Oil Supply Rising

March 16, 2010

With higher rig counts and increasing OPEC production, is crude headed for oversupply?
  • Why quotas matter when prices are low, not high
  • How do rig counts affect the price of oil?
  • Why has the futures curve flattened?


Although oil closed down yesterday at $79.80—the lowest it's been at in two weeks—prices are still much higher than this time last year, back when oil was sitting around $55 a barrel. And that makes OPEC, for one, much happier.


OPEC's Failure To Hit Quotas

OPEC nations currently supply roughly a third of the world's oil: Data from the Energy Information Administration puts total global oil production for February at 85.77 million barrels/day, with OPEC contributing 29.49 million barrels' worth. This, of course, gives them remarkable power over the fate of crude oil.

But as our favorite dysfunctional monopoly gets ready to meet on Wednesday to decide the fate of the world—or at least the price of crude—there's a surprising lack of hoopla surrounding the meeting. Most analysts and commentators seem to think that OPEC will leave the current production quota of 24.845 million barrels per day intact. In Business Week, Harry Tchilinguirian, head of commodity derivatives research at BNP Paribas SA in London is quoted as saying:


"We think you would need to see prices go to $65 before you spur concern within the cartel. It is easier to turn a blind eye rather than go through negotiations over new quota allocations."


The blind eye Tchilinguirian refers to is the countries in excess of their production quotas. After all, with prices hovering near $80 and an economic recovery steadily gaining steam, things are looking pretty good for OPEC. Besides, ignoring overproduction has worked well so far for member states. OPEC's own monthly report puts production at 26.811 million barrels a day (not counting Iraq, which is exempt from the quota system), which is 1.966 million barrels per day over quota—a number which may get even higher.

Here's the thing—OPEC's power truly surges when oil prices are low, not high. When they are comparatively low, constraining supply has the real power to increase prices. Low oil prices give OPEC members the incentive to work together and comply with the set quotas, as countries need higher gas prices to meet their annual budgets. But that incentive to work together crumbles as oil prices rise and it becomes more profitable to pump over quota. As the Financial Times states, "Compliance has slipped to about 53 per cent from more than 80 per cent a year ago."

If half the OPEC countries are pumping over quota, then you can probably expect a lot of backroom arm twisting at the meeting tomorrow.


Rig Counts

One way to increase crude production is through exploration and development of new oil fields—something that OPEC members have apparently started taking an interest in again.

According to a recent Bloomberg report, OPEC nations have increased crude drilling at the fastest rate in 2 1/2 years: In January and February alone, OPEC countries added 22 rigs—an 8 percent increase to a total of 283 active rigs (the blue line on the chart below):


Rig Counts


And while non-OPEC countries also added 22 rigs, that brought the total number of rigs operating outside of OPEC to 785, only a 2.9 percent increase (the red line on the chart above). These new rigs are mainly used for exploring and developing new fields, rather than for maintenance or work-over activities, according to Baker Hughes.

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