ISSUES: Does OPEC have a future?

20 January 1995

OPEC used to be able to claim the credit for most oil price movements. OPEC production ceilings, or their violation, set the tone for oil markets around the world. Yet, OPEC's ability to assert itself has taken a hammering over the past decade. Today, the principal forces at work appear to be a combination of commodity traders and institutional investors. Together they drive the refined products markets, exploiting sophisticated financial instruments, market rumours and minute movements in supply and demand. The fiscal policies of the industrialised countries are also a powerful influence on prices.

However, after years of watching its influence wither away, OPEC is hoping that its ministerial meeting last November will help it regain the pricing initiative. It is not alone in thinking so. Supporters of this view believe that financial regulators are poised to bring the futures and derivatives markets, which have dominated the oil trade over the past two years, under stricter control. Tighter regulation and closer scrutiny of paper trading could sharply reduce their leverage.

The fallout from the $1,500 million losses suffered by Orange County, California could have a dramatic effect. 'By the time government regulators have finished with all of the Congressional hearings which will result from this, there will be an effect all across the derivatives markets,' says Peter Gignoux, head of the energy desk at the London office of US brokers Smith Barney.

But, such optimism about OPEC recovering its former influence could easily be undermined by the failure of the OPEC states themselves to address their own political and economic problems.

OPEC countries have been slow to open up their economies and subscribe to the global free market agenda. A typical OPEC state still has an insignificant non-oil economy, little or no tax base, subsidised utilities and public services, and no tradition of democratic accountability.

'The government wants to do everything regardless of what the people want,' says Jasem al-Sadoun, managing director of the Al Shall economic agency in Kuwait. 'Governments are under pressure in Kuwait, in Saudi Arabia and in Oman and other places. Unless some powerful reform happens soon unemployment will be a serious problem in two years' time. The consequences will be a political and social confrontation and, in some years, this process could create another Algeria.'

Opinion among some mainstream OPEC watchers is much more optimistic. The November decision to roll over the 24.52 million barrels a day (b/d) production ceiling for the 12 members was well received. An increasing number of oil traders and analysts are starting to believe that OPEC's self restraint could produce the desired results. They note the 40 per cent surge in world commodity prices over the past 12 months and the end of the recession in the industrialised countries. If production is kept constant and demand increases, then prices must rise, or so the reasoning goes.

The optimists are also impressed by the change of heart at OPEC. Its sessions are more akin to corporate board meetings than the unruly affairs of the past, says Gignoux. 'There's a special sense of economic reality,' he says. 'I am interested in what they are saying now even though they have lost the buccaneers.' Gignoux believes that the world is looking at the start of a commodity cycle and that sooner or later market fundamentals will begin to reassert themselves. OPEC will have to change its strategy if and when Iraq returns to the market but it can do this through a 'collective diplomatic agreement'.

OPEC has lost none of its powers to influence markets psychologically. Traders are far more sensitive to strikes or supply disruptions in OPEC states than they are to similar events elsewhere. Oil prices moved to $19 a barrel from $13 when several hundred thousand barrels per day were knocked out by strike action in Nigeria in the summer of 1994. Yet, two industrial strikes in Brazil later in 1994, which removed similar amounts of crude from the market, were barely noticed.

Leo Drollas, chief economist at the London-based Centre for Global Energy Studies, also believes that OPEC's prospects have improved and that the organisation is far from finished. 'There was a time when I would have said that (OPEC was finished) but I don't think it is quite true. They are actually having some effect. Before, they were over-producing, but now demand has pulled the market up on the tight side and excess production has gone. If they manage to hold and don't cheat too much, then they can affect the price.'

Some analysts believe that OPEC is destined to have a far more modest role in future. According to John Toalster, oil analyst at London stockbrokers Societe Generale Strauss Turnbull, OPEC has little influence today beyond providing a floor to the oil price. 'If OPEC did not exist then we would be looking at $6 a barrel oil,' he says. He believes that research and experience show that oil prices are moved by supply and not by demand. And, with so much capacity available outside OPEC, the OPEC ambition of boosting prices by holding production constant will come to nothing. 'There is a realisation that there is no shortage of oil on the market,' says Toalster.

Al-Sadoun thinks that the power to determine oil prices now rests with consumers rather than producers. He concedes that the growing importance of the Gulf as a source of world oil might help producers in the region regain some influence. 'But it will be a time-consuming process to regain this power.'

OPEC's track record in influencing the policies of oil-consuming countries has been a dismal failure to date. Efforts to head off higher taxes on oil, legitimised by the 1992 environmental summit in Rio de Janeiro, have had no impact. OPEC collectively, and member countries individually, have criticised carbon tax proposals and threatened non-specific reprisals, but have not influenced the debate.

There are serious scientific doubts about the so-called greenhouse effect but the OPEC response to the carbon tax plans failed to exploit well known flaws in the environmentalist argument. OPEC's contribution to the debate was simply to say 'it's not fair on us' Some critics argue that OPEC's inability to influence the oil and environment debate in the industrialised countries is an indication of its growing impotence.

Al-Sadoun fears that because of OPEC's weak position, member countries are also enfeebled in negotiations with prospective foreign investors. Most OPEC countries have been considering opening their oil sectors to private sector investment - to increase production capacity, provide essential maintenance for producing fields or restore infrastructure which has been neglected over the past decade. However, both banking and oil executives who have examined investment opportunities in OPEC countries remain notably unenthusiastic about them.

The real problem is taxation. The UAE, Indonesia, Algeria, Nigeria and Venezuela have punitive tax terms which deter potential oil investors. Host governments believe the tough terms are justified by their vast reserves and the huge potential for commercial discoveries. The counter argument from the private sector is that fiscal flexibility is the main reason why such high cost areas as the North Sea have become major non-OPEC oil sources and continue to attract investor interest. Because of their tax regimes OPEC countries are competing against each another for investment, rather than against non-OPEC countries.

Pessimistic oil analysts also stress that OPEC states must do more to diversify their economies away from oil, so great are their fiscal imbalances. They point out that oil faces an increasingly competitive energy market in an energy efficient world. Many OPEC countries are already suffering the consequences of their reduced earnings. Power cuts, unemployment and cancelled infrastructure projects are commonplace.

Few OPEC states offer either a fiscal regime or the internationally recognised investment guarantees that foreign investors demand. The problem in some states, such as Iran, is that such guarantees may be unconstitutional or politically impossible to provide.

And, there can be a political price to pay for economic restructuring as instability in Venezuela and Nigeria has shown. Even free-marketeers such as Al-Sadoun are wary. He advocates a slow approach to economic reform and building a revenue base by charging for public services and adopting sales taxes rather than imposing taxes on income.

OPEC may demonstrate a renewed ability to maintain quota discipline in 1995 and even achieve the rise in oil prices it is seeking. But the fiscal and political pressures on each member state show no sign of abating. OPEC's fate could be to achieve the status of a well managed international organisation just as its members face insurmountable domestic difficulties.

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