VOL. XLVI

No 42

20-October-2003
 

OPEC

What Future For OPEC?

By Fadhil J Chalabi

The following is a synopsis of a presentation by Dr Chalabi, Executive Director, Centre for Global Energy Studies (CGES), London to the CGES 7^th Annual Symposium on 6-7 October.

1.     It has often been said that if OPEC were to die, another OPEC should be invented.  The truth of this maxim lies in the fact that without OPEC’s control of supplies there could be a huge surge in oil price volatility with far-reaching, adverse effects on growth of the oil industry and on the world economy at large.  In the past, when the major oil companies used to control the industry, their highly efficient supply regulations fostered greater price stability in the oil market. Nevertheless, OPEC supply regulations, although much less efficient, remain necessary as a mechanism of oil supply control, a sine qua non for relative price stability.

2.      There is a paradox, however, in the fact that during the era of supply regulation by the major oil companies, the oil industry in OPEC countries, especially the Gulf, benefited from considerable growth. Whereas when OPEC took control of the industry and adopted high price policies, the centre of growth in the world oil industry shifted from OPEC to new, high-cost areas, such as the North Sea, West Africa, the Caspian, Russia and other non-OPEC supply sources.  The growth of new high-cost oil will continue to depend on OPEC’s maintaining its policy of being the last-resort supplier and defender of high prices, and thus continuing to lose its market share to the benefit of the non-OPEC suppliers. OPEC production control through its quota system, devised to defend high price levels, has secured very high profit margins for the oil companies, aiding their investments in high cost areas.

3.      Because of its policies, OPEC became the guarantor of the oil industry’s growth outside the organization. Without OPEC’s policies we would not have even seen the phenomenon of oil development from the FSU, the North Sea and several other high-cost areas. OPEC’s pricing policy is, in fact, a necessity for US oil production, especially for the 48 lower states where production costs are very high.

4.      For the last 20 years (or since 1983) OPEC’s quota system has been based on the concept of the so-called “swing producer” in the sense that buyers lift their crude oil requirements from non-OPEC producers and resort to OPEC oil to fill the gap between world demand and non-OPEC supplies. In other words, this concept gives marketing priority to non-OPEC oil. To this extent, along with its high price policies, the practice ensures that OPEC actually subsidizes its own competitors, with the result, naturally, that OPEC’s own market share is in continual decline, to the benefit of the others.  OPEC’s production 25 years ago was about 32mn b/d.  Thanks to its own policies, its total production (including Iraq’s) has now dropped to 27mn b/d; while, during this same period, world oil demand has grown by 14mn b/d, testifying to the fact that this incremental world demand has been provided for by non-OPEC oil, and also affirming the fact that the decline in OPEC’s share has become endemic. The brunt of the decline has been borne by the five Gulf OPEC members.  The attached  table and chart show the share of the Gulf five in the world’s non-FSU production has fallen from over 44% in 1976 to 29% in the year 2002.  By contrast, the share of non-OPEC oil supplies has risen from 35% to 59% by 2002. The fall of Saudi Arabia’s share is even more pronounced:  from a peak of over 22% in 1982, the Kingdom’s share fell to 13% in 2002.

5.      This loss of OPEC’s market share to the benefit of other producers brought the organization close to the point of collapse in 1986, its policy as swing producer (with Saudi Arabia being the swing within OPEC) having caused by the summer of 1985 a serious fall in OPEC production to half its capacity, thus provoking a short-lived policy of promoting its production to gain a higher market share for OPEC.  This inevitably led to a severe price collapse that was not tolerated by the oil industry, in particular the US, since very low prices damage investments in high-cost areas.

6.      When OPEC moderated prices from the late 1980s to the late 1990s it regained an increasing demand for its oil to the point where its production continued growing until 1998, at an annual average incremental production of 0.7mn b/d.

7.      A turning point for OPEC’s price policies was the oil price collapse in 1998, which caused OPEC to panic and impose a series of severe production cuts in pursuit of higher prices, from an average price of $17/B to $25/B.

In their quest for higher prices, OPEC policy-makers adopted a price band of $22 to $28/B, agreeing that if world oil prices fell for a certain period below the band’s lowest price, they would then reduce production, and, conversely if world prices were to exceed $28/B, they would increase production.  In effect, they settled for a target price of $25/B, but this target could not be achieved without periodic production cuts, often severe. According to BP’s Annual Statistical Review, OPEC production peaked at about 31mn b/d in 1998, before declining to 28mn b/d in 2002, a loss of almost 3mn b/d in just 4 years. This year they have had to reduce production again in order to maintain the required price.

8.   The question is why does OPEC continue to pursue a high-price policy that only serves to promote the market share of other producers? 

Despite disparities in their long-term interests, OPEC member-countries all meet with one objective in mind, which is to maximize short-term revenue without looking ahead to the impact of such policy measures in the long term on the world oil industry and on OPEC’s role within it.  If we take as an example the organization’s most important member, Saudi Arabia, we shall see that despite the massive inflow of petrodollars since the 1970s, the Kingdom suffers from huge, cumulative budget deficits, financed mainly by internal borrowing. For the Saudis to meet their budgetary requirements without further borrowing, a minimum price of $25/B is estimated as necessary.

