From: John W. Schoen, msnbc
Published October 24, 2008 10:19 AM

OPEC faces fresh dilemma in setting oil targets

With demand slowing and supplies rising, the world is awash in oil — sending prices crashing by more than 50 percent from a record high of $147 a barrel just three months ago. That has prompted oil producers to convene an emergency meeting to try to regain some control over prices.

But as OPEC ministers sit down Friday in Vienna to decide on production cuts they face a number of thorny obstacles to regaining control of the market.

The bursting of the oil price bubble has been as dramatic as the financial crisis that exploded onto the scene in early September. The two events are related: As the crisis has heightened the prospects for a deep global recession, energy prices have plunged on the expectation of lower demand.

Already demand for oil is down 8 percent from year-ago levels. As a result, oil supplies have begun backing up; stocks of crude have risen more than 7 percent in the past month.

“The oil market is shrinking right now,” said Paul Sankey, an energy analyst at Deutsche Bank. “The level of demand destruction in the U.S. is very, very significant. We think the global oil market will be not only lower this year but also very likely lower next.”

With oil revenues crashing, the 13-nation Organization of Petroleum Exporting Countries is trying to decide how much to cut production to try to keep prices from sliding further.

OPEC's control of the world's oil production has declined over the years as non-OPEC producers like Russia have expanded output. OPEC produces about 40 percent of the world's oil, while Russia alone produces around 11 percent. OPEC officials met this week with Russian President Dmitri Medvedev to discuss coordinating production targets but failed to win a commitment.

Even in the best of times, managing production levels to keep oil demand and supply balanced is an imperfect science. With the financial markets in turmoil, and the economic outlook cloudier than it has been in decades, the decision about how many barrels to produce will be extremely difficult.

To begin with, high energy prices on their own have been battering the world economy and could do more damage — even at current, reduced levels. If OPEC tightens too much, and prices remain too high, that could produce a deeper global recession and send demand falling further.

“Any (production) cut will just delay an eventual upturn in demand,” wrote Cameron Hanover energy analyst Peter Beutel in a note to clients. “OPEC thought the world could afford high-priced oil; now it can’t even afford what just a short while ago might have seemed like moderate prices.”

High oil prices also have spurred efforts around the world to develop alternate sources of energy. If OPEC producers tighten supplies and keep prices at elevated levels, they will help accelerate the process of weaning the world off their major source of revenues.

There are also a number of variables that are outside of OPEC’s control. The recent strength in the U.S. dollar, as investors fled to the relatively safe haven of dollar-denominated Treasury bills, has helped cut the price of oil in dollar terms. Another major wild card is the weather. No matter how poorly the economy performs, a colder-than-normal winter heating season could help prop up demand.

OPEC officials acknowledge they have got their work cut out for them.

"If the decision goes too far, it will affect countries who are already affected by economic crisis," he said. "If it doesn't go too far, then it will affect the producers who might end up in the category of people affected by financial crisis," OPEC's President Chakib Khelil of Algeria said on his arrival in Vienna.

No matter what production levels the cartel decides on, it also faces many of the traditional obstacles to implementing any cutbacks — especially at a time when producers are coping with a sharp drop in oil revenues. OPEC has a weak track record on adhering to announced production quotas; throughout its history, cheating on those quotas has been widespread.

“Anything that OPEC says has to be followed up by actually doing something about it,” said Mark Waggoner, president of Excel Futures. “One of the things that we know that OPEC has done is to say they are going to cut back, but then they’re reluctant to do so and continue pumping at their current rates.”

Despite efforts to present a sense of unity, OPEC members are sharply divided over where they think prices should be. Part of the reason is that oil producers don’t all enjoy the same profit margins.

“For Saudi Arabia the cost of bringing a barrel of oil out of the ground is the least expensive," said Linda Rafield, a senior oil analyst at Platts. “So they can withstand lower prices and not really have it affect their budget. Not all producers can produce at their costs."

Iran and Venezuela, on the other hand, have traditionally pushed for higher prices. Because their oil is heavier and more sulfurous, it sells for less than benchmark crude. Ahead of Friday’s meeting they were pushing for fairly higher price targets; Iran is reported looking for a price target of $100 a barrel, while Venezuela would like to see prices around $80 or $90.

That’s why the Saudis will likely play their traditional role of “swing” producer — bearing the brunt of any production cuts. Analysts say that, no matter what OPEC says in its official pronouncements, the market will be closely watching what OPEC’s biggest producer has to say at Friday’s meeting.

“We still have not heard yet from Saudi Arabia about what their intentions are,” said John Kilduff, and energy analyst at MF Global. “This cut will fall, in my opinion, on them by a large amount. So if they come out and say they are going to cut and agree to this, they will cut and follow through.”