VOL. XLIII

No. 38

18 September 2000

OPEC

OPEC In The Eye Of The Storm

Ian Seymour and Walid Khadduri of MEES Report on the Outcome of OPECs 10-11 September Ministerial Conference in Vienna.

Only three times before in its 40-year history has OPEC been caught in the center of an international storm of such magnitude as the current oil price imbroglio. The first was in 1973-74 when a tight oil supply situation was compounded by the outbreak of the October Arab-Israeli war; the second in 1979-81 when oil price explosions were set in motion by the Iranian revolution and the onset of the Iraq-Iran war; and the third in 1990-91 at the time of the Iraqi invasion of Kuwait and the ensuing Gulf war.

However, unlike its predecessors, the current oil crisis - arising from the tripling of crude prices since early 1999 - is not in any way linked to wars or political upheavals. Its concerns are concentrated on economic problems: spiraling oil prices, output volumes of crude and products, and the availability of sufficient production capacity to meet present and future demand. On the production side, OPEC has this year put in place output quota increases of 1.7mn b/d in April and 700,000 b/d in July. These have now been followed by the decision of the OPEC Oil Ministers to raise quotas by a further 800,000 b/d with effect from 1 October. As a reaction to this latest move, crude prices have moved down a little from their previous highs of around $35/B, but still remain stubbornly well above the $30/B danger mark. Meanwhile, consumers - both on the governmental and public opinion levels - continue to voice strong protests against excessively high oil prices.

OPECs essential problem lies in the over-achievement of the targets of its program to raise prices from unacceptably low levels by means of supply management. Its task now is to create a soft landing on the price front at a level of, say, $25/B - the midway point of the OPEC-agreed $22-28/B price band - without precipitating any new price collapse in the process. But OPEC has only one instrument to accomplish this goal: boosting crude supply when the price is too high and cutting it when the price falls too low. However, crude supply in itself is only part of the problem. There are many other complex facets of the present crisis which are beyond OPECs power to control. Let us therefore conduct a brief review of the main causal constituents of the crisis:

Consumers have been subjected to a double blow as regards oil prices: firstly the tripling of crude prices in US dollar terms from $10/B in early 1999 to over $30/B now; and secondly the fact that most world currencies (except the Yen) have registered sharp declines against the dollar in recent times. Thus the financial burden of the oil price rise has been particularly onerous for the developing countries. Calling for increased pressure on OPEC to bring down oil prices, Indias Finance Minister Yashwant Sinha said on 13 September: As far as developing countries are concerned, and especially India because we depend on oil imports to a very large extent, it is putting an unnecessary and almost unbearable burden on our resources. In Europe, the problem has also been compounded by the high levels of excise taxes levied on oil products which oblige European consumers to pay twice as much for a gallon of gasoline as in the US. This issue of high taxes levied on gasoline by their own governments has, of course, been the focus of the widespread popular protests about fuel prices in Europe, rather than indignation against OPEC.

Stocks of crude oil and products are at historical lows at present, particularly in the US, and need to be replenished if proper equilibrium is to be restored in the market. But buyers are reluctant to purchase crude supplies for restocking in current conditions, not only because of the high prices but more particularly because the present steep backwardation in the futures markets (i.e., prices for prompt deliveries being higher than those for future months) makes it uneconomic. In order to give buyers a proper incentive to replenish and hold stocks, the markets need to move over into a state of contango; but it is difficult to see how this could be achieved in a short time. Possibly the collapse in the last few days of the unprecedented premium of $3/B for Dated Brent over first month could be a harbinger of some movement in that direction, as well as of an alleviation of market manipulation by the big players.

Making substantial volumes of fresh crude supply available for sale is one thing. To ensure, in the face of reluctance on the part of the customers to buy at high prices, that the supplies reach the market swiftly is quite another. Price discounting by the producers would no doubt help to speed up crude sales for inventories as well as refining, but this - not surprisingly - is something of a taboo subject within OPEC.

Low stocks of crude and key products such as heating oil represent only one of the multiple complications afflicting the US market. Another is a shortage of refining capacity (US refineries are operating at over 98% of capacity at present), together with supply constraints on crudes of appropriate qualities. Yet another stems from the widespread emergence in the US of stringent quality specifications for various petroleum products, thereby causing further problems for refiners as well as making it difficult to offset any shortages by means of imports from elsewhere. Moreover, if there were to be a severe winter, the situation could be exacerbated by shortfalls in heating oil and natural gas supplies. It seems that, to head off potential crises in oil supplies and prices, the US administration is seriously considering allowing the withdrawal of some crude from the countrys Strategic Petroleum Reserve (SPR) which currently holds around 560mn barrels. In such a complex set of mega problems, there are obviously many faults and bottlenecks which cannot be laid at the door of OPEC. In its press communique after the Vienna conference (for full text see page A4), OPEC points out that, even in advance of its new 800,000 b/d quota increase as from October, the level of supply to the market already exceeds anticipated demand and goes on to point the finger of blame elsewhere in the following terms: In this connection the conference emphasized that the confusion in the oil market is basically as a result of shortages in the products markets caused by bottlenecks in the refining industry, speculation in the futures market, manipulation of the Brent market due to the dwindling volumes of this crude, and widening differentials between light sweet and heavy sour crudes.

