London, 7 June 2011: Reuters

Pressure is mounting on OPEC to boost output and offer more generous discounts for poorer quality crude to encourage refiners to boost runs ahead of an expected increase in demand during the second half of the year. Demands for more and cheaper crude rest on two assumptions:

(1) While the market may remain comfortably supplied at present, with ample inventories of both crude and products, the normal seasonal pick-up in demand during the second half will result in a drawdown in inventories leaving the market uncomfortably tight. Given transport and processing delays, OPEC needs to raise output now to avert an upward surge in prices later in the year.

(2) Refiners must be given more incentive to process crude into refined products. Operating rates remain depressed. Given all the marginal crude on offer is heavy, sour, and is therefore more expensive to process, OPEC and Saudi Arabia in particular should increase discounts available for these lower quality oils to give refiners an incentive to process them and boost run rates.

Both these arguments reflect muddled thinking. There are good reasons for Saudi Arabia to boost crude output -- but these are not two of them.

NO SHORTAGE OF CRUDE

Even die-hard bulls admit there is no shortage of crude and products at the moment. The International Energy Agency (IEA) estimates commercial stocks amounted to 59 days of forward cover at the end of March, according to the latest edition of its "Oil Market Report".

Forward cover has remained unchanged at 58-60 days of demand since the summer of 2009. There is no sign of the market tightening. Forward cover is currently more than 5 days higher than in the first half of 2008, when prices were surging towards their peak of $147 per barrel, and well above historical averages.

It is unlikely the market has tightened in the last two months. Soaring prices have already begun to restrict gasoline consumption in North America.

What about the second half of the year when demand normally picks up?

"Without additional oil, stocks will fall and prices will rise, threatening economic growth. Raising the output ceiling would send a strong signal to the market that OPEC raises the need for more oil," according to Petroleum Argus, one of the leading price assessors in the oil market. But there are several problems with this argument.

The market is already discounting a tightening in the supply-demand balance during the second half. Brent prices over $110 per barrel and near-record speculative long positions in crude futures and options reflect expected tightening rather than current supply and demand.

Tightening is already in the price. Observers fearful of further price increases are double counting and assuming the market is not forward-looking.

Soaring prices are already forcing supply, demand and inventories into a more favourable configuration by forcing more efficient use and slowing global growth. As oil bulls are fond of noting, the best cure for high prices is high prices. The economies of North America, Europe and Asia are already starting to slow under the impact of rising fuel and food costs, putting the supply-demand balance on a more comfortable trajectory.

Boosting output to limit price increases and protect global growth can only offer temporary relief. Every additional barrel of oil produced reduces spare capacity by an equivalent amount. If Saudi Arabia offers more oil to head-off fears about falling inventories, the market will instead start to fret about the falling margin of spare capacity.

Demands for Saudi Arabia to up production amount to an argument that strong global growth will rapidly draw down inventories, and the kingdom should boost output rather than risk a slowdown in growth restraining demand.

But any output increase will only delay the inevitable slowdown by around six months. By the end of the year, all the extra output will have been absorbed, and the market will be facing the same supply crunch.

Underlying this is the recognition that consumption is growing too fast. The solution is some combination of rationing, permanent demand destruction and slowing global growth to limit demand growth until more supplies can be brought onstream. Raising Saudi output is not a sustainable solution to the problem. At most it buys time and at present rates of consumption it would not buy much more than six months.

RELUCTANT REFINERS

The second argument -- that Saudi Arabia should discount its heavy sour crude oils more heavily to give refiners more of an incentive to process them -- is just as wrongheaded.

Refinery operating rates across North America and Europe are low because product demand, especially for gasoline, is poor. Refining margins remain moderate. This is not a market characterised by strong expected product demand. Refiners respond to the incentives offered by the product market, and at the moment product prices are not high enough to encourage more capacity reactivations.

If market participants expected a big rise in demand in the second half of 2011, crack spreads would be higher than they are now, giving refiners a strong incentive to boost their throughput. It would be economic to process even the heavier sourer oils that Saudi Arabia is offering to the market at the margin.

Discounting heavy crudes will not produce a lasting increase in refinery output. Even if it encouraged refiners to boost their throughput temporarily, the resulting rise in product stocks would quickly depress margins, and refinery run rates would fall back again.

BUILDING INVENTORIES

There is a good argument for Saudi Arabia to boost its output -- but it has nothing to do with meeting increased demand in the second half or somehow bullying refiners to boost their throughput.

The kingdom's strategy remains confused. Senior officials continue to state policy in terms of the need for stable prices, but at an operational level the focus is on stabilising inventories. Like any other product supplier, or a central bank, the kingdom can control prices or quantities, but not both.

If it continues to focus on matching physical supply and demand, it must accept speculators will set prices based on sentiment and expectations. If the kingdom instead wants to control prices, it must accept speculators will determine the level of inventories with which they are comfortable for any given price, and the kingdom must supply that level of stocks. It cannot control both prices and inventories.

If the kingdom is serious about stabilising prices, it must accept that the equilibrium level of inventories will be determined by the market -- including the (possibly irrational) expectations and fears of investors and other market participants about demand growth, supply shortfalls and geopolitical risk.

Riyadh needs to raise output and boost stockpiles to meet and saturate investors' demand for increased inventory at the moment. Rising inventories will not be comfortable for the kingdom's policymakers, who tend to see them as a sign the market is oversupplied, and fear they imply big output reductions later when sentiment shifts.

But if the kingdom really wants to stabilise prices, it must accept bigger swings in inventories and its own production.

Ends --

By John Kemp, Reuters market analyst – for Commodities Now.

The views expressed here are his own.