Monday, October 23, 2006

OPEC's Credibility Problem

Boy, does OPEC have a credibility problem. The cartel was rumored to be considering a production cut of a million barrels per day. However, it was concerned the market wasn't taking it seriously. So, it held an emergency meeting and announced it would cut production by 1.2 million barrels per day. What did oil traders do? They bid down the price of oil.

Let's see if we've got this straight. OPEC announces a greater-than-expected production cut and oil prices fall. It seems no one is taking OPEC seriously--and for good reason. OPEC doesn't have a good record of making planned production cuts stick. That's because member nations have an incentive to cheat and produce more than their assigned quotas.

I bet OPEC nations know they've been getting a great deal. Thanks largely to Osama bin Laden and his terrorist network, oil prices have been factoring in a fear premium of perhaps $10 to $20 per barrel. Now that the fear is subsiding, so is the premium. Lower prices are also the result of a mild hurricane season, and a marginal decline in demand caused when gasoline prices hit $3 per gallon in August.

Can OPEC make production cuts stick this time? That depends on how much member nations love high prices. The planned cuts are supposed to go into effect on Nov. 1. They may stick for a while, but if history is any guide, many countries will soon be pumping more oil than they agreed to. As always, the burden will fall on Saudi Arabia. If the Saudis cut production in a meaningful way, oil prices will stabilize. If they don't, prices could fall to the mid-$40s in no time at all.

Falling oil prices get at least some of the credit for the rally in stocks. The S&P 500 is well above the yearend target set by the firm's investment policy committee. But Standard & Poor's Chief Investment Strategist Sam Stovall says it could go higher. He tells us why in the current segment of MoneyMasters.