In order to review this highly volatile situation, the OPEC Ministers agreed to meet again in Vienna in two months time, on 12 November. It has also been indicated that, if necessary, further supply adjustments, up or down, could be made either at that time or before if the price band mechanism is activated.

As indicated in the detailed analysis of the numbers involved later on, it would seem that on current supply/demand projections the present OPEC crude supply arrangements - which should result in OPECs total output rising to around 29.5mn b/d as from October - would be enough, or if anything rather more than enough, to meet demand for both consumption and stocks through the next three quarterly periods. In fact, it could be that OPEC might be obliged to consider a cut in production for the second quarter of next year.

However, it could be that the prevailing market malaise and the persistence of high prices also stems from something rather deeper than the concern about immediate supply availability - namely a perception that the level of spare producing capacity in OPEC (and therefore the world system as a whole) has now reached a dangerously low point. There would be some justification for such a perception given that, according to MEES estimates, total spare capacity within OPEC (after the latest 800,000 b/d quota increase) will stand at no more than 1.5mn b/d, of which roughly two-thirds is located in Saudi Arabia. Of course, particularly with the current high prices, the capacity problem can be rectified without much difficulty through expansions both inside and outside OPEC. But this will take time, and meanwhile for the next couple of years or so a tight market will be the order of the day - unless, of course, there is significant erosion on the demand side.

How Many New New Barrels In OPEC Latest Increase?

At the Vienna conference, the decision to raise quotas by a total of 800,000 b/d distributed pro-rata between the 10 OPEC countries concerned (excluding Iraq) was taken with remarkably little difficulty. Saudi Arabia took the high road with a proposal for 1mn b/d, with Iran and some others opting for 500,000 b/d. A compromise on 800,000 b/d was thereupon arrived at expeditiously. The only question remaining in peoples minds, and particularly the minds of the markets, was: how many barrels of actual incremental supply would this new agreement bring to the market, given the fact that some countries have already reached their capacity limits.

According to MEES estimates, the volume of new supply under the latest OPEC agreement is likely to be in the region of 600,000 b/d. This assumes, among other things, that the new Saudi quota increase of 259,200 b/d (under the 800,000 b/d OPEC tranche) will be produced incrementally on top of the 400,000 b/d output boost made independently by the Saudis as from August.

Taking the August OPEC production of 28.9mn b/d (see story on page A5) as a base, this 600,000 b/d increment is calculated to raise OPEC production (including 3mn b/d for Iraq) to around 29.5mn b/d for October onwards. The table on page A4 shows the potential for stock change if this OPEC production level of 29.5mn b/d were to be maintained until the middle of next year - projected according to the differing forecasts for the demand call on OPEC crude supply by OPECs Economic Commission Board (ECB), the International Energy Agency (IEA), the US Department of Energys Energy Information Administration (EIA), and the Centre for Global Energy Studies (CGES). Although these forecasts differ quite widely, particularly for the first half of next year, they all show stockbuild potential for all the quarterly periods under review, ending up with huge inventory builds of between 2.2mn and 3.6mn b/d in the second quarter. Hence the perception that a cutback in OPEC output may well be needed by then.

As regards the price band mechanism - providing for a 500,000 b/d supply increase if the OPEC basket price exceeds $28/B for 20 consecutive days and a 500,000 b/d decrease if the price falls below $22/B for 10 consecutive days (for full details of the mechanism see MEES, 26 June, page A2) - it was agreed that this should operate unchanged during the periods between OPEC ministerial meetings, but that at these meetings ministers would naturally be at liberty to take different decisions according to the prevailing circumstances. In the connection, Saudi Oil Minister Ali al-Naimi is understood to have given his OPEC counterparts assurances that Saudi Arabia would be fully prepared to cut its production in the event prices were to drop below $22/B.

The conference decided to postpone a decision regarding the appointment of a new OPEC Secretary General in place of Dr Rilwanu Lukman of Nigeria, whose term of office expires at the end of this year, until the next ministerial conference on 12 November.

http://www.mees.com/news/a43n38a01.htm

-- Martin Thompson (mthom1927@aol.com), September 22, 2000