The oil market's conflicting signals complicate OPEC's output choices

OPEC is facing a bit of a dilemma as it prepares for a production meeting later this month: Does it evaluate the oil market based on supply and demand fundamentals -- or on the current price? Oil traded late Wednesday afternoon down sharply, to around $70.75 per barrel, after falling on Tuesday. However, it's still up about 100% since this time last year.

The consensus is that OPEC nations, which produce about 40% of the world's oil, won't cut production during a meeting in Luanda, Angola, later this month where the cartel will discuss production policy and output quotas. Saudi Arabian Oil Minister Ali al-Naimi signaled as much when he told Bloomberg News oil prices are in "the right range" and there is no need to reduce production.

As the U.S. and global recessions took hold, OPEC (excluding Iraq, which isn't subject to quotas) cut its production ceiling by more than 4 million barrels per day (bpd) in 2008-2009, eventually agreeing on 24.8 million bpd. However, with most members exceeding their quota, OPEC actually pumped about 26.5 million bpd as of November, according to cartel data.

Taking account of oil supplies globally, which include an above-average 61-day supply in November for the world's developed economies, according to the U.S. Energy Information Administration, one could make a case for a production cut.

The production-cut camp argues the real culprit in today's high, $70-plus oil price isn't supply, which is plentiful, but the weaker dollar. Because oil is traded in dollars, it frequently rises when the dollar weakens, and vice versa. If the U.S. trims its budget deficit and/or the U.S. economy strengthens, the dollar will also strengthen, leading to a large drop in the price of oil.

On the Other Hand...

Conversely, another camp of economists -- and no doubt most business executives and American drivers -- would argue that despite plentiful oil supplies, a production cut with oil at about $70 would be close to preposterous. This camp argues that at $70 to $75, oil's price is already high from a historical standpoint and that anything higher would jeopardize the young U.S. and global recoveries. That's especially true in the U.S., where every $1-per-barrel rise in oil decreases U.S. annual GDP by $100 billion, and every 1-cent increase in gasoline pump prices decreases annual U.S. consumer disposable income by $600 million.

Further, U.S. consumers' pain at the pump has been acute in 2009. The average price for unleaded regular gasoline in the U.S. is $2.64 -- up 60% compared to December 2008. In many high-cost areas, such as New York, Los Angeles and San Francisco, that's already approaching $3 per gallon, with super unleaded over $3 per gallon. Without question, high gasoline prices throughout much of 2009 reduced Americans' disposable income. And persistent prices over $3 would further crimp those already pinched budgets.

Taken together, we're at a point in the oil market where, paradoxically, the price of oil is too high to suggest an OPEC production decrease, but supplies are also too plentiful to justify a production increase.

Oil Is a Commodity -- and an Investment Hedge

The typical investor will read about high oil prices amid a glut of oil and conclude "the oil market is out of whack, there's a contradiction" -- and that conclusion would be accurate. But investors should also know that the oil market has been out of whack for a long time:Supply/demand fundamentals haven't exclusively determined oil's price for more than two years.

The reason? During that time, in addition to being the world's most important commodity, oil became a major hedge investment against a weakening dollar and/or a rise in U.S. inflation. Therefore, barring an international crisis, oil's price in 2010 will be determined every bit as much by the size of the U.S. budget deficit (which affects the dollar's value) as by the size of oil demand increases in China, India and other emerging markets.

Hence, because Congress determines a U.S. budget, a significant portion of OPEC's revenue will be determined by any and all actions legislators take to reduce the budget deficit. That's not a position OPEC is accustomed to being in -- but it's an economic reality of the early globalization age. It'll be interesting to see how the ministers juggle this market's conflicting dynamics in trying to control where oil goes from here.

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