Concern over high oil prices and OPEC during the past year produced abundant reaction, analysis and comment. Crude oil prices, at well over $30/B during much of the year, had tripled from their December 1998 low, and during most of the year were running at 75 percent higher than their average of $19/B during the previous 10 years (from 1988 to 1997) – a level with which both consumers and producers seemed happy enough, despite some considerable volatility around the mean.
Such volatility is now an uncomfortable fact of life in the oil industry, and has several contributory causes, such as exchange rate fluctuations, the industry’s ‘just-in-time’ inventory practices, seasonality of demand, and, most importantly, the control (or lack of it) exercised by OPEC over the supply of crude oil. But the roots of the difficulty lie elsewhere.
In many ways, the most problematic feature of the oil industry is, and has for long been, the wide disparity in producing costs in different areas. Last year, the Saudi Oil Minister, Ali al-Naimi, said that Saudi Arabia’s “all-inclusive cost of production is less than $1.50/B.”1 Similar, though slightly higher costs, obtain in the rest of the Middle East.
Indeed, the Middle East with its vast reserves (65 percent of the world total) and highly prolific oil wells could, if it were so minded, develop reserves to produce and sell enough oil to satisfy present world demand at under $4/B, and still enjoy substantial government revenues. That is what would happen in a highly competitive world.
Nobody in fact wants the price at that level. Ritual appeals to OPEC to ‘allow the markets to work’ – meaning compete for market share – are made by people who either don’t understand what that would mean for price, or merely think that it is the politically correct thing to say. They are an annoyance because they obscure the problem.
Indeed, when some members of OPEC (notably Saudi Arabia and Kuwait) tried just that – fighting for market share – and prices fell at one point to $7/B, the then Vice President George H Bush was dispatched to Saudi Arabia (in 1986) to tell the Saudis they were being irresponsible. Oil Minister Yamani was later fired, the policy reversed, and prices recovered.
But there was an important proviso: the rest of OPEC was given to understand that, come hell or high water, Saudi Arabia would never again accept the burden of swing supplier; others would have to share in any future reductions in demand or cutbacks designed to bolster prices. Later, the Saudis let it be known that they would not allow their production to fall below 8mn b/d.
This minimum and other circumstances eventually led to the collapse of crude prices in the wake of badly-timed OPEC production quota increases at the end of 1997 and the (unrelated) economic recession of South East Asia.
Demand dropped, Saudi Arabia refused to abandon its floor production, other OPEC members again began to fight for market share, a huge inventory overhang was created, and prices collapsed once more. Competition had reared its ugly head again, and no-one in the ‘West’ liked it.
When everybody (exporters and other producers, including the US) had had enough of prices of around $10/B, by early 1999, a few OPEC producers, mainly Saudi Arabia and Venezuela, got together with non-OPEC Mexico and Norway (a member of the International Energy Agency), and cobbled up an agreement to reduce output. The deal was later ratified by the full membership of OPEC.
Further cuts in production proved necessary, and these plus the recovery of the South East Asian economies, brought us to over $30/B with, spectacularly, higher crude prices providing the straw that broke the truckers’ and motorists’ backs in Western Europe, leading to widespread protests directed against the scandalous level of consumer country taxes on automotive fuels (over 70 percent of the pump price in some countries).
OPEC then went into reverse, cautiously and in stages increasing production each month since April 2000 – without any visible effect on prices for eight months! Perhaps the whole episode should be an occasion to take greater cognizance of the abiding dilemma of low costs in the Middle East and the West’s presumed need for oil prices high enough to protect higher cost oil elsewhere and the diversity of supply it provides.
The West does not want free, competitive markets in international oil. President Clinton said last August that the price “needs to be, I think, in the low 20s somewhere,”2 and a spokesman for the European Union’s Commission said, approvingly, that most observers considered a price of around $25/B to be justified3.
More recently, US Energy Secretary Richardson came out in favor of a price between $20/B and $25/B (a difference of only tactical significance from OPEC’s target band)4 .
Prices in a truly competitive market would be miles below this. OPEC in the meantime got a lot of stick for not achieving the impossible.
