Only a few weeks ago, the price of oil was in the low-$60s having recovered from lows in the mid-$50s. It seemed that the plunge from the record high of $78 hit in July was over and that a measure of stability had been restored. If so, OPEC could take credit for that, having responded to the huge drop in prices by announcing two production cuts totaling some 1.7 billion barrels daily.

Saudi officials in Riyadh. Are they in danger? (illustrative)
Photo: AP

Yet, on Wednesday, oil prices approached $50/bbl. and, in the view of technical analysts at least, were heading for the mid-$40s.

The latest break in prices was being blamed on the exceptionally balmy weather being enjoyed by the northeast US last month and into January. Warm weather means low demand for heating oil which, in winter, means falling oil prices. Thus, while inventories of crude oil were declining, suggesting the OPEC cuts were having an impact, stocks of distilled products such as heating oil were soaring, because no-one was buying the stuff.

In the face of another rapid price drop, market participants expected OPEC to announce an emergency meeting that would decide on further production cuts. Instead, Saudi oil minister Ali al-Naimi told reporters that "there is no need to worry, because the market is in a very healthy condition." This had the immediate result of sending the price down by a further two dollars.

So what gives? What's with the "no worries" spiel? Have the Saudis become Aussies, or lost the plot completely? How comes that OPEC, which a few weeks ago was talking about the need to maintain the price at or near $60, is now comfortable with a sub-$50 level? As usual with the oil market, the answers are not straightforward.

The place not to start is with the weather. The mild winter is a lucky break for the consuming world, but the slide started long before and has much more fundamental causes - notably that supply now exceeds demand. This is a total reversal of the 2003-2006 bull market, in which the key feature was excess demand (the China/India story) and growing supply problems (lack of refining capacity, Iraq, Nigeria, Hurricane Katrina, etc.).

Now we have declining demand (US economy slowing, slower increase in Chinese demand) and rising supply (every oil-producing country around the world is reactivating old fields and most are drilling new ones). Spring-in-January on the Hudson and Potomac is playing the reverse role of Katrina, by removing demand when it is falling anyway.

As for OPEC, this is an organization renowned for disunity, cheating on quotas and whose members have vastly different agendas. Each member-state has interests determined by how much oil it has, of what quality, how easy it is to extract - as well as its demographic and economic structure, and so on. But because the key member of OPEC and the biggest oil producer in the world is Saudi Arabia, politics, geo-politics and religion are important elements in the equation.

Saudi has always been an OPEC "dove," preferring lower and more stable prices to higher and more volatile ones. Its perennial rivals regarding OPEC policy have been Iran, Venezuela and Algeria. The fact that Saudi and Kuwait are American allies while Iran and Venezuela are stridently anti-American is part of this, but the underlying rationale is commercial logic: the Saudis have traditionally acted as OPEC's swing producer, by using their massive production capacity as a valve to turn higher or lower, as market conditions required. When OPEC makes cuts, other members cut output slightly while Saudi makes the big moves.

On the margin, therefore, Saudi Arabia controls the oil market, at least within certain parameters.

Saudi Arabia is now engaged in the biggest expansion of its oil industry in decades and intends to add some 25% to its existing production capacity by 2010. To sell this additional oil, it needs prices to remain at levels that don't choke off demand on the one hand or spur huge investments in additional global production on the other.

But Saudi has another, even more pressing, agenda. It is no less concerned about Iran's aggressiveness and nuclear ambitions than Israel - and for the same reason: the Shi'ite fundamentalist regime in Tehran is an existential threat to the Wahhabi Sunni kingdom. But it is the oil price boom that is driving Iran's rise. Prices in the $40s would seriously incommode Iran and the resultant social and economic stress may help undermine the regime. In other words, whether the market is "in a very healthy state" as prices fall through $50 depends on which side of the Persian/ Arab Gulf you sit on.

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