Why $25 oil is the right price

24 October 2003
Criticisms are flying that OPEC has again got its price and production policies wrong. Russian Oil Minister Igor Yusuf, justifying his country's aggressive output strategy, said in early October that $25 a barrel was too high and would hurt consumers. Venezuelan President Chavez declared in a speech, also this month, that the target OPEC price range should not be $22-28 a barrel but $28-32.

The trigger for the outbursts was OPEC's decision on 24 September to cut output by 900,000 barrels a day (b/d) in November. The market, expecting a quota rollover, was wrong-footed. Prices have subsequently risen 20 per cent to their highest levels since the end of the war for Iraq in April.

The argument about the oil price is older than most imagine. The first commercial oil development was in Pennsylvania in 1859. After an initial boom, overproduction led to the industry's first slump. Between 1865 and 1870, the price of refined products in the US market fell by more than 50 per cent. The first attempt to control prices originated with John D Rockefeller. He helped found Standard Oil Company, the world's first fully-integrated oil firm, and used every trick in the book, including price fixing, to make it the dominant force in American oil. Provoked by its massive profits and charges of anti-competitive behaviour, the US government passed laws that split Standard Oil in the first anti-trust measure in history.

A century later, there is still no oil price consensus. So why do the experts continue to disagree? And why has the oil price debate been going on so long?

Wrong equations

Economists find the issue particularly irritating. They argue that, in free market conditions, prices would tend to fall to the industry's long-run marginal cost. This is how much it costs the most efficient producer to supply one more barrel of crude.

If this principle were applied in oil, Saudi Arabia, the world's lowest-cost producer, would supply most of our oil and charge not much more than $1 a barrel. In fact, crude is selling this autumn at more than 20 times this figure and the kingdom produces less than 10 per cent of the world total. No wonder economists are annoyed.

The truth is that macro-economic theory is of little value in helping us to understand how the petroleum industry works. The struggle in the oil market is not between consumers and producers but about who gets the massive profits the industry commands.

Owners of oil say the lion's share is theirs since they control the reserves. Oil companies argue that oil only has value because it is found, developed, processed and exported using the technologies they have developed and own. In the end, how the surpluses are divided mainly depends on the bargaining power of the two sides at any particular moment.

Strong OPEC

Since early 1999, when Saudi Arabia, Iran and Venezuela reached a broad understanding about oil and other issues, the advantage has been with OPEC. The organisation has used it to drive oil prices from under $10 a barrel then to almost $30 now despite sluggish growth in world oil demand and soaring non-OPEC production.

Economists argue that there is a possibility of an oil price slump in 2004 because of a forecast imbalance in supply and demand. But the real threat to prices originates in the uncertain oil strategy of the government of Iraq after the fall of Saddam Hussein, and the shambolic oil policy of the Russian government since the collapse of communism in 1991.

Dealing with these challenges depends most on OPEC's ability to convince both countries that the present price structure is good for everyone. If it succeeds, the organisation's price target next year is eminently achievable. If it fails, Saudi Arabia is in the best position it has been for more than two decades to launch a market share war that will bankrupt Baghdad and Moscow long before Riyadh feels serious pain.

Saudi Arabia's Petroleum & Mineral Resources Minister Ali Naimi said in an interview last week with the Financial Times that $25 a barrel for the OPEC basket was fair for both producers and consumers. The price target owes little to the logic of the market, but Naimi is probably right. It suits the OPEC majority and Saudi Arabia has the muscle, in the form of substantial spare production capacity, to back up his words with actions.

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