At the end of April 2003, OPEC agreed to cut actual production by 2 mbd to 25.4 mbd on the assumption that there would be a seasonal drop in demand and that Iraq would be gradually reintegrated into the market. Saudi Oil Minister Ali al-Naimi stressed renewed effort to keep the price as close to US$25 per barrel as possible. Iraqi production began to slowly recover. Oil prices were at the top of the price band. But in August, Iraq’s northern export pipeline was sabotaged and UN headquarters were bombed in Baghdad, exerting upward pressure on oil prices.

In a somewhat surprising decision, OPEC decided to cut production further in September 2003 and return to the February ceiling of 24.5 mbd to preempt stock-build in the fourth quarter and maintain prices in the upper part of the price band. OPEC did this under the assumption that the world economy was slowly improving and that Iraqi production and exports were slowly expanding. Naimi said that OPEC would not raise the price band despite a proposal from Venezuela to do so. Oil prices rose to between US$28 and US$29 per barrel in September and to between US$30 and US$32 per barrel by November. Both US President George W. Bush and IEA Executive Director Claude Mandil expressed disappointment at the September decision, concerned that it would harm economic growth.

In December 2003, OPEC reaffirmed its September decision, noting continuing political tensions because of disorder in Iraq and the continuing weakness of the US dollar, which lowered OPEC purchasing power. Meanwhile, Iraqi production reached 2.35 mbd and the OPEC basket price had exceeded US$28 for long enough that the automatic price band adjustment should have been triggered. But OPEC resisted this action, fearing that demand would tumble by the second quarter of 2004.

Market Misreadings

OPEC lost control of oil prices in 2004. In the first three quarters of 2004, the OPEC basket price remained above US$40 per barrel, although it fell slightly below US$40 per barrel in September. A series of factors contributed to these developments, which have been characterized by observers such as Edgard Habib, chief economist at ChevronTexaco, as a “perfect storm.” Factors included a largely unanticipated surge in oil demand spurred by high economic growth in China and the United States (estimated at 13 percent and 4.5 percent respectively in 2004 by Deutsche Bank), low oil inventories, deepening violence and instability in Iraq, declining OPEC spare capacity, and bottlenecks in the gasoline market due, in part, to stretched refineries.

OPEC, led by Saudi Arabia, began the year by misreading the market when it announced its intention to reduce overproduction and adhere to a 24.5 mbd ceiling in March before cutting production in April. Naimi reaffirmed his belief in a US$25 per barrel price for the OPEC basket, citing concern about falling demand and a large stock build in the second quarter, and was determined not to repeat the mistakes of 1997 to 1999. In March, WTI prices reached a high of between US$36 and US$38 per barrel and the OPEC basket price ranged from between US$32 and US$33 per barrel.

On March 31, 2004, in Vienna, OPEC confirmed its earlier decision to cut output by one mbd on April 1 to 23.5 mbd despite high oil prices. It blamed the cut on tightening US gasoline supplies, geopolitical uncertainties, and on the futures market where speculators were taking long positions. Ministers insisted that the market was well-supplied with oil and that OPEC would not allow any shortages in world oil markets, but they seemed focused on keeping inventories low and prices high. White House and US Department of Energy officials criticized OPEC’s production cuts while prices were high. Meanwhile, Venezuela, Nigeria, and Iran argued for the need to raise the price band, causing disagreement within OPEC.

In the face of growing oil demand and attacks on oil facilities in Iraq and Saudi Arabia, oil prices rose above US$40 per barrel in May. Naimi finally began calling for a production increase. He got his wish at the June 3 meeting in Beirut when OPEC raised its production ceiling for the OPEC-10 by 2 mbd to 25.5 mbd from July 1, and by a further 500 kilobarrels per day (kbd) from August 1. This was a compromise between Saudi Arabia, which wanted an immediate increase to 26 mbd, and Iran, which would initially only accept 25.5 mbd.

The measures were instituted “to ensure adequate supply and give a clear signal of OPEC’s commitment to market stability and to maintaining prices at acceptable levels to both producers and consumers,” according to a June 7 OPEC communiqué. Actual OPEC-10 output was reported as 26 mbd in April increasing to about 27 mbd in June, with Saudi Arabia increasing to 9.1 mbd. As a result, remaining OPEC spare capacity was significantly reduced to about one mbd in Saudi Arabia, and only a small amount in perhaps two other producer nations, limiting the ability to deal with any future supply disruptions.

Very tight market conditions continued in the summer of 2004, reinforced by continuing high oil demand and geopolitical uncertainty. In July, the IEA increased its oil demand projection for the year by an additional 2.5 mbd. OPEC canceled its July meeting but proceeded with its planned August increase in supply of 500,000 barrels to a ceiling of 26 mbd. Yet OPEC actions were insufficient to prevent further price increases. The WTI oil price moved above US$40 per barrel in July and hit record highs of US$44.73 on August 5 and US$48.75 on August 19.

Among the factors increasing the risk premium was continuing uncertainty about the future of Yukos, the Russian oil company that normally produces 1.8 mbd, after it was threatened with a government take-over because of tax evasion charges. The insurgence in Iraq heated up and spread to the oil-rich southern regions with attacks on the South Oil Company pipelines. US oil inventories were still low compared with demand. Refineries continued at peak production. And there was continuing concern about the small OPEC spare capacity (between one and 1.5 mbd) to meet any supply disruption. Saudi Arabia continued to defend the price band. But other countries, including Iran, Nigeria, and Venezuela, were content with oil prices in the US$30 to US$40 range.