The future of the Organization of Petroleum Exporting Countries has been increasingly questioned of late.
Some authorities say OPEC has lost price control to oil traders. Others say OPEC needs to change to survive. And some see a new dawn for OPEC as inevitable.
This year OPEC appears to have entered a period of self-analysis. Among issues that may decide its future:
- Other oil producing countries have recently had more influence on oil prices than OPEC.
- Oil trading in paper markets has drained OPEC's market dominance yet introduced other sources of volatility that affect oil prices.
- OPEC's period of absolute power in the 1970s is seen as the root of many of its current problems.
- OPEC must solve the problem of divided membership before it can forge a strategy.
- One hope for OPEC lies in redefining its role to become guardian of the whole industry's welfare. Another lies in a move into the paper markets by its members.
OPEC members effectively seized control of oil prices from the seven oil majors in the early 1970s. For much of the time since then, oil prices have been on a roller coaster ride.
Two oil supply crises and resulting price spikes in the 1970s set oil producers and consumers searching for ways to limit their susceptibility to oil price volatility. OPEC's dominance has been curtailed since then.
RECENT HISTORY
OPEC's influence on world oil markets is very clear in the behavior of oil prices.
For example, Saudi Arabian crude was only $2.50/bbl in summer 1973 but had rocketed to $36/bbl about 7 years later. By summer 1986 the price had plummeted to less than $10/bbl.
OPEC abandoned fixed prices in favor of market-based prices, and the market entered a period of relative prosperity until 1990, when Iraq invaded Kuwait. The resulting loss of oil supplies from both of those countries initially sent prices beyond $35/bbl, but conservation and increased production from other countries made up the shortfall and brought prices down. Since then, the trend generally has been downward. Earlier this year, oil fell below $12/bbl to a 5 year low.
Between 1990 and 1993, OPEC's power to sway the market drained away. Oil producers still blame OPEC when prices fall and look to OPEC to trim production quotas, but OPEC says it cannot engineer price recovery on its own.
Last year, OPEC struggled to accommodate Kuwait's need to increase production in order to gain added revenue and help pay for reconstruction after its devastating invasion.
OPEC's June 1993 meeting to set third quarter quotas saw Kuwait's frustration boil over. While other members agreed to roll over a 23.58 million b/d production total into the third quarter, Kuwait refused to accept the agreement and produced outside the quota system for 6 months.
Kuwait had been offered a 10% quota increase to 1.76 million b/d. This was rejected. Eventually Kuwait reentered the OPEC quota agreement with a 2 million b/d quota for third quarter 1993 and first quarter 1994.
In late 1993, pressure returned for OPEC to trim production as oil prices fell to less than $15/bbl. A key point in recent OPEC history was the quota agreement forged at the Sept. 29, 1993, ministerial meeting in Geneva.
For much of 1993 low quotas encouraged some members to overproduce in a bid to maintain desperately needed revenues. Last September, OPEC raised its quota ceiling to what was deemed a supportable level.
The agreement was intended to cover 6 months--fourth quarter 1993 and first quarter 1994. Although quota levels were at first received with pessimism by some analysts, the quotas are still in place.
This agreement's relative success lies in the added production allowed to some members, compared with the previous agreement. The additional oil has discouraged quota-busting (OGJ, Oct. 4, 1993, Newsletter).
Yet in November 1993, the quota agreement was widely seen to be foundering. Analysts called for a temporary OPEC cutback, "...to jolt bearish market psychology and break the widespread perception among traders that supplies will be plentiful for some time" (OGJ, Nov. 29, 1993, Newsletter).
While oil prices fell to less than $12/bbl early this year, OPEC maintained its production agreement and members mainly adhered to quotas. As d result of this restraint and increasing world oil demand spurred by economic recovery, oil stock levels declined and prices recovered by midyear to more than $17/bbl.
PAPER MARKETS
During winter 1993-94, traders on the New York Mercantile Exchange were buying and selling light sweet crude futures for as little as $13-15/bbl for next month delivery.
Taking inflation into account, this was close to the lowest price in the history of oil.
