Oil & Gas: Testing the record

24 January 2003
Gulf finance ministers must be beaming from ear to ear, eyes clocking dollar signs like cartoon characters at the oil prices, which in minions to ramp up production. After all, one year ago demand was rock-bottom, prices were crawling along below $20 a barrel, non-OPEC market share was aggressively growing and OPEC production was lower than it had been for a decade.

But before settling in for a pleasant year of price and production highs, OPEC members could do well to ponder the largely political reasons for their success and ask whether their strategy of price targets and output curtailment is really working.

The goal is simple: a stable oil price within the range of $22-28 a barrel. And the tactics are straightforward too: review and adjust production every three months to keep the market in balance.

OPEC's record over the past two years has been largely successful. In 2001, the oil price only twice punctured the preferred January registered two-year highs and do not look likely to slump. Oil ministers must also be tempted to sit back smugly and order price ceiling before sinking beneath $20 a barrel after 11 September - depths from which it did not recover until mid-March. Since then it has remained largely in the band, albeit helped by the high political premium on the threat of war in Iraq.

Now, the price has jumped above the band - propelled by a collapse in Venezuelan exports as the state oil company went on strike. OPEC is pumping at near-full capacity but the combination of lost Venezuelan barrels and growing fears of war has kept the price high. And OPEC has responded by meeting regularly and acting quickly. In January, it committed to a production increase of 1.5 million barrels a day (b/d).

'OPEC has shown that it is a viable organisation,' says Sarah Emerson, managing director of Boston-based Energy Security Analysis. 'It has learned that its collective power is really substantial. Many people have talked down OPEC of late, but in my mind it is alive and very healthy.'

Much of its togetherness is a result of the 1998 price collapse - an event that convinced the organisation's members to abandon market share in favour of strong prices. To some extent, the 1998 collapse was itself the result of other historical events. In 1991, OPEC - and in particular Saudi Arabia - picked up the market share dropped by a war-ravaged Iraq and a post-communist Russia. Quota compliance became a joke until demand began to flag and the price started to sink.

Now it is developing another string to its bow - working with non-OPEC producers. The extent of Mexican and Norwegian readiness to curtail production when the price was low last year took many analysts by surprise. But there are clear reasons for both. Mexico and Venezuela share similar oil revenue needs and once the OPEC member committed itself to defending prices higher than $22 a barrel, its Latin American counterpart started to understand the benefits. Norway is also running up against capacity problems and will need high prices to offset the lack of new output growth.

OPEC's three-year experiment with micro-management has often been criticised by analysts, even though it appears to have been successful from the organisation's point of view. But that does not mean there is no basis for such criticism.

'It is easier to predict annually than quarterly, so OPEC should set its production targets on a yearly basis,' says Leo Drollas of the London-based Centre for Global Energy Studies. 'The point is that in the second quarter, companies restock for the third quarter because the price is low. If you cut back in the second quarter, like OPEC did in 2002, and deny the market the opportunity to build up reserves, you get disruptive price surges.'

Besides the tactic of micro-management, there are significant questions regarding the sustainability of OPEC's price strategy. How much market share is the organisation prepared to lose to non-OPEC producers? Can the larger producers - in particular Saudi Arabia - risk becoming swing producers if the smaller ones cheat on their quotas? How far will oil prices around $25 a barrel damage the global economy and oil demand?

Between January 2000 and December 2002, the average production of OPEC 10 members, which excludes Iraq, was 24.7 million b/d, falling from a 2000 year average of 25.6 million b/d to 24.9 million b/d in 2001 and 23.4 million b/d in 2002. Over that period, non-OPEC production has risen by 4.1 million b/d to 48 million b/d, according to the International Energy Agency (IEA).

There are two principal reasons for the non-OPEC expansion: new technology and higher prices make new non-OPEC reserves more economically attractive; and the establishment of a strong private Russian oil industry has led to the aggressive development of major existing reserves.

Although non-OPEC production will continue to rise as long as the oil price stays high, the rate of growth will slow down. OPEC's hopes are pinned on world oil demand offsetting the gradual increase in competitors' output. Several OPEC members are already increasing their production capacities and will become frustrated if this is not reflected in actual production.

The organisation will be squeezed further still by the re-emergence of a stable Iraq - whether that happens soon as a result of US military action or in other ways over the medium term. However, it will take several years to bring Iraqi production capacity back up to reasonable levels - buying OPEC some time to ease the new production into the market.

But outside the organisation, the debate often focuses on a different issue: the relationship between the oil price and the global economy. High oil prices put upward pressure on inflation, weakening demand and slowing economic growth.

However, the extent of that pressure is a matter of debate. Dresdner Bank in a 2002 study estimated that an oil price of more than $30 a barrel sustained over several quarters would reduce economic growth in the West by half a percentage point. Other studies are more sanguine, arguing that high oil prices have little more than a moderate inflationary impact.

What cannot be disputed is that oil prices are a matter of global concern, drawing producers and consumers into a symbiotic relationship that demands stability. The best example of such symbiosis is between the world's largest exporter and its largest importer - Saudi Arabia and the US. Immediately after 11 September 2001, Saudi Arabia pushed out tankers loaded to the gunwales in a gesture of support that did not go unnoticed. In December, it responded to another cry for help as Venezuelan exports dried up.

'There's an absolute armada headed this way with oil,' says Emerson. 'And that has impressed a lot of people here. There has been a lot in the press about a bad bilateral US-Saudi relationship, but when it comes down to it oil is the key, and there is as strong an energy relationship as ever.'

Ultimately, OPEC is all about standing up for producers' interests in a world long dominated by powerful Western consumers. The path of higher prices is beset by criticism - sometimes impartial and justified, often not. If, over the coming months, OPEC can shepherd prices back into the band through the minefield of political crises and market fundamentals, it will have gone a long way towards answering its critics.

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