It would simply not have been possible to fine-tune a market which is truly global, where the main centers of consumption in North America and Western Europe are more than 30 days’ steaming time from the new supplies that can only come from the Persian Gulf, and on which reliable data is non-existent or incomplete for several months after the event.
However, fine-tuning was not the problem: the problem was the absence of competition.
Let me elaborate.
When OPEC (or certain of its members) proposed, in the light of sharply rising prices, making increased supplies available, the buyer had to ask, At what price? The reply was, At the going market price.
And what was the going market price? The going market price was the price that prevailed without the increased supplies. Thanks a lot, muttered the buyer under his breath.
In fact, production did then increase, but only by the amount it would probably have increased anyway in response to normal demand growth at that price, at least until August.
In other words, for increased supply (availability) to work on price, there must be competition – somebody must be actively pushing to displace another supplier, by cutting price, or to increase total demand, by cutting price, or a bit of both.
That this element was lacking went unremarked; hence the puzzlement over why price was not responding to increased supply, with many vain conjectures over time-lags, stocks, market data, even a brief shortage of reformulated gasoline in the US Mid-West.
Secretary Richardson was among the puzzled: “In fact, OPEC’s four production increases ... have been positive steps, but they haven’t reduced oil prices significantly.
So what we need are other factors ...,” he said, but did not elaborate. In fact, neither Saudi Arabia nor anyone else made any attempt to push additional supplies onto the market by aggressive price-cutting.
True, Saudi crude price-formulae over the year showed a widening differential vis-à-vis the WTI and Brent reference crudes, but these merely reflected the growing differences in their respective gross product worth in the markets, as well (presumably) as increasing freight rates.
When prices finally tumbled with a short, sharp shock in early December, they were led down by falling crude oil demand: buyers were full up, short-term requirements dropped off, and producers fell over themselves scrambling for the cargoes that were left to be supplied.
Historically, oil prices were managed by the Texas Railroad Commission, which regulated the State’s crude production, Texas being at the time the international market’s swing supplier. The system worked well until 1948 when the US ceased being a net exporter.
Its demise as arbiter of international oil prices had been foreseen, and towards the end of World War II, the US and Britain drew up and signed a treaty to set up an international body which would control production and set prices. The treaty was never ratified.
The task then fell by default, not long after the war, to the major oil companies, who initially pegged the price at US levels (subject to freight and quality differentials).
During the next two decades, prices suffered slow and erratic erosion brought on by ample supplies and faint (barely discernible) competition.
In the early 1970s, OPEC (at first with the tacit blessing of the US) grabbed the reins and has in effect been managing prices ever since, sometimes well, sometimes very badly indeed.
But if OPEC cannot do a good job for itself and for the world at large, who will? Can they be fixed by a formal agreement between producer and consumer? Almost certainly not.
On the producers’ side, there is no group – certainly not OPEC – that would or could make a formal, treaty agreement worth the paper it was written on.
On the consumers’ side, there is no stomach for attempts to institutionalize the setting of oil prices by treaty.
The dismal failure of the Conference on International Economic Cooperation in the mid-1970s put paid to that, and after long and fruitless discussions, occasionally bordering on the surreal, no further efforts have been made in that direction.
So the world, it seemed for a while, was stuck with OPEC stumbling along, as it had done since 1973.
But a lot has changed recently. Much of OPEC, with its development of new capacity lagging, has become irrelevant to the setting of price.
Only a few members of OPEC, in a shifting coalition with a few non-OPEC exporters, have been active in manipulating supply, and the formal blessing of OPEC as a whole has simply been an expedient exercise in political correctness to cover Saudi et al’s flanks.
Realism has crept in, and the world of oil is the better for it: notably, there is no more talk of setting the price at some chimeric cost of alternative sources of energy, nor, in the Middle East, of embargoes and the use of the ‘oil weapon’, and countries are once again opening up exploration and development to the international oil companies.
OPEC has set an objective for oil prices, a band of $22/B to $28/B, clearly acceptable to the major countries of the OECD, and a mechanism for achieving it. Above $28/B, production will be increased; below $22/B, production will be decreased.
