TheOrganizationofPetroleum Exporting Countries` outlook for the 21st Century will be determined by whether the organization performs like the OPEC of 1999 or the OPEC of 1997.
In late 1997, OPEC disregarded market signals and opted to increase its production quotas on the prospect of perpetually rising demand (notably in Asia), which not only never materialized but reversed course. That helped set the stage for an oil price collapse in 1998 and early 1999. OPEC`s initial struggles to deal with the oil price collapse spurred widespread talk that the group`s days were numbered; that, in turn, yielded scenarios of a long-term, low-price oil environment.
In 1999, OPEC showed remarkable solidarity in hewing to pledged production cuts in order to siphon off much of the oil-inventory overhang that was depressing oil prices. The result was a doubling of oil prices. This time around, the talk centered on rising alarm that OPEC would not increase production quickly enough to avert a dangerously high price spike (the danger being a threat to a fragile global economic recovery).
Which OPEC will hold sway in the dawning decade of the new millennium? One that succumbs to internal politics to the point that it misreads markets and falls into disarray over production and price policies before dissolving? Or one that responds to the realities of the market-both physical and speculative-and then fashions a coalition with competing oil exporters outside the group while maintaining its own internal solidarity to bring supply and demand into equilibrium and enshrine a long-term, widely acceptable oil price outlook?
The simple answer would be the latter, seeing that OPEC recognized its blunder in 1997, learned from its mistakes, and then responded not only with the correct strategy but also the collective will to carry it out.
But oil markets, oil politics, and even OPEC itself are anything but simple. And the outlook for how much OPEC oil the market will need in the decades to come remains far from clear.
OPEC`s failure
Although OPEC has often had the opportunity to protest that, like Mark Twain, reports of its demise were greatly exaggerated, it seemed in 1998 and early 1999 that the conventional wisdom had it right: that its dissolution was imminent and that, consequently, markets were headed for a long stretch of low oil prices.
Leo Drollas, deputy executive director of London`s Centre for Global Energy Studies, at a conference on oil price challenges into the next century sponsored by CGES and Oil & Gas Journal in Houston during September 1999, offered on overview on OPEC`s recurring inability to manage oil prices.
Drollas looked at oil markets for 1974-2010, separating the period into three 12-year portions that reflect the ebb and flow of oil prices.
During 1974-85, OPEC established control of its production and was able to keep official selling prices. From 1973 to 1985, real oil prices rose by 11%/year, Drollas noted. The result was a squeeze on oil demand growth outside the Soviet Union thataveragedonly 270,000 b/d/year. At the same time, however, non-OPEC oil productiongrewby 900,000 b/d/year in response to higher oil prices. And the call on OPEC oil dwindled to the point where group members had 14 million b/d of spare productive capacity, or about56%oftheir total, Drollas said.
The switch to netback pricing by Saudi Arabia to recapture lost market share spawned a decline in real oil prices of 9.5%/year during 1985-88 and the resulting oil industry collapse. The main response to those lower oil prices was a revival in oil demand growth during 1986-98 of 1.4 million b/d/year, excluding the former Soviet Union, Drollas estimated. The secondary response was a plunge in non-OPEC production growth and a rise in OPEC production growth-the latter reaching 730,000 b/d/year. And OPEC`s surplus productive capacity had shrunk to only 3 million b/d, or 91% of total capacity, which represented only 4% of total world demand.
Drollas contended that, while OPEC`s actions had helped whittle down its surplus productive capacity, "...assessing OPEC`s role as manager of the surplus, we can see a period where OPEC was not a very capable manager.
"OPEC...since `86 has been reacting to rather than preventing trouble-and very often reacting late. There are periods where OPEC did very little...prices were drifting downwards, and then they decided to act.
"It seems like $15 is the trigger point...(at) which OPEC eventually reacts; if the price of oil goes much below $15 and stays below that point, it seems that eventually OPEC gets around to acting."
