Déjà vu at Opec, all over again
On February 17th Sheikh Ahmed Zaki Yamani made a speech in the Commonwealth Institute in London. The subject discussed was a close to his heart--the Opec's long-standing weaknesses. Starting in 1962, Yamani was Saudi Arabia's oil minister for almost a quarter of a century. A colorful figure, he dominated the international as well as Arab oil arena. Although the speech is five months old, it remains remarkably valid and is well worth reading. The following are excerpts:
Putting the words Opec and price stability side by side induces him a distinct feeling of deja vu. Many times Opec was told to take a certain course of action from--invariably in its own best interests--but it procrastinated.
When it should cut production at the first opportunity, it delays and delays until oil prices are scraping along the bottom of a deep trough. When it should wait and see, it decides to increase quotas--and then, to make matters worse, it actually strives to reach them.
When it should boost production, it decides to wait for oil inventories to decline. When inventories do decline eventually and prices are taking all the strain, it still cannot bring itself to raise output.
Oil price stability is the "holy grail" of the oil industry, for without it there can be no orderly planning for the future. What can ordinary consumers possibly think of a fuel that goes from $23/bbl in January 1997 to $10/bbl in December 1998 and up to almost $30/bbl in February 2000? With what confidence can companies invest in oil exploration and production after such volatility? How can producer governments manage their fiscal and monetary affairs when confronted with such wild swings in the price of their key national resource?
For oil price stability a so-called "manager of the surplus" is needed. This proposition is accepted without argument by almost everyone in oil industry and for this reason needs no elaboration. Such a role was performed in the past by the major oil companies and was subsequently abrogated by Opec. What really matters, according to him, is the astute management of this surplus to good effect.
Before we deal with such matters, however, it would be sensible to examine briefly how Opec got itself and the oil industry into such a state of crisis.
The recent episode of extreme oil price instability brings forth the following sorts of questions. Why did oil prices collapse in 1998 and how much was Opec to blame for this? How did Opec manage to stop the downward price spiral? Are matters likely to get out of hand in the opposite direction? Could Opec's current stance on output lead to a price explosion?
Much has been made of the impact of the Asian economic crisis on the oil price in 1998, often in terms that imply it was the sole reason for the oil price collapse, but its impact on the oil market was made much worse by Opec. The key to the oil price collapse is the first quarter of 1998. World oil consumption dropped by 0.6 million bpd between 4Q97 and 1Q98, primarily due to the Asian crisis, but also because of a mild winter in the Northern Hemisphere. Instead of cutting its output to meet this contingency, Opec's crude production rose by 1.1 mllion bpd between those two quarters. Around half of this increase was due to Iraq, but the rest resulted from the higher quotas agreed in November 1997 in Jakarta.
In consequence, global stocks rose by 2.1 million bpd in 1Q98, pushing average stock cover up by three days' worth over 4Q97 and causing the price to fall by $5 a barrel. Although people might say that Opec could not have known about the impact of the Asian economic meltdown. The answer is that Opec should have had a pretty good idea of what was going on. After all, the crisis erupted in July 1997 with the collapse of the Thai baht, and the contagion spread quickly thereafter. Even allowing for Opec's slow reaction times, the Organization had at least four months to realise what was happening;
The story took a turn for the worse in 1998, because when Opec eventually cut production in March and then again in June of that year, the cuts were inadequate. By our reckoning, worldwide oil stocks rose in the first three quarters of 1998 by 1.9 million bpd despite Opec cutting production by 2.3 million bpd during that period. No wonder oil prices carried on drifting downwards! In other words, Opec should have cut output in 1998 by another 2 million bpd.
Why was Opec reluctant to reduce output further in 1998? A key reason for this was Saudi Arabia's unwillingness to allow its production to drop below its self-declared 8 million-bpd floor. Larger cuts would have required the kingdom to abandon this totemic output minimum, which had been cemented into place during the Gulf crisis nine years before. Moreover, Saudi Arabia's share of Opec production (without Iraq) had dropped by almost a full percentage point in 1997, reinforcing its disinclination to cut its output below 8 million bpd. Eventually, Saudi Arabia conceded that it would have to go below this minimum, leading to the third round of Opec cuts agreed in March 1999. But by then enormous damage had been done to the Kingdom's and Opec's finances.
