This summer finds the oil market in unexpected rude health, with the crude price now comfortably ensconced in OPEC's preferred bracket of $22-28 a barrel. On the face of it, the organisation has stood by its policy throughout a period of extremely high political volatility and a barrage of criticism from analysts - and has been fully vindicated. The majority of analysts now forecast that the price of Brent crude will be around $24 a barrel for 2002 as a whole, significantly higher than the $20 a barrel that many had predicted at the start of the year.
But despite this apparent success, it is becoming clear that the low production quotas are starting to hurt, and that the organisation is on the verge of exhausting its capacity to keep cutting in defence of the price.
At 21.7 million barrels a day (b/d), official production is now some 20 per cent less than it was 18 months ago, and it shows no sign of recovering quickly. In 2003, non-OPEC output will continue to rise apace, while global demand will not grow fast enough to allow OPEC to substantially increase output. And if Iraqi production exports return to their full potential volume, OPEC 10 members may not be able to increase production at all for more than a year.
The danger is that if the price falls again, in an environment of higher non-OPEC production, the organisation will have precious little scope to keep cutting output.
The stringent production quotas introduced by OPEC and non-OPEC producers in December have underpinned the price, but other events have conspired to keep OPEC ahead of its game. Persistent political tension in the Middle East - the violence in the occupied territories and the US threat to launch a military offensive on Baghdad - has certainly strengthened the market, while the continuing problems with Iraqi production have presented OPEC with plenty of output elasticity. For the immediate future, both the political price premium and unreliable Iraqi exports can be counted on to help OPEC maintain a strong price (see page 26).
But amid the stern warnings of many oil analysts that OPEC cannot hope to sustain its price policy over a long period, others are more sanguine about the organisation's chances. Sarah Emerson, managing director of the US' Energy Security Analysis (ESA), argues that OPEC market share is not vulnerable for at least four years, and that its preferred price is therefore easily defensible. 'It's true that OPEC market share has fallen by a few per cent since the high point in summer 2000 because of output curtailments and weak demand,' she says. 'But if you look forward, demand is strong enough for everybody to increase production a little, with OPEC market share staying flat.'
The key areas to watch are demand growth and rising non-OPEC production. Conflicting sets of data and expert forecasts abound for both. The Paris-based International Energy Agency released its latest demand growth estimates in mid July. It projects a 1.1 million-b/d growth in global oil demand in 2003, based on a recovery in the US and world economy. At the same time, it predicts that non-OPEC output will increase by about 700,000 b/d and that production of OPEC liquefied natural gas (LNG) and non-conventional oils will add the equivalent of 170,000 b/d. The scenario would leave OPEC members with room to increase their own oil production by about 230,000 b/d, assuming that Iraqi production does not significantly rise.
In contrast, the US' Sempra Energy Trading puts 2003 demand growth at 1.2 million b/d, of which non-OPEC will account for about 1 million b/d, leaving 200,000 b/d for OPEC to build output, again assuming low Iraqi exports.
Rising non-OPEC production has been a feature of the oil market this year, with Russia taking the lead. In June, Russian output was up by 430,000 b/d year-on-year. Mainly operated by private companies, Russian production is very difficult to lever politically and operators are widely reported to be happy as long as prices are higher than $14 a barrel. Clearly, a repeat of the export moratorium of 150,000 b/d implemented during the first half of this year to help OPEC defend the price, is unlikely to happen.
Indeed, press reports of recent weeks have instead focused on the possibility of a price war. Unnamed officials in OPEC and Moscow have been rattling their sabres in off-the-record briefings, while in public they talk about the strength of their reserves and production capacities. Others have been more open. 'We know what their costs are and if it comes to a competition we know who is going to win,' said OPEC president Rilwanu Lukman at a London conference in mid July. 'But we are not engaging in a price war.'
Although OPEC members are increasingly frustrated with holding back their volumes as Russia boosts its own, there is little likelihood of a price war erupting because both sides have too much to lose. While OPEC has far more spare capacity, its members are under greater financial pressure than Moscow because oil represents a far higher part of their annual revenue. Similarly, while Russian companies believe they can survive at a much lower price than OPEC countries, they are simply not big enough to fight for long. As it stands, Russian companies are likely to be persuaded to slow down their increases at times, while OPEC will accept their increases at others.
In any case, there is conflicting evidence over how far new Russian output is shaving customers from OPEC. 'Looking forward, I think that the former Soviet Union production growth will cut into the market of other non-OPEC producers, rather than damaging OPEC market share,' says ESA's Emerson. 'If we're in a world where demand is rising, based on a US economy recovery that is still fundamentally sound, then OPEC need not be worried.'
Yet there are signs it is worried. Apart from the slightly neurotic comments of some officials about Russian increases being won off the back of OPEC work, quota compliance is slipping badly, a sure sign that OPEC members are concerned about volume. Venezuela, one of the worst offenders in recent months, was called to order by OPEC at its meeting in late June. And while the organisation accepted the argument that a brief spell of increased production was acceptable so long as the regime of President Hugo Chavez was under threat, it is unlikely to be forgiving for long. Algeria, already producing something over 20 per cent more than its ceiling, has requested a production increase and Nigeria too is making disgruntled noises.
For now, the poor compliance is just about permissible. Rock bottom Iraqi production and exports have created a gap that OPEC members can fill with excess production. But if a solution is found to the controversial retroactive pricing regime, allegedly responsible for falling Iraqi exports, OPEC could lose this vital elasticity.
More daunting is the scenario that some analysts forecast based on low economic growth and bearish demand figures. In such a scenario, non-OPEC production will rise significantly, demand will be low, political tension will ease and prices will start to fall again. In such an event, OPEC will have a very tough time. Already at what is effectively its lowest sustainable production level, it would have to beg non-OPEC producers to cut their output again, or just sit out the period of lower prices. In either case, it would be a blow to both revenue and prestige.
But for now, that does not look the likeliest outcome. A more probable sequence of events is medium demand growth combined with strong non-OPEC production - keeping the price where OPEC wants it and allowing a little increased production next year. The Iraq factor is unlikely to disappear soon, allowing extra compliance flexibility and adding a political premium to the price.