Looking at the price collapse of 1998-99, OPEC at first dragged its feet in response to lower prices, cutting production in March 1998. Prices continued to drift down, and OPEC trimmed a bit more in June 1998. By March 1999, OPEC implemented another cut, and benchmark oil prices soon started to rebound, to more than $20/bbl by late summer 1999.
"So the last episode is telling us that OPEC is still acting late, cutting too little and too late," Drollas said. "So it hasn`t been a very effective manager of the surplus."
OPEC`s success
But has the group learned its lesson? There are two significant observations about OPEC`s production cuts in 1998 and1999:First, thesecutswere accomplishedin concert with several key non-OPEC oil exporters,notably Mexico,Russia, Norway, and Oman; second,thecuts were enforced with an almost unprecedented level of cohesiveness among OPEC`s major players.
The former observation might not be a sign of a sea change within OPEC. These production cuts were engineered first by agreementsamongSaudiArabia, Venezuela, and Mexico. It was the change of oil policy within Venezuela (a new government) and Mexico (a new energy minister) that enabled the rapprochement of OPEC rivals Saudi Arabia and Venezuela as well as Mexico`s overtures to OPEC. While that suggested individual domestic politics was a critical factor in these watershed cuts, there was nevertheless a positive sign for OPEC`s future cohesiveness in Saudi Arabia`s recognition of Iran`s claim to a higher production quota.
Such developments tended to reverse the conventional view of an OPEC in frequent disarray, as outlined by New York consultants Lucian Pugliaresi, LPI Consulting Inc., and Larry Goldstein, Petroleum Industry Research Foundation, in a presentation at the Middle East Petroleum & Gas Conference in Bahrain in April 1999:
"Since the late 1980s, neither OPEC nor the Arab producers have been able to limit (or have collectively been willing to agree to a strategy of limiting) sufficient volumes of oil production to gain price levels which are substantially above long-run replacement costs," Pugliaresi said. "In fact, senior officials among the major Middle East producers believe, correctly in our view, that it is in their long-term interest to `manage` oil production such that prices do not get to the level where they are an inducement for substantial long-term substitution of petroleum (conservation and alternative fuels) and an inducement for excessive competition from non-OPEC production.
"Part of the problem with OPEC is that it collectively does not (and cannot) arrive at the same conclusion because of the divergent long-term interests of its membership and, in the end, any effective agreement requires a complicated set of negotiations and tradeoffs which are inherently unstable. Saudi Arabia, with its vast low-cost reserves, should-and does-have a different outlook and strategy than, say Iran."
But with its rescue of oil prices in 1999, OPEC seemed to have pulled off just such an effective agreement, against expectations.
Drollas contended that 1999 "was a momentous year for the oil industry, because OPEC had been written off, but no (longer)."
What seemingly had OPEC on the ropes was the massive overhang of stocks that was the result of what Drollas called an "involuntary global stockbuild" in excess of normal market requirements in 1998.
"The actual increase, we reckon, points to a 400 million-bbl increase in `98...There was no surprise, really, that oil prices climbed by 42% in 1997, given that kind of involuntary, unneeded increase in stocks."
But the pledged production cuts held, peaking at a remarkable compliance rate within the group of 92% in August 1999 and staying close to that level for the remainder of the year (Table 1).
While the massive stock overhang had been drawn down as a result of OPEC production cuts by only about 25% by September 1999, the slowly dawning realization that OPEC would continue to hold the reins on production even during the seasonal upsurge in demand had speculators bidding up futures contracts. That was enough to push prices to almost $30/bbl by January 2000 and to progressively push up expectations of future prices (Fig. 1).
The turnabout in expectations of OPEC actions meant a fresh new concern: that OPEC would soon have to begin increasing production-or at least announce plans to boost production-to avoid an overheating of oil markets. The concern was often expressed that oil supplies might get tight during the winter, resulting in oil prices rocketing to $40/bbl or more. That would not only threaten the economic recovery that was under way in Asia at the end of 1999 but also hinder economic growth throughout much of the rest of the world. And it would encourage a rebound in non-OPEC production growth that, in turn, could find OPEC once again in the role of being residual supplier with a shrinking market share.
