OPEC: Hard Choices
This article appeared in Middle East Economic Survey Vol XLIII, No 11, 13 March 2000.
The oil-exporting countries spent fifteen months (January 1998-March 1999) to agree upon and implement production cuts of the magnitude required by a sceptical and intemperate market for correcting the declining trend in prices. They all knew that a small percentage reduction in production of the order of 7-10 per cent would most probably lead, within a few months, to a price increase of 80-100 per cent and to a higher percentage increase of per barrel revenue. They found it difficult first to make a small production sacrifice that would yield a significant monetary reward and second to convince the market on two occasions (March and June 1998) that they meant business.
The oil-exporting countries are now asked to increase production in order to bring prices down. It is not surprising that such a decision is proving difficult to make. The production policy that would succeed in lowering the oil price would undoubtedly entail a loss in revenues. Oil ministers who were unable to make a quick and effective decision involving tangible gains only a year ago are asked to now make a quick decision involving tangible losses.
True, a production policy that would calm an over-excited market which is overshooting every conceivable reference (WTI closed at $34.13 on Tuesday March 7) involves some benefits. Some of them, however, are in the nature of intangibles, others are uncertain and others may only accrue in the long term.
There are two political factors to consider. First the relationship with the USA that no country in the world (with the possible exceptions of Cuba and North Korea) can ignore. The US Congress is not hiding its unhappiness with high oil prices and the administration with various degrees of conviction is echoing the concern. The USA would have perhaps been more effective had Mr Richardson not engaged in high profile shuttle diplomacy. Sovereign states do not like to obey orders given in public by an overbearing superpower. They have legitimate pride and need to take into account domestic political repercussions. But Mr Richardson has his own agenda at home and will no doubt claim credit for any OPEC decision to increase output irrespective of when and how it is taken.
The second political factor is the relationship with developing countries that are net importers of oil. As always, rich countries who can afford to pay more for their imports complain loudly, and with no sense of shame, about their economic vulnerability to high oil prices. Most of them have a remedy available in the form of a reduction in the excise taxes on petroleum products but will never contemplate using it. As always, poor countries either remain silent or utter muffled complaints which are never listened to. To put things in the correct perspective, it is the plea of developing countries not that of the OECD that oil exporters should want to heed.
The arguments that are more relevant to the economic interests of oil-exporting countries are:
(a) The oil price may cause a world economic downturn which will reduce demand for oil, then the oil price and consequently oil revenues. This negative impact could well hit the producers’ interests in the short or medium term.
(b) High prices would encourage investment in high cost oil, non-conventional oil and energy substitutes. This will hurt the producers’ interests in the long run.
Consider the first point first. Whether high oil prices which are unlikely to obtain for a very long time (they never do) would be the main cause of an impending recession is, to say the least, highly debatable. Just recall that the issue of whether the US economy will have a soft or hard landing has been talked about since early 1999 when the oil prices were hovering around $12 a barrel. One may be fairly certain that the US economy will slow down sooner or later. A high oil price may or may not be the straw that breaks the camel’s back. But why focus on the straw and not on the heavy burdens which have been heaped on the camel such as low savings rates, frenzied speculation on Wall Street, and indebtedness of large sections of the population? What is certain, however, is that the oil-exporting countries will be blamed for any slowdown of the US economy whatever the real causes of that event might be.
Consider now the second argument. It is true that high prices provide an incentive to investments in energy efficiency and in the production of substitutes. This argument however requires some clarification. The incentive to improve energy efficiency relates more directly to domestic fuel prices and national policies than to the international price of oil; and the domestic price is strongly influenced by domestic taxes. High oil prices only provide an inducement to investment in high cost substitutes when the industry becomes convinced that high prices will be sustained over the long period. The industry today remains very sceptical about this sustainability.
Oil exporters may nevertheless wonder whether they should adopt a low price strategy to protect their share of the energy market in the long run. The problem faced is that the price level that would provide a deterrent to the entry of substitutes reduces revenues over a long period of time; and many countries cannot afford for both economical and political reasons such a costly policy which may only bear fruit in a distant and uncertain future.
All these reasons explain the oil-exporters’ initial reluctance to respond to the current price movements with a new production policy.
But as oil prices have kept on rising the major exporting countries have become convinced that some action is needed to calm an over-excited market and to regain some control over a price movement which reflects both an imbalance in the supply/demand equation and the dynamics of expectations about the future course of this imbalance. Because they wield market power through production policies they are vested with a price-making role. Despite many limitations on the ability to perform this role in a very effective manner, a price-maker, as it were by definition, needs to have a view on a preferred price level and a concern for a measure of price stability.
Now that the main exporting countries appear to have surmounted their initial reluctance, and are attempting to design a production increase policy that can secure a high degree of agreement, a new set of difficulties arises.