"To some traditional crude oil producers, this was a brutally low assessment of their economic lifeblood," said Edward N. Krapels, president of Energy Security Analysis Inc., Washington.
"For once in its long career, international oil was a market in the classical economist's sense of the word."
To Krapels, this marked the point at which the old guard of the oil industry--OPEC and major oil companies--was overthrown. A new guard had taken over, made up of oil traders who saw low oil prices simply as a risk of the business, one that can be hedged against by trading on futures markets.
Oil traders are constantly trying to find out what the oil price will be in a day, a week, a month, a year, a decade. Their view is clouded by OPEC, which exists solely to safeguard the price and market share of members' oil.
Traders from the financial community have no innate respect for anything in the commodities markets, oil or otherwise, Krapels said. Instead, their respect has to be gained.
"OPEC would get more respect if it ran a better oligopoly," he said, "or better yet, a monopoly like De Beers runs in diamonds. OPEC's failure to 'run a tight ship,' its tendency to cheat on production quotas, and its frequent misestimation of the state of the market have allowed financial market oil traders to profit by systematically taking short positions in the crude futures markets."
Since OPEC's latest quotas were forged in September 1993, it has been the reaction of oil traders around the world to OPEC's agreement and other worldwide events, rather than OPEC itself, that has set oil prices.
Prospects of lifting an oil export embargo against Iraq, civil war in Yemen, an oil workers' strike in Nigeria, surging North Sea oil production, and fluctuating pessimism about former Soviet Union oil production have kept OPEC quota compliance out of the forefront of traders' minds recently.
When none of those things seemed particularly threatening, other factors came into play. Prices rose unexpectedly last April, after OPEC ministers agreed to roll over September's 24.52 million b/d production quotas.
A $1/bbl jump in Brent crude price to $14.40/bbl was attributed to fears of rising U.S. interest rates. Investments funds were pulling out of equities and bonds in favor of oil and were thought just as likely to pull back out again (OGJ, Apr. 11, Newsletter). Some of the blame was placed on inexperienced traders, who saw oil as a cheap investment without considering supply/demand problems.
Richard Schenz, chairman of Austria's state owned OW AG, praised OPEC members for their production restraint. He said if OPEC members tried to maximize production in the same way as non-OPEC states, crude oil prices would be $10/bbl lower than they were.
"They would simply fall to the very low level of the cost of producing the marginal barrel," Schenz said.
By the end of last April surge in products demand was reviving crude oil prices, with Nymex future jumping more than $1/bbl to $16.82/bbl. This was seen a vindicating OPEC's policy o sticking to quotas and letting recovering economies, led by the U.S., revive oil prices.
London's Centre for Global Energy Studies (CGES) said there is little doubt oil prices will recover sharply by fourth quarter 1994 OPEC holds oil production near quota levels for the rest of the year.
Last June's OPEC ministerial meeting was the most relaxed in a long time, as demand surged and prices were the highest for 2 years at almost $21/bbl on the Nymex for light sweet crude. Ministers were so confident their 24.52 million b/d quota was working they canceled a scheduled September meeting.
OPEC's self-restraint slipped a little in June, however, as its total production rose to more than 25 million b/d for the first time this year. This had no effect on the markets.
Instead, oil traders were jittery over the strike by Nigeria's oil unions, which has since curtailed the country's production by about 20%. Also, Islamic fundamentalists' attacks on expatriates in Algeria and concerns over the outcome of Yemen's civil war helped buoy prices (OGJ, July 18, Newsletter).
ROOT OF PROBLEMS
Earlier this year, when oil prices plunged below $12/bbl to a 5 year low, OPEC was widely thought to be in crisis. An imminent OPEC ministerial meeting was expected to roll over the production quota agreement-against the hopes of non-OPEC producers.
At that time, Ahmed Zaki Yamani, chairman of CGES, advised OPEC to look at its history to see if it could learn something that would help it extricate itself from the mess.
During the 1970s, Yamani was oil minister of Saudi Arabia and a man often blamed among non-OPEC members for the oil price crises of the period. Yamani now sees those crises as keys to OPEC's current problems.
