A glut in the oil market


The speed with which members of the Opec met in an emergency session in Vienna last Friday, and the extent of the reduction in oil production that they announced, surprised most analysts. Instead of the widely expected cut of 1m barrels per day (bpd), Opec opted for 1.5m bpd.

Amounting to 4.3% of their total output, it was the deepest reduction Opec had agreed in the past five years. Furthermore, Opec president, Chakib Khelil of Algeria, warned that a further cut at the organisation's meeting on December 12 will exceed 500,000 bpd.

Opec states are apparently responding to a dramatic collapse in oil prices – "unprecedented in speed and magnitude", in their words – falling as they have from over $147 a barrel in July to under $64 a barrel last Friday, a drop of 57% in three and a half months.

As they look ahead, they see a glut in the market towards the end of the year, despite cold weather. The economic recession in North America and western Europe has reduced demand for oil sharply.

Some analysts expect that as recession bites deeper in the west, Opec's cumulative cuts will rise to as much as 4m bpd.

This could be avoided if one or more non-Opec countries decide to cooperate with Opec by slashing their output. For the first time in its 48-year history, Opec publicly appealed to non-Opec producers to "contribute to efforts to restore prices to reasonable levels and eliminate harmful and unnecessary fluctuations".

The most suitable country to help achieve these ends is Russia. At 9.8m bpd, it is the second largest petroleum producer in the world, after Saudi Arabia, exporting seven out of the 10 barrels it extracts. It is the enormous sums that exports of oil and natural gas have contributed to the Russian coffers since 2000 that have given the Kremlin the clout it displayed in the recent war in Georgia.

Last Tuesday, Russia joined Iran and Qatar to announce the formation of gas G3, possessing 60% of the globe's natural gas reserves. It would meet three to four times a year to discuss "critical issues of mutual interest". Alexey Miller, chairman of Russia's Gazprom warned that the era of cheap hydrocarbons had ended.

As a commodity, petroleum should sell for whatever it costs to produce one additional barrel, known in economics as the marginal cost. Nowadays marginal barrels of oil are produced only in inaccessible and expensive terrain. The best known recent examples are the oilfields found in deep waters of the ocean off the Brazilian coast and the tar sands of Canada.

Analysts at Morgan Stanley estimate the cost of producing a marginal barrel of oil at $70 to $90. Though Opec has not specified what a "reasonable [price] level" should be for petroleum, its members have said privately they would be satisfied with $80-90 a barrel band.

Given this, and the estimate of the International Monetary Fund that the aggregate economies of the Asian countries, except Japan, will grow by 6.6% in 2008, it is fair to expect a reversal of the recent oil price plunge in the coming months.