However, it has already become abundantly clear that the mechanism is not to kick in automatically. It has not yet become clear whether push will come to shove, to ensure that increased availabilities affect price.
Nevertheless, it is appropriate to ask: are we getting there? Do we now have a tacit agreement between producers and consumers on a long(ish) term price of crude oil? Can the producers really deliver? The answer is a qualified ‘Yes’6.
Qualified by the fragility of the structure, the survival of which depends in large measure on a dangerous reliance on essentially one country – Saudi Arabia, and its continued good will – as sole guardian of the world’s spare producing capacity.
If demand continues along its present path and if non-OPEC oil supplies keep on increasing more slowly than they have done in the past, the Middle East will have to supply an ever greater share of world demand.
For the past two years, the numbers issued on these premises by the forecasters of the International Energy Agency (including its latest World Energy Outlook) and the US Department of Energy have carried dire political and economic implications which the forecasters decline to explore and indeed view with inexplicable (perhaps politically prudent?) equanimity.
Ever greater dependence on two or three OPEC members for increases in supply inevitably puts at risk the agreeable consensus we now seem to have reached.
On the other hand, the development of spare capacity in other OPEC and non-OPEC countries is devoutly to be wished by prudent consumers.
There is a glaring ambivalence here because such spare capacity would of course be even more life-threatening for the ‘agreeable consensus’ on prices, but (one can only assume) it takes precedence over consensus-preservation, in a kind of ‘we’ll cross that bridge when we come to it’ attitude. For the development of spare capacity, time and technology are everything.
Today, the latter is an article of faith which most of us are confident will not be frustrated. The former is there, in some good degree, for the having.
In particular, the US could help everybody and most especially itself by reversing its long-standing policies prohibiting US petroleum investments in Iran, Iraq and Libya.
As a result of these policies, the development of new capacity has been seriously curtailed, possibly to the tune of 5-6mn b/d, which, if it were now in place, would have prevented prices from rising excessively in the first place.
But, alas, revanchiste policies die hard, and anyone advocating their reversal is thought to be in the pay of the oil companies.
Perhaps the new Bush administration in Washington, about as oil-oriented as one can get in the US these days, can lift or ease the sanctions on Iran and Libya, but the Iraqi conundrum remains: Versailles-like conditions that cannot be enforced on a regime that cannot be tolerated. Moreover, the Cheney-Powell-Bush triumvirate will undoubtedly want its pound of flesh.
Everything is temporary, and perhaps the ‘agreeable consensus’ will work for an agreeably long period of time. It would be helpful if it received greater public recognition.
Pro-forma babble about competition and ‘letting the markets decide’ is an unnecessary distraction and an implicit denial of the consensus, which should be talked up, not down.
When the President of the US, and later, a spokesman for the European Union, brand prices of over $30/B as excessive, and call for prices in the low to mid-20s as ‘reasonable’, no-one thinks to ask what is reasonable about them, and certainly no-one volunteers an explanation.
More recently still, US Energy Secretary Richardson stated repeatedly that the US regarded a price range of $20 to $25 as desirable, though he felt it necessary to preface his remarks by saying that he stressed “three points for the future: First, rely on open competition, market forces, is the first principle” – rather like saying grace before a meal attended exclusively by hungry atheists.
Perhaps it is simply too embarrassing to admit that OPEC or an OPEC-equivalent is needed to impose a sort of inverted protectionism on the rest of the world to facilitate the survival of high cost oil outside the OPEC area and encourage its further development.
After all, this was the idea of the ‘minimum price’ adopted back in the 1970s (at then Secretary of State Kissinger’s urging) and still, as far as I know, technically on the books.
Yes, dialogue is needed, in the context of shifting demand, dialogue on the inputs necessary to sustain the consensus.
It would be needed if only to increase awareness of the nature of the problem, to ensure that an understanding of the consensus’s desirability is firmly embedded in the minds of those responsible for energy policy, and to forestall the adoption of more counter-productive policies.