Rather than respond to these concerns, however, OPEC in late 1999 continued to demonstrate not only its continued cohesiveness on sustaining the pledged production cuts to the end of March 1999-when an OPEC heads of state meeting was tentatively slated (but later postponed) to roughly coincide with a scheduled ministerial meeting in Caracas-but also suggested that the cuts would be extended into the seasonally slack second quarter.
CGES suggested in a late-1999 oil market report that OPEC was "paranoid" about the prospect of repeating its mistake of November 1997, when it hiked production quotas in anticipation that the call on its oil resulting from soaring economic growth in Asia would continue to rise-despite evidence that oil demand was collapsing in Asia in response to the region`s financial crises.
Small wonder the group wanted to avoid a repeat of that ill-advised move: OPEC`s revenues plummeted by $51 billion in 1998, by CGES estimates.
So OPEC greeted the new year in 2000 with oil prices still above $25/bbl and threatening to climb higher in the event of an isolated supply disruption or a protracted period of frigid weather in the Northern Hemisphere.
And markets at the start of 2000 were left wondering whether they were looking at a "new" OPEC that could successfully manage its supply so as to engineer a "soft landing" for an oil price level that neither spurred growth in non-OPEC production (and squelched demand) nor crimped members` ability to balance their budgets, much less replace reserves. Is the group capable of such market fine-tuning?
OPEC`s market power
While OPEC may be a "passable" crisis manager, the "subtle maintenance" of stable oil prices may be beyond the organization`s grasp, because financial markets by the end of the 1990s had made it possible for commodity price hedgers and speculators to exploit the market`s inefficiencies.
Sarah Emerson, managing director, petroleum, for Energy Security Analysis Inc., Cambridge, Mass., presented that view at the CGES/OGJ conference.
Looking at how OPEC wields its considerable market power has always been expressed in the context of a tradeoff between maximizing price and maximizing market share, she said.
"The member states of OPEC are well aware of their dependence on steady oil consumption, thanks especially to the Asian economic crisis," Emerson said. "Moreover, they know that high prices encourage investment in non-OPEC countries. So, at one extreme, the idea of deliberate supply curtailments designed to dramatically raise prices is a nonstarter."
At the other extreme, she noted, is the objective of maximizing market share, which Emerson contended OPEC does not have the will to follow through on to its conclusion.
"At the heart of it, OPEC`s current spare capacity is concentrated in only a few countries," she said. "As a result, there are too many countries within OPEC that suffer from low prices but cannot necessarily increase production to gain market share.
"In the meantime, the core (spare capacity) countries are unwilling to cut the others loose and exercise this market power on their own. Perhaps they fear an energy security backlash by consuming countries or a diplomatic break with the US. Or, as it happens in many multilateral organizations, the core countries get caught up with issues of membership and procedure rather than substance and outcome."
With OPEC at a frequent stalemate between conflicting goals, it had fallen to the financial markets since the mid-1980s to wield the greatest influence over oil prices because of their ability to exploit market inefficiencies. OPEC member countries contributed to market inefficiency in their lack of transparency regarding individual country production and stocks, Emerson argued.
By example, if a fund manager or oil firm trading manager believed oil prices would fall, he might go short in the months to come in order to lock in the current value of the crude production. Assuming prices fell by, say, $3/bbl, then the speculator would have a pure gain of $3 in the futures market, and the hedger would be able to offset a loss in the physical market. But the OPEC producer would have a pure loss of $3.
"Over the last 15 years, the futures market has allowed both commercial and noncommercial traders to periodically steal economic rent from OPEC," Emerson said. "In doing so, they can move prices against OPEC`s interests."
