent of world crude supplies -- but the way oil consumption is dropping, there's really nothing the group can do to lift prices, analysts say.

"There's historical precedent that OPEC doesn't have a lot of power within an environment of declining demand," said Jim Ritterbusch, president of energy consultancy Ritterbusch and Associates.

"They can certainly go out and flex their muscles when global oil demand is strong. But when it's weak, they simply don't have a lot of power -- at least not enough to inject a price floor into this market."

Q: What exactly did OPEC decide to do Wednesday?

A: As expected, OPEC powerhouse Saudi Arabia said the group will slash a record 2.2 million barrels from its daily production as of Jan. 1, while Russia and other OPEC outsiders announced their own cutbacks of hundreds of thousands of barrels.

Combined with previous cuts announced in the past few months, OPEC is taking 4.2 million barrels a day off the market compared to September levels.

Q: How did the market react to this move?

A: Oil prices fell. Light, sweet crude for January delivery fell below $40 a barrel on the New York Mercantile Exchange for the first time since 2004.

Q: Wouldn't a cut in production usually increase prices?

A: You can cut supply all you want -- but as long as demand drops even more sharply, prices are unlikely to rise. And demand for oil has crumbled amid the global economic downturn.

Other factors also likely contributed to how the market reacted to the production cut, which was announced at an OPEC gathering in Algeria.

For one, the latest cut was pretty much expected and, analysts said, its impact had already been priced into the market. Also, just because OPEC announces an output cut doesn't mean it's going to happen. OPEC's November production was well above quotas agreed to by member states, so it's no surprise some are skeptical everyone will abide by the new quotas.

"Frankly, the market doesn't believe that OPEC can cut production by 2 million barrels a day," said Phil Flynn, an analyst at Alaron Trading Corp. in Chicago. "It questions whether OPEC has the ability to adhere to the cuts."

Q: What stops these planned production cuts from going into effect?

A: OPEC has to weigh the cuts against the risk of driving the economies of its top customers deeper into recession. Yes, production cuts theoretically can push prices up, but producing and selling less oil means you're taking in less oil revenue -- and that cut in cash flow can be painful in a country with an oil-dependent economy.

Q: Is oil demand expected to turn around anytime soon?

A: Anywhere you look, the numbers paint a bleak picture for at least the coming year.

The International Energy Agency said last week that oil demand will shrink this year for the first time in a quarter-century as rich nations fall into recession and growth slows in the developing world. The Paris-based agency, which represents the interests of 28 oil-importing nations, slashed its forecast for global oil demand next year, saying a rebound depends on economic recovery in the second half of 2009.

The U.S. Energy Information Administration said last week it expects global oil consumption to decline by 450,000 barrels a day next year, down from a November forecast of flat demand.

Some experts say worldwide demand next year could fall by more than 1 million barrels a day.

Q: Aren't plummeting pump prices encouraging Americans to use more gas?

A: Even as gasoline prices have fallen to their lowest levels in nearly four years, money-conscious Americans have sharply curtailed their driving, logging 9 billion fewer miles on the nation's roads in October than they did a year ago.

What's more, subways, buses, commuter rail and light-rail systems have reported record increases in ridership. The bottom line, transportation experts say, is that Americans are fundamentally changing the way they travel.

Q: So the economy's gotten so bad, even plummeting prices won't lift oil demand?

A: Exactly. Many people have been directly affected by the recession, and those who haven't are worried about what might happen to them down the line.

"People aren't buying oil because they're not sure their factories are going to be open next week," Flynn said. "They're not sure they're going to have a job."

Q: Will oil prices go up again at some point?

A: The growing consensus is that not only will prices go up, they will return with a fury.

Falling oil prices lead oil producers to cut budgets for exploration and production. Nothing has changed on the supply side -- oil is getting harder and harder to find. So when economies rebound, there is a fear that we are in for a major price spike as supplies fail to keep up with skyrocketing demand.

[Associated Press; By JOHN PORRETTO]

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