Significance

It was OPEC's decision to pre-emptively cut output in February 2004 that ultimately set the scene for the record crude price run in 2004. 

Implications

OPEC's decision to hold fire for now suggests that lessons have been learnt from its extremely ill-judged decision this time last year to cut back on production. Suspending the price-band (of US$22-US$28/b) is a long overdue decision that signals official backing for a far higher base price of crude. However, by not cutting yet OPEC is perhaps running the risk of a price fall, where last year the risk was all upside - though with prices still close to US$50/b in the US a drop of even US$10/b would still see OPEC relatively happy with crude prices. 

Outlook

A March cut, barring unforeseen circumstances, now appears inevitable. Should the worst of the US weather now be behind us, prices should steadily slide towards US$40/b through to March.

Learning from 2004

It was in February 2004 that the die of US$55/b prices was cast. OPEC decided at that time to pre-emptively cut production in order to avoid a large price fall in Q2. With OPEC quotas relatively low and the outlook for Iraq uncertain, the International Energy Agency (IEA)'s expectations of a moderate 1.2-million-bpd rise in global oil demand looked likely to be adequately compensated for by growing non-OPEC production. Of course, as we now know, the analysis was highly flawed given a completely underestimated demand picture and unforeseen problems for non-OPEC producers (Russia, Nigeria, Norway, UK, US) that would dramatically shift the balance over the course of the year. Add to that an up-and-down year for Iraqi oil output that was a little disappointing and the scene was unwittingly set by OPEC for a surge in prices, given the backdrop of low global crude stocks that had been drawn down during the Iraq war of 2003. 

OPEC this time decided that there was enough in the market to warrant action occurring later in the demand cycle. With prices close to US$50/b in the US last week, OPEC would have had a difficult time justifying a quota cut. However, OPEC is not simply going to stand by should prices fall sharply. All members have indicated that a March cut is all but certain and the decision to suspend the organisation's formal oil price target (of US$22/b-US$28/b) does at last bridge the gap between stated and actual OPEC policy. It would have been rather awkward from a presentational point of view to implement a new price-band - likely in the US$35/b range - while clearly not taking action to reach this target, but there will also be discussions over exactly where the band should be pitched. With some press reports actually quoting the Saudis as saying that US$50/b or even US$60/b was not too much for the global economy to cope with, the target price could yet surprise some. 

The Fundamentals

Although fears remain of high prices through the course of 2005, and OPEC was under some pressure to moderate its instinct to slash output, there are rather more reasons to suggest prices are a little high at present on the basis of fundamentals. US crude stocks are in a far healthier state in 2005 than they were at this time last year, and they are, if anything, continuing to rise at a time of seasonally high demand. Growth in demand is also expected to moderate this year from the 20-year highs of 2.6 million bpd seen last year, though these are IEA forecasts and should be viewed with a little scepticism in light of 2004. OPEC production capacity is also expected to rise in 2005, while non-OPEC output is set to see far better growth this year than it did in the troublesome year of 2004. When you add up all the factors in 2005 as opposed to 2004 the crude price looks a little over-valued.

2004 Oil Fundamentals Versus 2005 Oil Fundamentals 

Of course there is also a new understanding of how far prices can rise before demand completely cools off. Despite last year's record crude prices demand was still strong throughout the year, spurred on by Chinese and US consumption. In addition it became clear that there are some structural limits to the oil market imposed by refining and transport capacities. With petrol (gasoline) and distillate stocks alternately driving crude prices over 2004, products were more closely watched than ever. There is no quick fix to these problems. Add in higher production costs (due in part to the rise of all commodity prices) and the industry itself is demanding, and comfortable with, a higher price. This altered perception is having a real impact on base crude prices.

Outlook and Implications

Prices are set to remain high throughout 2005, though they should moderate from the current prices down to below US$40/b over the course of the year. How far they will fall prior to OPEC's anticipated March cut will go some way towards determining the depth of OPEC's cutback. Prices over February and through March should retreat from the highs seen last week, given OPEC's commitment to maintain current output levels and the reasonably healthy state of US crude stocks. However, low distillate inventories and the continued threat of cold weather in the US, along with tightness in the global refining sector, should limit any price falls prior to OPEC's next meeting.