High price, low demand creates production dilemma for OPEC

Trying to cultivate sympathy for OPEC's concerns is a little like trying to cultivate sympathy for Donald Trump: chances are you're going to wait awhile for a groundswell of support to form.

That said, OPEC does face a bit of a dilemma as it heads into its May meeting Thursday.

The U.S. and global economies remain in recession. There are signs that certain U.S. economic indicators are bottoming, and pointing toward recovery, but no one denies that 'recession bottom' does not mean 'robust GDP growth.' Hence, conditions in the world's largest economy can perhaps best be described as serious and guarded, but no longer on life support, to use a medical metaphor.

Conflicting oil market signals

In this environment, OPEC's goal typically would be to produce at levels that would help keep oil prices low enough to stimulate an economic recovery, but not so low that they jeopardize the cartel's profit margins and oil exploration projects. However, oil inventories at three-year highs argue that the cartel should cut production, as it has to the tune of 4.2 million barrels per day (bpd) since the recession's onset, if it hopes to place a floor under oil prices. Further, that downward pressure would intensify (at least in theory) if the U.S. and international economic recoveries to not arrive as expected in the second half of 2009.

Now consider another factor: oil prices. Aided by a five to ten percent decline in the dollar, and the belief that the U.S. recovery will start soon and could spark inflation, oil prices have risen more than 50 percent in three months to trade around $60 per barrel. Many traders argue that oil at $60 is not in sync with the oil market's fundamentals, but that hasn't mattered much to the spot market. Each day traders sense a major price break to the downside, but days pass, and the price remains at lofty levels. American drivers can certainly vouch for oil's intransigence: it's helped boost gasoline prices by more than 35 percent in five months, to an average price of about $2.35 per gallon for unleaded regular – and this despite weak demand for gasoline, stemming from U.S.'s high unemployment rate.

Hence, OPEC's dilemma: does it look at the current oil price, and keep oil production the same, on the calculation that the $60 is real, forward-looking, and justified, if both the U.S. and global economies start to recover in 2009? Or does the cartel take its cue from inventory levels, and cut production again, on the forecast that current and likely future oil demand can not support prices above $60 per barrel?

Oil Analysis: Most oil analysts expect OPEC to maintain current production quotas, and that fact, combined with bearish technical and fundamental indicators, point to a decidedly downward move in oil prices in the months ahead. That said, this analysis and $20 will get you a cab ride back to the East Side, as we say in Manhattan. Investors should not assume that a major oil price break is ahead: oil has shown a remarkable ability to defy gravity, despite the worst U.S. and global demand conditions in more than 20 years. Rather, investors should look for oil to continue to trend lower, incrementally, pending further signs of strength in the U.S. economy.
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