"In one sense it would have been better for OPEC if the two oil price crises of the 1970s had never happened," Yamani said.
"They created within OPEC a feeling of excessive euphoria from which flowed a false sense of omnipotence. In turn, this arrogance of power, with the inevitability of an ancient Greek tragedy, led to nemesis and a serious weakening of OPEC's position."
Yamani said OPEC's current troubles stem largely from members' inability to see the reality of their situation. Actions by Arab states in October 1973 created panic among consumers who bid up product prices in response, and crude prices followed.
"Yet when these measures ended months later, oil prices did not collapse to their previous levels," Yamani said.
"The oil companies, faced with dismantling of their concessions, panicked in turn and signed long term contracts at officially determined prices, endorsing in the process OPEC's fixed price system.
"This encouraged OPEC member states in their belief that their time had come and the companies were at last on the run. Decades of company domination were finally ending."
Yamani recalled the shah of Iran talking about making the West pay for its extravagant way of life and complaining that a liter of Coca Cola cost more than a liter of oil.
OPEC's view was that oil pricing was simply a matter of dictating a price to oil companies, Yamani said. Oil companies were seen as having no option but to agree. Such was their dependence on OPEC oil.
"What many OPEC member states had not appreciated at the time is that it takes a considerable amount of effort to keep oil prices reasonably stable and oil demand growing," Yamani said.
"The oil companies, after all, had been under a lot of pressure to hold oil production in check and thus prevent oil prices from weakening. Oil prices during the 1950s and 1960s were more stable than at any time before or since, essentially because oil companies ensured that oil production did not get too much out of line with oil demand on a worldwide basis."
Oil consumption declined in the non-Communist world during 1974 and 1975 for the first time in decades. Companies built oil stocks because of weak demand, and substitution for oil began in electrical power generation.
Yamani said, "By the mid-1980s, OPEC apparently still had not taken on board the grave changes in the underlying conditions of the market and the shift in oil investments worldwide toward the upstream sector in non-OPEC areas."
OPEC introduced production quotas in March 1983 as a response to falling oil prices. The system was supposed to operate in tandem with fixed official prices. But, Yamani said, some members adhered neither to fixed prices nor to production quotas.
OPEC was effectively an inverted pyramid, with Saudi Arabia forming the organization's foundation in its role as swing producer. The Saudis stuck to the policy of selling oil at official prices, which became increasingly out of line with market prices.
"The net result was that Saudi Arabia had become de facto the world's swing producer," Yamani said. "No wonder the whole pyramid soon toppled."
In summer 1985 Saudi production was only 25% of capacity as the country carried the burden for OPEC output adjustment. So the kingdom introduced netback pricing for its crude, in which the sale price was related to product price minus refining and transportation costs.
"This took the risk out of purchasing oil and brought buyers flocking back to the kingdom," Yamani said. "However, other OPEC members were quick to follow suit in defense of their market shares."
As a result, the price of oil crashed, reaching a low point of $8.76/bbl for OPEC's basket of crudes. OPEC's survival at this point was attributed by Yamani to its collective fear of where the price would bottom out.
In August 1986 OPEC members set a production quota below prevailing production levels, and members abided by the agreement. When prices had recovered in October 1986, OPEC reintroduced a fixed minimum price of $18/bbl.
Yamani said, "OPEC can either control production, leaving oil prices to find their own level, or it can set government selling prices, producing the amount of oil needed by the market at these prices.
"It is self-evident that OPEC cannot rigidly regulate both volumes and prices. It lacks the degree of monopoly power to achieve that level of market control."
Yamani said OPEC has never formulated a coherent long term strategy. It still does not appear to know whether it wants higher prices or higher volumes, he said, which are mutually exclusive routes to higher revenues.
OPEC MEMBERSHIP
"There is a fault line that runs right through the organization, based on this dichotomy between price seekers and volume chasers," Yamani said.
On one side of the line-price seekers-Yamani places Libya, Algeria, Qatar, Nigeria, Indonesia, and Gabon, each with very little spare productive capacity. In a similar situation are Iran, United Arab Emirates, and Venezuela, each with about 10% spare capacity.
