London, 7 April 2010

Riyadh's commitment to stabilising oil prices is about to receive an early, unwelcome test, as prices push on up above its $70-80 target range and show every sign of gathering momentum to move even higher. While the revenue windfall will be welcome to a kingdom that has large investment commitments and is struggling to provide high-quality employment for its youthful population, escalating prices will call into question the government's commitment to price stabilisation, unless Riyadh moves quickly to cool the rally.

Saudi Arabia's King Abdullah and Oil Minister Ali Naimi have both stressed the importance of price stability to ensure both "security of supply" for consuming countries and "security of demand" for oil producers contemplating expensive investment programmes. Both have sought to anchor expectations around $75, describing this as a "fair" price, and fostering a consensus with consumer nations around this level. By definition, if $75 is "fair" then prices substantially below or above this level are in some sense "unfair" to one side or the other.

Fairness is an empty concept when talking about markets. Markets are not moral. But replace the rhetoric about fairness with language about "sustainability" and it becomes apparent what Naimi and other Saudi policymakers are getting at.

In their view, price much below $75 are not capable of financing enough investment to meet growing global energy needs. Prices much above it cause too much demand destruction -- some driven by the market and some by governments worried about cutting excessive dependence on expensive energy imports.

No Security of demand

OPEC has complained bitterly about consumer-country taxes, subsidies and mandates tilting the playing field from oil in favour of gas, coal, nuclear and renewable fuels. In exchange, it has held out the promise that if consumer countries guarantee a fair share of energy demand for its oil exports, it will ensure adequate supply and investment to keep prices to a reasonable level and minimise excessive volatility.

It is that implicit bargain which was the subtext of last week's producer-consumer dialogue at the International Energy Forum in Cancun, prompting a panegyric from Naimi about the market's current state: "good demand, reliable supply, beautiful prices -- we are very happy". Therein lies the problem, however. If OPEC cannot, or will not, deliver stability on the upside it cannot complain if consumer countries accelerate their already-advanced programmes to penalise oil and switch in favour of other fuels, some of which are greener, and all of which depend less on supplies from the Middle East and other regions with difficult operating environments.

Conservation and substitution have slipped down the agenda as policymakers battled with recession and the insolvency of large parts of the banking system. Falling energy prices reduced the sense of urgency for dealing with the problem. In many ways, lower energy prices helped kill plans for an economy-wide cap-and-trade programme by eliminating the sense of "crisis" complex legislation needs to have any chance of passing.

But many measures approved during the last crisis in 2005- 2008 are only now coming onstream (EPACT 2005, EISA 2007, the revised biofuels mandate and accelerated increases in corporate average fuel economy for cars). They will continue biting into oil demand for at least the next six years. Destruction has been delayed not avoided.

If oil prices again hit $100 or more, conservation and substitution will move back to the top of the agenda -- not just in the advanced economies but also emerging markets, which are now OPEC's only growing customer base. If spot prices are already at $86 per barrel when the recovery is barely under way and the advanced economies are operating with substantial cyclical slack, imagine how high prices could go left unchecked as the business cycle matures. The pressure for substitution, conservation and developing alternative resources will then become immense as all countries prioritise the reduction of imports of expensive, volatile and basically unreliable oil.

Irresolution on Display

The recent steady escalation in prices stems as much from Saudi Arabia's confused thinking on the issue as growing signs of a global recovery and wavering commitment to climate change goals. The market senses Riyadh is not wholly committed to stabilising prices at the $70-80 level.

Divisions were on prominent display during last week's Forum. One delegate from a Middle East Gulf country indicated OPEC would raise output if prices remained above $85 for a sustained period of time, only for another to disclaim there was any automatic trigger level and noncommittally say the group would add more output if prices "were to stay high for a long time".

Meanwhile the drumbeat of bullish commentary has intensified and investors have become progressively more optimistic about future prices (rising oil prices can only reflect increased expectations about shortages in future, since the market remains plentifully supplied in the near term).

The market senses Saudi Arabia's response to price movements remains uneven, cutting rapidly in the face of falling prices but adding slowly and reluctantly to blunt increases.

It is this asymmetry that sunk previous attempts to stabilise prices and has encouraged investors to explore the upside boundary. Unless Riyadh proves it is willing to take prompt and aggressive action, investors will ignore the $70-80 price target and push for much higher levels.

Physical or Financial Aim

Nowhere is Riyadh's uncertainty more evident than in its confused articulation of targets. While the kingdom's headline announcements focus on the need for stable prices around the $75 mark, its output decisions seem to remain guided by physical availability.

Saudi policymakers have focused on the need to drain "excess" inventories, resisting calls to provide more oil while the physical market remains comfortably supplied. This is exactly the confusion between price and availability targets which contributed to the last spike. Riyadh remains reluctant to add oil when physical availability remains good, even if futures prices are climbing, preferring to wash its hands and blame speculators for the rise.

If the kingdom continues to sit on the sidelines while prices climb towards $90, the market will be primed for a re-run of the events of the 2006-2008. The longer it delays action, the harder it will eventually be to regain control. The more prices rise the more investors will be drawn into the market by the chance to benefit from a momentum trade.

If the kingdom is serious about stabilising prices around $75, it has no choice but to begin adding extra oil in the short term in a bid to break the market's expectations about a one-way bet. It should become apparent within the next few weeks how serious Riyadh really is.

Act Early, or Get Out of the Way

Some commentators counter that Saudi Arabia has no power to influence the level of prices, only the shape of the futures curve, by altering the market balance and the level of inventories the market carries. Saudi officials sometimes seem to endorse this view.

But it is not quite right. Curve shape (the degree of backwardation or contango) determines the cost of remaining long (or short) and returns for investors, in some cases decisively (for example when a huge contango bit deeply into returns during 2009).

While the kingdom has spare production capacity, it can always break the back of any rise in prices by adding physical oil into the market, forcing a big enough contango and raising the cost of remaining long in expectation of further price increases. The question is whether the kingdom is prepared to use that power.

If Saudi Arabia dithers in the face of rising prices, it will have only itself to blame when investors force prices up above $100 and the anti-oil drumbeat of substitution and conservation picks up again.

Ends --

By John Kemp, Reuters columnist - for Commodities Now

The views expressed are his own.