What is applicable to Saudi Arabia is also true for the others:  the necessity of meeting a price policy pegged to short-term financial requirements.

9.   The problem, however, is that these requirements are always bound to escalate correspondingly with population increase, world inflation, employment opportunities, etc.  In other words, the financial problems faced in the short term by OPEC countries, are endemic to the economic structure of those countries – unless they undertake drastic and painful measures, involving radical economic reform.

10.  The possible future duration of OPEC’s policy in pursuit of defending higher prices at the risk of losing its own market share is a question of particular relevance for those member countries with inordinately large oil reserves, ie Saudi Arabia, Iraq and Iran, the answer to which depends on what world supply/demand trends will be through to the year 2010.

11.  The OPEC price band was highly instrumental in rapid production expansion in the FSU (in particular Russia), as well as in many West African countries. Russia’s production grew from about 6mn b/d in 1998 to 7.7mn b/d in 2002; while production from both Kazakhstan and Azerbaijan has doubled during that same period. Given present expansion plans in Russia and these two Caspian producers, total production by the year 2010 could reach as much as 13.5mn b/d, compared with 9.5mn b/d in 2002, an increase of 4mn b/d.  In addition, investment plans from West Africa (principally from Nigeria and Angola) will add some 2-3mn b/d by the year 2010 (see Table).

12.  Apart from all the capacity expansion plans outside OPEC, growth in capacity is noticeably underway within OPEC itself.  Iraq currently produces about 1.4mn b/d, but given favorable conditions in the reconstruction of its industry, together with political stability, Iraq can, in a matter of two years, easily regain its 3.5mn b/d, which was its former production capacity prior to the invasion of Kuwait. Given its tremendous expansion potential – owing to prolific, giant oilfields (discovered but left undeveloped) – by 2010 Iraq could easily reach 5 or even 6mn b/d, ie additional oil from Iraq may exceed 4mn b/d by that year.

13.  In addition, expansion plans in Iran, Algeria, UAE, Saudi Arabia and all the other OPEC countries could by that year add another 9mn b/d (see Table 2).   If we total all these extra OPEC and non-OPEC capacity targets, we may arrive at a staggering additional capacity of about 20mn b/d by the year 2010!

14.  In the face of such an enormous surge of plans for expanding production capacity, inside and outside OPEC, the question arises as to what kind of demand increase would absorb this huge supply increment?  Even if we take the over-optimistic projections of both the IEA and OPEC which show world demand increasing at an annual rate of 1.6%, by 2010 world demand will have reached 86mn b/d, which means a demand increment of 10mn b/d, compared with 2002.  With such a large increment, OPEC could, with difficulty, survive by following a lower price policy to discourage oil expansion capacity outside OPEC (since, according to this assumption, the quantity of unused world capacity would not be enormous).

15.  However, these projections of world demand cannot be considered realistic if we take into account present and future trends, which lead to a much lower rate of increase. In the last 10 years, the average annual increase of world consumption has been 1.2%, falling to 0.9% over the past five years. Predicting a higher growth rate for future world demand, despite huge technological advancements, environmental pressure, government policies, etc., is hardly conceivable.

16.  CGES projects a much lower rate of demand increase:  less than 1% per year, or about 0.8-0.9% per year, in which case an incremental demand until the year 2010 would not exceed 3mn b/d. Under such sluggish world demand growth and increasing oil supplies, OPEC’s ability to maintain the present price band would be inconceivable. It may be able to do so if a host of economic and political factors conspire to handicap the industry in reaching capacity expansion targets. Iraq, for example, may not reach the above-mentioned expected capacity target if the present chaotic situation prevails, where security and services continue to be absent. In fact, Iraq has helped OPEC enormously in the past when, because of Saddam’s wars, Iraq’s oil exports were interrupted, which allowed the other members to increase their quotas without jeopardizing the price. The oil price may similarly be sustained if investments in expansion programs in Russia, the Caspian, West Africa, the Gulf of Mexico were to be hampered by technological or financial problems, or unforeseen political events.

What OPEC should not do is count on the cooperation of non-OPEC countries to cut back production, since past and present experience shows that this may be more a daydream than a policy.

The alternative course of action is for OPEC to change its price policies with a view to encouraging an increased call on its oil.  A price of $14/B will cause painful financial problems for all OPEC countries in the short term, but in the longer term this low price would reap a high yield of world demand for OPEC oil, while halting, or drastically deterring investments outside OPEC. The question is to what extent OPEC countries are ready to pay the high cost in the short run in order to benefit in the longer run and secure OPEC’s survival.  Can OPEC live with this price range? Also what degree of increased call on OPEC oil will compensate for the fall in price?

A simulation exercise done by CGES indicates the amount of fall in OPEC revenue in the short-term, but how in the longer run will OPEC’s finances ameliorate? (Table).

The big question for the survival of OPEC is whether the organization continues to sacrifice the future for the sake of the present, or conversely, to sacrifice the present for the sake of the future.  This is the real challenge for the OPEC policy makers, especially for those members holding the largest reserves.

Table 1

Percentage Shares Of Gulf Five Countries’ Crude Oil

Production In The World Excluding FSU

Source: Oil & Gas Journal and CGES.

Table 2

Production Forecast To 2010: FSU, Nigeria, Angola, West Africa

Source: Compilation by CGES of expansion programs data.