This group's interest lies in high oil prices here and now, Yamani said. It has little interest in higher volumes and expanding oil markets.
On the other side--volume chasers--Yamani places Saudi Arabia, with 20% spare productive capacity, and Kuwait, with the potential to increase production 20%. Iraq.'s productive potential groups it with Saudi Arabia and Kuwait.
This group is best served by high volumes of production, low prices, and expanding oil markets, Yamani said.
"Every time OPEC holds back collectively its oil production in defense of higher prices, countries such as these in effect hand over market share to other producers.
"What is more, higher oil prices place more revenues in the hands of producers everywhere, thus encouraging exploration--and in due course development--outside OPEC."
While OPEC may be split into two camps, Yamani steadfastly believes the organization will not split simply because any alternative setup is far worse.
"It is true that members of OPEC fall into rival camps," Yamani said, "but they still have an overriding common interest in ensuring that the oil market does not slide into a catastrophic free-for-all in which member states will suffer."
A different view comes from Fadhil Chalabi, executive director of CGES, who sees the OPEC of the future as a club of limited membership made up of the five founding members and U.A.E.
Chalabi said, "Saudi Arabia, Iraq, Iran, Kuwait, Venezuela, and U.A.E. together have more than 700 billion bbl of oil reserves, which would be enough to sustain their current production for more than 80 years. Such a long life span allows for a very substantial increase in those countries' production capacity."
Chalabi believes these countries' strategies will determine the oil price profile in years to come.
Chalabi said Gabon, Algeria, Indonesia, Libya, Nigeria, and Qatar, on the other hand, have reserves totaling less than 60 billion bbl. This yields a reserves/production ratio of 20 years.
"Unless substantial discoveries of oil are made in those countries," Chalabi said, "the life span of their reserves is too short to allow any meaningful expansion in their oil production capacity."
Whether these countries stay in OPEC or not, Chalabi said, their influence in price making will be very small.
Yet another view is that voiced by Abdulaziz Al-Dukheil, president of the Consulting Center for Finance & Investment, Riyadh. He believes OPEC should be replaced by a group of Persian Gulf nations led by Saudi Arabia.
But before a replacement for OPEC could work, member countries would have to put their economies in order. Despite OPEC, prices are controlled by western countries, notably the U.S., Al-Dukheil maintains. He said western countries use strategic stockpiles to keep prices low.
A long term prospect for OPEC is entry of former Soviet Union (FSU) countries. The Russian Association of Oil & Gas Producing Territories (Raogpt) was formed recently with plans to join OPEC as an observer at first (OGJ, Aug. 1, Newsletter).
Krapels said entry of FSU countries into OPEC would make the organization even more fractious.
"If OPEC let the FSU in," Krapels said, "it would be a sign of OPEC's desperation."
OPEC'S FUTURE
Before his retirement at the end of June, OPEC Sec. Gen. Subroto denied the organization is losing its grip on the market and cannot exercise control.
Such accusations, he said, show a lack of understanding of OPEC's role as a coordinating group that seeks consensus and the harmonizing of market forces.
"OPEC's relationship with the oil market and the international oil industry has evolved over the past 30 years," Subroto said. "I believe this is an appropriate moment to redefine that relationship."
The oil market tends to be volatile if left to its own devices, Subroto said, which is why many people use futures markets. However, while such markets pay close attention to efficiency and price transparency, it is not their function to provide stability.
Future markets are not capable of providing stability, Subroto said. Rather they "...offer the means for investors, producers, and consumers to manage their exposure to risks related to volatility--and indeed to benefit from it.
"The futures market thrives on volatility and could have a detrimental effect on the stability of the oil market by transmitting nervous signals."
Subroto said OPEC's formation in 1960 came about when Saudi Arabia, Iraq, Iran, Kuwait, and Venezuela sought a more equitable return from their oil production and moved to take control of their natural resources.
"OPEC has evolved over the past three decades, and its founding principles are valid today," Subroto said. "Yet we have additional concerns to pursue, including stability of oil prices, balance of supply and demand, adequacy and equity of environmental measures, trade liberalization, and the flow of investment.