To recapitulate, Opec was too slow to react to changing conditions during the winter of 1997-98 and when it did its response was inadequate. The lessons are obvious: Opec's ability to interpret information is flawed and its decision-making processes are too cumbersome. The dramatic $51 billion drop in Opec's oil income in 1998 certainly concentrated its members minds wonderfully—especially Saudi Arabia's. Small wonder that the Kingdom was instrumental—along with Venezuela and non-member Mexico, which acted as a catalyst—in engineering the third round of cuts in March 1999. After all, Saudi Arabia could only afford to pay its wages and salaries bill with its much-depleted oil income in 1998 and nothing else—The advent of a new Venezuelan government keen on reversing the oil price slide with additional output cuts, the continuing support of Mexico and a timely visit by US Energy Secretary Richardson to Riyadh helped finally to resolve the price crisis early last year. The subsequent rise in the oil price was even more astounding than the price collapse had been, prompting many to claim 1999 as Opec's finest hour since 1986.
Although Opec was obviously responsible for the price rebound that has made everyone so happy, the long-standing weaknesses of the Organization are still with us—but with a new twist. Opec's slowness to read the market and its lack of resolve conspired to bring about the 1998 price collapse—that is certain. However, these same defects are now threatening to destabilize the market in the opposite direction. With Brent hovering between $27/bbl and $30/bbl, there can be little doubt that the oil market is very tight right now—and it will get tighter if nothing is done soon.
The CGES believes that industry forward stockcover in the OECD declined to 51 days' worth at the start of 2000—a level very close to minimum operating levels or "minops". The three rounds of output cuts by Opec, and the 100,000-bpd drop in non-Opec supplies in 1999 following the price debacle of 1998, brought about a 1.3- million bpd global stock draw in 1999 that has eliminated the hugh stock overhang of 1998. A continuation of Opec's output restraint beyond March 2000 would take the oil industry, into uncharted territory. Quite how companies would behave should their stockcover go below minops cannot be ascertained at present. One thing is certain: in such circumstances oil prices would be higher—much higher—than they are today.
For Opec member-government officials to claim—as some did until quite recently—that inventories remained at high levels suggests that their sources of information are flawed. Erroneous information, when added to Opec's habitual slowness to react, may well be an explosive mixture in the months to come, which is why he is so reluctant to congratulate Opec. Whom who may ask "what is wrong with prices at $30/bbl; surely in real terms such prices are not that bad?" the answer is that $30/bbl oil today is above the average $28/bbl price of oil in the Kuwaiti-crisis year of 1990 and only 10 percent less than the average price of oil in the crisis year of 1974 (both prices in current Dollars). To put it differently, the average price during the period 1991-97, when world oil demand excluding the FSU was growing at a healthy 1.7 million bpd per annum, was $20/bbl. I would say that a price 50 percent above this 1991-1997 average, sustained for some time, is likely to harm oil demand growth.
There are two ways in which this detrimental impact takes effect. One is directly via higher oil product prices, which make oil consumers reduce oil consumption at the margin. Despite high oil-product taxation levels in many developed economies that obviously lessen the impact of higher crude prices, retail oil prices have increased substantially in the West. How much may come as a surprise to some of you, Ladies and Gentlemen: the cost of the retail oil-demand barrel rose during 1999 by 31 percent in the US, 44 percent in Germany, 39 percent in France, 35 percent in the UK and 24 percent in Italy; only in Japan did it increase by a modest 8 percent. These are very big price increases indeed and are bound to affect oil demand growth in due course.
The other way is indirectly via the effect of higher oil prices on inflation rates, leading in turn to higher interest rates that harm economic growth. Inflation rates have been creeping up lately in most developed economies (for example by 0.5 percentage points in Germany and 0.7 percentage points in the US from the summer of 1999 onwards), admittedly from very low levels. Part of this increase is not oil-related, but part of it definitely is and will reduce economic growth rates, and by extension oil demand growth, despite oil's reduced role in our economies.
