London, 10 August 2011: Reuters

Calls are growing on OPEC to cut production to halt the plunge in oil prices, but the rationale is confused and cuts might do more harm than good. Researchers at JP Morgan last week highlighted the risk price falls would draw a response from the cartel, arguing the core Middle East producers could cut production by 1-1.5 million barrels a day while still achieving the revenue targets underpinning their budgets for this year.

The theme has been taken up by other banks and fund managers, and the sense of expectation was neatly summed up in a Wall Street Journal headline Monday, "Market Awaits Response by OPEC to Oil Price Fall". But pressure for an aggressive response from the producer cartel reflects the pain of oil bulls as a year's worth of price gains evaporate rather than a considered response to the mounting turmoil in global markets. It would be the wrong strategy at this point, and its chances of producing durable price gains are poor.

FEAR OR FUNDAMENTALS?

Calls for an output cut reflect confusion about whether the dive in prices is being driven by deteriorating "fundamentals" or just irrational "sentiment". Most analysts argue oil's supply/demand/inventor capacity fundamentals remain tight and will support prices at a relatively high level. They dismiss comparisons with the price plunge in 2008-2009. In the short term they believe prices are being driven by a summer market panic but should recover once fundamentals reassert themselves.

But if prices really are being driven by irrational sentiment, cutting output would be the wrong response. It would leave the market short of oil and create conditions for an explosive rise in prices once the panic passes.

Cutting output would make sense only if the market crash reflected or was causing a real deterioration in demand. In that case, OPEC could try to offset the fall in demand by reducing its output and try to rebalance the market. Producers would, however, have to judge what price level the market can bear without creating recession in the advanced economies and inflation in emerging markets, and there are plenty of reasons to think oil prices are simply not stable above $100.

The onset of the soft patch in the United States and Europe coincided with the surge in oil above this level in February/March. Rising prices have been fingered as one of the culprits for the slowdown, offsetting the earlier stimulus provided by quantitative easing.

In emerging markets, meanwhile, inflationary pressures are worsening. China Tuesday reported higher-than expected inflation of 6.5 percent in July, the highest rate since June 2008.

AUTOMATIC STABILISERS

Efforts to prop up prices at an artificially high level threaten to make the economic situation worse. Crude prices have come to play a role as speed limiters and automatic stabilisers in the global economy. Rising prices cut off an over-fast expansion in late 2010 and early 2011. Falling prices are now the economy's best hope of a soft landing.

In a Financial Times article Friday, hedge fund manager and former Goldman Sachs chief economist Gavyn Davies asked "What are the escape routes?" ("Only luck and wise policy can save us from a double dip" Aug. 5). "The first is that oil prices might fall, bringing down global inflation and boosting incomes. If this happened, some of the forces that weakened the world economy earlier this year would then go into reverse, while central banks would be more willing to ease further," wrote Davies.

It sounds a much more plausible mechanism than Davies' second escape route: "The corporate sectors of the developed economies, which are in rude health given the economic backdrop, may gradually pass their profits growth into extra employment and investment." While that would be desirable, there is no easy way to achieve it.

If OPEC interferes with the automatic stabilisers by cutting too early and aggressively in an attempt to prop up prices at an artificial level, it will make the impending recession far worse and will fail in the long run. The cartel is right to worry about the destabilising effects of the sudden price drop (in the same way central banks worry about abrupt price movements in exchange rates and the IEA worried about an acute shortage of Brent crude over the summer).

It could easily scale back some or all of the extra 1 million barrels per day of crudes Saudi Arabia pledged to the market after OPEC failed to reach a new production agreement back in June. The justification would be that the conditions that prompted the pledge no longer exist. Demand has fallen sufficiently and the market is no longer expected to be tight.

Output cuts might prevent a decline to very low prices, but no one should expect Saudi Arabia to stabilise Brent at $115, let alone $125 per barrel. If the Saudis cut, it will be because demand is dropping away and they judge the pace of global growth is slowing significantly -- not because they are trying to defend some theoretical budget revenue target.

It would restore a more comfortable cushion of spare capacity to the market, easing some of upward pressure on prices from that source. Cuts would be a signal of weakness, not strength, and certainly not a bullish indicator.

Ends --

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

The views expressed here are his own.