"We continue to provide a valuable voice for developing countries, we are a focal point for the oil industry, and we are playing the role of coordinator and collaborator in many international and technical fora. We are part of the oil industry establishment, and yet we do not rest on our laurels."
Subroto said if OPEC ceased to exist today, the market soon would be forced to create a substitute for it because the industry and the market could not operate as smoothly without it.
Among those who believe OPEC's return to power is inevitable is Petroconsultants SA, Geneva, which believes the Middle East's big producers are sleeping giants and could trigger another oil price shock by 2000.
Consultant Jean Laherrere has said that when OPEC swing producers Saudi Arabia, Iran, Iraq, Kuwait, and Abu Dhabi supply more than 30% of the world's oil needs, they will realize their power in the market and hike prices.
Petroconsultants estimated swing producers currently supply about 27% of world oil and will reach the 30% level before 2000.
Drewry Shipping Consultants Ltd., London, said oil companies continue to invest worldwide in upstream activities with a view to reducing their dependence on Middle East suppliers.
Assuming oil prices do not jump significantly this decade, Drewry said, it seems inevitable the Middle East will remain the major source of the world's oil.
The consultant sees current modest oil prices working in OPEC's favor. Declining U.S. production reflects poor economics of exploration there, while new field development in the North Sea is often made viable only by tax concessions. Non-OPEC oil production is set to decline or, at best, peak in the medium term, Drewry said.
"Thus," it said, "it can be anticipated that OPEC producers MU begin to take a larger share of the world oil market in the latter years of the decade, probably after 1997, according to current projections.
"Oil prices will therefore be significantly higher in real terms from 1998 onward than they are at present...
"It is uncertain whether prices will rise gradually or suddenly. But in view of historical trends, it is most likely that a sharp hike in the general level of oil prices will be seen."
OPEC HEDGING
OPEC members occasionally have traded on futures markets in attempts to control their vulnerability to oil price peaks and valleys.
The International Petroleum Exchange (IPE) of London is wooing OPEC states in a bid to persuade them to trade regularly in futures on the IPE.
Alban Brindle, contracts and research manager at IPE, said the approach is slow and patient. Middle East countries in the main are being educated in the ways of futures markets and benefits of hedging.
"Some countries are closer than others to being ready to decide," Brindle said. "We have had a positive response to our approach everywhere. There is a feeling in OPEC that hedging is inevitable because of the increasing need to protect national budgets from changing oil revenues."
IPE believes OPEC has a role to play in trading because the oil market would be more balanced if OPEC were a participant. IPE says benefits to OPEC would include:
- Top earnings from oil reserves because futures market pricing mechanisms would give customers improved flexibility in timing of deliveries, for which buyers would be prepared to pay slightly more.
- Good information on what is going to happen in the oil market. This would allow oil to be sold forward through futures contracts, securing good prices.
- In the long term, as paper markets grow, producers will be able to hedge all their production and minimize volatility in revenues.
Brindle said if a large producer attempted to hedge more than, say, 5 million b/d, the futures market would not be able to cope at present. But the producer could hedge 10% of production and build up over a period.
Krapels confirmed that use of paper instruments by OPEC states for partial hedging is under way. Futures markets are big enough to absorb everyone except the Saudis, he said.
Krapels sees Saudi Arabia, rather than the whole of OPEC, as one of the major influences on oil markets in the future. And he sees OPEC as a tool for the Saudis to use or ignore as it suits them.
"The Saudis are a potential oligopoly all by themselves," Krapels said. "They have learned their lessons and won't make markets in future. They will produce 8 million b/d whatever the price, and if it stays at $12-25/bbl they will be happy."
Paper markets are in control when the oil price is $12-25/bbl, Krapels said. Outside that range he believes political factors hold sway.
At more than $25/bbl, governments will intervene to control prices, and below $12/bbl Saudi Arabia will take action, Krapels said.
"OPEC is not a key player at either one of the extremes," he said.
He believes internal disputes have weakened the organization.
Copyright 1994 Oil & Gas Journal. All Rights Reserved.