The desirability, in the interests of geographically diversified supplies, of keeping serious competition at bay should be stated clearly. A spade is a spade, and it isn’t any ‘invisible hand’ that’s using it.
The meeting of the International Energy Forum in Riyadh in mid-November was a welcome development.
The US is now clearly and unequivocally advocating a price range which to a large extent overlaps the range advocated and pursued by Saudi Arabia and OPEC.
There is agreement on the price objective. There is agreement on how to get there (managing supply – forget the free market babble). There is agreement as to who should do it (Saudi Arabia).
In fact, it looks almost like a commodity agreement, except of course there is no formal agreement between the parties –they have merely, individually and separately, stated their views, in a conscious parallelism of action.
Nor is there, on present showing, likely to be a formal agreement, with the commitments that it would entail.
But this should not obscure the very considerable progress that has been made over the past few years in bringing producers and consumers to a consensus.
And it seems quite likely that this consensus will be preserved under the new Bush Administration in the US, despite some sportive OPEC-bashing prior to the mid-January Conference which cut production by 1.5mn b/d.The practical side remains fraught with difficulties.
Today’s world market is not like Texas 60 years ago under the Texas Railroad Commission, and fine-tuning it is virtually impossible: turning the tap on to produce large additional amounts of sour crude in Saudi Arabia is certainly one way to influence the spot price of small amounts of sweet crudes, Brent and WTI, several weeks away by tanker, but it does not invite comparisons with high-tech surgical instruments.
And as a way of changing the price of sour crude in Saudi Arabia7, which is what you’re trying to do in the first place, it is positively bizarre. The system has not worked well in the past, and it won’t work well in the future.
The search for an objective, independent8 market-determined peg on which to hang the price of Arab Light (the world’s marker crude) is understandable but is, in the end, a mere subterfuge to get the monkey off Saudi Arabia’s back.
Saudi Arabia does not want to set the price of its crude itself, directly, because that makes it too obvious that it is the world’s swing supplier, a role it has repeatedly and emphatically repudiated in recent years.
There was indeed some justification for this when other OPEC Members had surplus producing capacity and were exceeding quota, notably Venezuela.
Saudi Arabia was quite rightly insistent that others share the burden of cutting back in order to strengthen prices; but spare capacity outside Saudi Arabia has now all but disappeared and making the system work depends more than ever on the Saudis acting, like it or not, as swing supplier.
And making the system work efficiently probably depends on the Saudis once again setting the price of their crude directly, or at least establishing the oft-mooted spot market for Arab Light crude in the Gulf.
We now have an admittedly precarious consensus on price. It won’t last forever, and if the US does lift sanctions on Iran and Libya, and other development in the OPEC area bears fruit, spare capacity may well reappear, bringing renewed price turbulence with it. In the meantime, this is as good as it gets.
By Francisco R Parra
Francisco R Parra, a former Secretary-General of OPEC, is a private consultant and lives in Cambridge, Mass. where he is currently completing a book on the international petroleum industry since 1950.
Notes:
1. In a speech to the Houston Forum in October 1999. See Oil and Gas Journal, 17 January 2000.
2 Quoted in Middle East Economic Survey, 28 August 2000.
3. Ibid.
4. In a press interview following the meeting of the International Energy Forum in Riyadh in November. Quoted in MEES, 27 November 2000, p. D1.
5. Ibid.
6. But beware, we have been there before. In an article entitled “Moving Towards a Price Consensus”, the Petroleum Economist said fifteen years ago (in its issue of November 1986, p. 398), ‘After the traumas of the past twelve months OPEC has adopted a moderate price target that will not immediately arouse the hostility of consuming interests.
Some of the main importing countries have learned, for their part, that their best interests are not served by very cheap oil. So there is developing a consensus among importing and exporting countries that augurs well for the stability of the oil business.’
7. Saudi Arabia sets its contract crude oil prices monthly, mainly by reference to Brent and WTI spot prices, though there is apparently no rigid formula, and other factors are routinely taken into account.
8. Set aside for the moment the question of manipulation of the reference crudes, particularly Brent.
(mees)
© 2001 Mena Report (www.menareport.com)