Lower oil demand than otherwise would have been the case is therefore a natural consequence of higher oil prices, all other things being equal. To this negative effect one must add the positive effect of these large price increases on non-Opec oil supplies. The delayed effect of the 1998 price collapse came through in 1999, causing non-Opec supplies actually to decline for the first time since 1989. That, however, has come and gone, and now we have the lagged effect of the price surge of 1999, which is expected to materialize this year, pushing non-Opec supplies up by 1.2 million bpd. Moreover, the much higher upstream profits reported by all the companies in 1999 imply higher E&P expenditures in due course and more oil supplies from these sources.
So, it is not too difficult to reach the conclusion that $30/bbl oil is not good for oil demand and not good for Opec either. An increase in Opec's output is therefore imperative, and the sooner the better. Opec, as the possessor of approximately 6- million bpd of spare oil capacity, needs to manage its surplus in such a way as to bring the oil price down to more sensible levels and keep it there—but to what levels and how; these are the vital questions.
The optimum price Opec should aim for must perform three functions. First of all, it must be high enough to meet—in conjunction, of course, with a certain level of oil production—the basic financial needs of Opec's key players. A price of $10/bbl may be wonderful for consumers, and may even be low enough to ruin some non-Opec producers, but it is almost certainly a financial calamity for most, if not all, Opec producers. On this point, the CGES has calculated that Saudi Arabia needs a minimum price of around $16/bbl at current levels of output just to meet salaries, interest payments, subsidies and supply and maintenance costs. To cover normal infrastructural investment and reduce the Saudi debt mountain by—say—$3 billion each year would require a minimum price of $20/bbl.
Secondly, the optimum price must not be high enough to impair healthy growth in consumer demand for oil. Ie has discussed this issue already and believes that $30/bbl is much too high. What then is the highest price level that would not discourage reasonably healthy growth in oil consumption?
The third task of an optimum price is to be low enough to discourage the growth in oil supplies from producers outside Opec. Given average lifting costs of around $11/bbl in the Lower 48 United States, it would be difficult for Opec to shut in much of this production without causing the Organisation itself immense grief.
The same argument applies a fortiori to the UK sector of the North Sea, where 93 percent of oil production has operating costs below $7/bbl, according to Wood MacKenzie. However, if we add in the costs of finding and developing oil in these two oil provinces, an oil price of between $15-$20/bbl is needed to grant companies enough of an incentive to boost supplies in both areas. Thus, while Opec can do little to shut in existing production in the more mature oil areas of the world, it can slow down the discovery and development of new supplies there with an oil price around $16/bbl in current Dollars.
We seem to have arrived at a key price range of $16-$20/bbl that should allow Opec to attain its medium- to longer-term objectives. The problem is how to get to this range from where we are right now without causing the price to overshoot in the opposite direction.
Obviously Opec has to increase production as soon as possible, but by how much? The longer Opec delays, the greater the production boost that will be needed eventually. We believe an output boost of 2 million bpd by Opec from April onwards should help the price achieve a soft landing around $18-$19/bbl in the fourth quarter of this year. As to the practicalities of how Opec could achieve this, I would have thought that a pro-rata increase in target output levels offers the least contentious route. Iraq of course would present a problem were it to remain outside such a scheme, which leads us to the question of how oil price stability can be maintained over the longer term.
If Opec decides to take it upon itself, that is—to keep oil prices within a band of, say, $16-$20/bbl over the foreseeable future, it must do the following. First of all, it needs to re-incorporate Iraq into the quota system, which makes Iraq's recent declared wish to be re-admitted all the more welcome. Secondly, it must engage in frequent, judicious and timely output changes on the basis of the best information and advice available on the true state of the oil market. Lastly, its member-states should try hard over the coming years to reduce their reliance on oil and gas as sources of state revenue.
Lower oil prices are not the work of the devil, but a means of achieving lasting stability for our industry. Whether Opec is disposed to share such a view is open to question.
In closing Yamani provided a definition of insanity. "Insanity,” he said, “ is when you do the same thing over and over again and expect to get different results each time."
© 2000 Mena Report (www.menareport.com)