Among the options available to OPEC to stabilize markets was one proposed by Venezuela: a quota system tied to an oil price band wherein production rises or falls depending on where prices fall outside the band. That isn`t likely to work, said Emerson, because a technically driven rally in futures markets might drive the price up, spurring OPEC to boost production at a time when speculators were going short in the futures market. Then prices would sag because of the twin effect of more oil in the physical market and a sell-off in the paper market.
The Saudi proposal of tying production policy to inventory levels would work only when oil stocks were very high or very low, warned Emerson, although this notion at least would tie production to a projection of supply and demand and not to a price.
"If stable prices are its objective, OPEC needs to embrace the other factors shaping price, understand those factors, and try to position itself, through its production decisions, to avoid a destabilizing drop (or jump) in price," she said. "In a sense, this means a renewal of the interseasonal quota-adjusting back in the late 1980s and early 1990s."
During 1994-98, OPEC meetings were essentially opportunities to roll over or boost production ceilings to the level of actual overproduction. But the collapse in demand in Asia and the return of Iraq to the market scheme ended the period in which OPEC could just keep letting production increase, Emerson said. "Now the pursuit of stable prices must once again entail cutting or raising production periodically or cyclically...The more OPEC tries to micromanage supply, the more vulnerable it will be to an overreaction in price."
OPEC`s growing clout
Whatever its policy approach, the signs at the start of 2000 pointed to OPEC gaining increasing clout in the following decades, providing it could avoid a catastrophic blunder on the scale of November 1997.
In a theory put forth by Malkewicz Hueni Associates` J.J. Zagar and Petroconsultants` C.J. Campbell, the world was at the threshold of a crisis in terms of future oil supply.
Zagar, in a presentation at the CGES-OGJ conference, estimated the world`s endowment of producible oil at 1.8 trillion bbl, of which about 90% had been found and about 45% produced. He calculated that, with production and consumption of about 23 billion bbl/year, or 2.2%/year, the world at the end of 1999 was less than 4 years away from the midpoint of depletion.
"Yet, we are finding only about 6 billion bbl/year, and that trend is falling," he said.
Zagar`s view represents the "scarcity" side of the world`s future oil supply that holds that production of conventional oil could well peak in the first decade of the new century (Fig. 2). On the other side of the debate is the "high technology" view, which holds that impending scarcity of a resource stimulates technological advances (e.g., horizontal drilling, 3D seismic) that in turn boost recovery of that resource.
Zagar contended that technological advances had actually increased production of oil, not the discovery rate.
Whoever is right, it is increasingly apparent that the concentration of the world`s remaining oil within OPEC will only continue to grow.
According to the Canadian Energy Research Institute, the concentration of the vast majority of the world`s remaining oil reserves in a handful of Middle East countries (all OPEC members) means that the world will grow increasingly dependent on OPEC for its oil needs. CERI considered two scenarios, one a high-technology case, the other a low-technology case; both views reflected a much higher call on OPEC oil (Table 2).
CERI said, "According to the IEA (International Energy Agency), OPEC`s Persian Gulf producers alone have the potential to increase crude oil productive capacity to 47.9 million b/d between now and 2020, assuming sufficient foreign capital is made available.
"All of these producers now have either opened their upstream projects to foreign investment (Iran, UAE, Qatar), appear to be in the process of doing so (Saudi Arabia, Kuwait), or have production-sharing agreements in place and are simply waiting for UN sanctions to be loosened or dropped to allow in foreign investment (Iraq)."
Under the high-tech scenario, these six producers alone could meet the incremental demand for OPEC oil, said CERI. Under the low-tech scenario, OPEC would have a toughertimemeetingtheexpected increase in demand, but it would not face an insurmountable task.
There remained some major uncertainties in the outlook for OPEC and oil prices, however. Market scenarios have a way of getting derailed by unforeseen major supply disruptions (a war involving Persian Gulf producers, for example) or unexpected political developments (a massive carbon tax imposed out of concern for catastrophic global warming).
But, if these unforeseen eventualities are weathered, given that oil demand will continue to rise early in the 21st Century, holding three fourths of the world`s oil reserves remains a trump card.
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