Zen and the art of oil market maintenance

15 January 2003
Self-mastery and a close affinity with the surrounding world are the underlying principles of Zen Buddhism. They are lessons OPEC members could do well to meditate on as they ponder the oil market outlook for 2003 and murmur their mantra of $22-28 a barrel.

Prices were unexpectedly good in 2002, but OPEC members know this had more to do with the rough winds of political turbulence than their own efforts to manage the market. Although the organisation cut an estimated average of 1.5 million barrels a day (b/d) from its total production, it dismally failed to stick to its stated quota of 21.7 million b/d.

The coming year will provide harder tests. Iraq and Venezuela stand on a knife edge of instability. The economic outlook remains poor. OPEC members are desperate to bring new capacity on stream. And rising non-OPEC production is cutting away at the organisation's market share.

If it wants to keep prices within its target boundary, OPEC must maintain discipline. At the 12 December meeting, it reinforced its intention to do just that. 'We know the value of discipline, because it gives us better revenues, better credibility,' OPEC conference president Rilwanu Lukman told the Vienna meeting. 'It's in our interest to be disciplined, so we work towards that.'

The organisation agreed upon a de facto production cut of up to 1.7 million b/d by raising the output ceiling to 23 million b/d and urging members to bring their actual production down to the new level. The decision was not easy. The delegates in Vienna were haunted by the memory of their last attempt to justify quotas by cutting production. In late 1997, they raised the quota and the price began a long downward spiral that culminated in a price of less than $10 a barrel a year later.

This time the tactic appears to have paid off. Prices regained a couple of dollars a barrel as traders accepted OPEC's promise of a cut. Now the organisation must deliver, and it is far from certain that it will have favourable circumstances in which to do so.

A good place to start is with the market fundamentals of demand and supply. According to the International Energy Agency (IEA), oil demand will grow in 2003 by only 1 million b/d on the back of almost no growth in 2002. The World Bank report 'Global economic prospects, 2003' filled in the background succinctly: 'Though global GDP is expected to rise 2.5 per cent in 2003 as a result of improved business health and policy stimulus in the US and Europe, the chances of the world economy sliding towards recession are real.'

The oil market crunch will come in the second quarter of 2003, as the peak seasonal demand of the northern hemisphere winter comes to a halt. Lukman told the OPEC conference: 'The first quarter of next year is not the time to worry, the time to worry is the second quarter.'

The concerns are amplified by non-OPEC production growth, particularly from the aggressive new private companies of the former Soviet Union (FSU). Alongside Russia, there is a strong drive to increase capacity in the Gulf of Mexico and West Africa. According to Boston-based Energy Security Analysis (ESA), non-OPEC supply will increase by 1 million b/d in 2003, after growing by 1.3 million b/d in 2002.

For OPEC, the implications are serious. At best, it will only be able to increase production by a couple of hundred thousand barrels a day in 2003 to keep the market balanced. And for some OPEC members, production growth is seen as vital. Algeria and Nigeria have both undertaken significant capacity enhancement programmes that need to be turned into actual output to combat economic difficulties.

'This is a big challenge for OPEC cohesion,' says Vera de Ladoucette of Cambridge Energy Research Associates (CERA). 'The problem is that it all depends on prices. If prices are good, OPEC will look the other way if some members raise their production. If prices are bad, the indiscipline of some will increase the pressure on the others.'

If the lesson of 2002 is to be learned, prices will be determined in large part by the political crises unfolding in Iraq and Venezuela.

How likely is war in Iraq? For all the tough talk in Washington and London, war is far from certain. The general public in the US and UK has shown a marked lack of enthusiasm for military action, while from European and Arab governments there has been outright opposition. By agreeing to work within the UN, US President Bush signed up for a process that could still take months to complete, months for Saddam Hussein to get off the hook.

However, the rhetoric from Washington remains robustly bellicose, and Bush's political strength has grown considerably over the last six months. The US' November elections to Congress and the Senate reinforced the administration's foundations. And when Washington and London decried the Iraqi weapons dossier even before the chief weapons inspector Hans Blix released his report, they were clearly stating they meant business.

The questions do not stop there. How strong are the Iraqi forces and how loyal are they to Saddam Hussein? What would replace the Iraqi government if it were removed? And in the event of war, how much damage would be inflicted on the country's oil facilities?

Each outcome has strikingly different implications for the oil market. A quick, successful war that did not damage Iraqi oil facilities would lead to a short-lived price spike, perhaps as high as $40 a barrel, followed by prices closer to $20 a barrel. If the oil installations in Iraq and neighbouring countries were damaged, there could be a more prolonged period of high prices. And if the cat-and-mouse game continued indefinitely, the continued high tension could keep prices level at around $25 a barrel.

The Venezuelan crisis could have as strong an effect. So far this year the country has produced an average 2.7 million b/d, compared with Iraq's 1.9 million b/d. It also has more production capacity.

Oil has been at the heart of opposition to leftist President Chavez for more than a year. When he was briefly ousted in April, it followed a series of strikes at the state oil company Petroleos de Venezuela (PDV). Staff believed his strategy of ploughing oil profits into poverty reduction was weakening the company's production capacity and independence.

In early December, the situation reached another head. Several people were killed demonstrating against the government and PDV went back on strike. By mid-December, Venezuelan oil production capacity was down to about 600,000 b/d, from more than 3 million b/d in November.

'This dispute will have a more bullish impact than Iraq,' says ESA senior analyst Aaron Brady. 'Venezuela is the third largest supplier of US crude. It is also an extremely important supplier of refined products.'

The effects of the strike will not be limited to its duration. Bringing capacity back on stream can take weeks or even months. In addition, the ongoing dispute and the channelling of funds away from PDV have had detrimental effects on its long-term capacity.

When Chavez was ousted in April, the talk was of a different market effect. Then, the opposition seemed certain to reverse the president's policy of cutting production to keep the oil price in OPEC's target band; now, that certainty has evaporated.

While a new government would want to seek higher production, it faces two problems. The country's reduced output capacity could physically prevent more oil from flowing. And some analysts now say the political price could be too heavy.

'OPEC has done a good job of managing supply over the past three years,' says Brady. 'My theory is that if Saudi Arabia and the others want to keep production in check, they'll lean heavily on Venezuela. I'm not sure it would be so bearish without Chavez.'

OPEC has become a master at doing little while appearing to closely manage the oil market. This year, its task is likely to be even more difficult and it will have to use all the tools available to it if stability is to be maintained. In years to come, OPEC's attempt to keep prices in its target range will be difficult because of the growing non-OPEC production. But there is light at the end of the tunnel. OPEC's domination of proven global hydrocarbon reserves means its share of total production will inexorably rise.

'Non-OPEC production will level off around 2007,' says CERA's De Ladoucette. 'The battle for market share will swing in OPEC's favour in 2008-09.' Just when this swing will itself start to impact policy and move markets is another tricky equation.

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