First, there is a structural issue. The oil-exporting countries divide into two groups. Some of them enjoy a degree of market power and can be considered as price-makers; others are price-takers. The latter know that they cannot influence the course of prices and are not particularly concerned about the future impact of high prices on the demand for their oil. They are small entities which will always be able to sell the volumes they manage to produce. When prices are low they urge the price-makers to respond with output cuts. When prices are high they are more than happy to collect the revenue and sternly oppose any move to raise production.
Second, there is an information issue. All that we know, with reasonable confidence, is that crude oil and products inventories have been declining in the USA at an alarming rate. What is happening in the rest of the world is less clear. A critical, yet very uncertain, piece of information is about the current production level. Does actual output of OPEC members plus Mexico and Norway correspond to the levels agreed in March 1999? Many observers believe that output is higher than these levels. And the question is by how much?
More synthetically, the question is about the current supply/demand balance in world oil. A small amount of light may be shed on this vexed issue by analysing US data. The USA is important because the WTI price is the leading reference and the WTI price is strongly influenced by the market conditions in this country.
The relevant statistics are:
(a) Crude oil imports from the Riyadh pact countries (Mexico, Saudi Arabia and Venezuela) were lower in 1999 than in 1998. They averaged 3.766 mb/d in 1999 compared with 4.104 mb/d in 1998.
(b) Total crude oil imports were slightly lower, averaging 8.519 mb/d in 1999 as against 8.659 mb/d in 1998.
(c) Total petroleum stocks (excluding the SPR) increased by 79 million barrels in 1998 and decreased by 185 million barrels in 1999. As there also was a build-up in 1997 of about 53 million barrels one could say the depletion of stocks in 1999 removed a larger volume than the surplus built up in the previous two years. The rate of depletion was 145,000 b/d in excess of that needed to remove the previous overhang. Coincidentally this is almost equal to the 140,000 b/d deficit in imports when 1999 is compared with 1998.
(d) Rather interestingly, the rate of refinery utilization in the USA in the four weeks ending on 18 February 2000 was as low as 85.9 per cent compared with a rate of 91.2 per cent in the corresponding period in 1999. This means that, earlier this year, the USA was refining 600,000-700,000 b/d less than last year in the corresponding weeks. No wonder that a dramatic rate of stock depletion obtained in January and February of this year.
The moot question is whether the low rate of refinery utilization is the result of a shortage in the supply of crude oil or whether it reflects a refiner’s response to low margins and to a steep price backwardation in the NYMEX where the price of the second month futures contract has been as much as $1.8-1.9 lower than the price of the first month?
The only way to find out is to increase supplies to the US market at the rate of 200,000 to 300,000 b/d and evaluate the buyers’ responses.
Third, there is a market response issue. The market behaves like a stubborn and ill-bred child who will not stop screaming until given what he asks for. And what he asks for is not necessarily what is needed. In 1998, the market responded to two production cuts (March and June 1998) with a decline in oil prices. Early in February 1999 it pushed the oil price down to an abysmally low level when all the available signs indicated that supply and consumption demand were more or less in balance. The market was demanding a new and very large production cut. When OPEC obliged, it was rewarded with price increases. Some months later it became clear that the market had demanded too much. And we may well be in a similar situation today. The market seems to be clamouring for a production increase of at least 2 mb/d. This may well be much more than needed. One cannot discount the possibility of a perverse market response – keeping the oil price at a high level or pushing it further up – if the production increase falls short of this demand. And one can be almost sure that if the production increase is larger than required by the economic fundamentals (as opposed to what is demanded by the animal spirits’ of punters) prices will eventually fall to low levels.
Fourth, the more fundamental issue relates to the price objective. The aim of a production policy is to steer prices towards a preferred level. For many years between 1987 and 1999 the conventional view was that an $18 per barrel price was, broadly speaking, an acceptable price. In fact, several ministers stated in March 1999 in comments about the OPEC decision to cut production that their hope was for a correction that would put prices back in the $18-20 per barrel range. But is this the target today? As mentioned earlier the price that may act as a barrier to entry to competing fuels is probably of the order of $13-14 per barrel, far too low for the budgetary needs of the main exporting countries. The choice of a price target depends therefore on a different criterion: either political acceptability or possible repercussions on the world economy. Some people believe that the USA will not object too strongly if the OPEC policy ensures that the WTI price does not breach the $25 line. Others talk of a $20-25 per barrel price band; and yet others mention a $22 per barrel price as a new magical optimum.
I do not know whether the exporting countries have been discussing at any length target prices, or more to the point, whether there is a consensus among the main price-makers about a possible target (the smaller countries are unlikely to agree willingly to any target that is lower than the market price, but this does not really matter since these countries, by definition, are price-takers).
As regards the world economy, two factors do matter. The first is the price level and the second is the degree of stability around that level. The price level matters for balance-of-payments reasons, particularly to developing countries. I dare say that $25, or even $30 per barrel will not break the back of most OECD countries on this particular front. The volatility, however, matters very much because inflation is about price changes, not about price levels. The inflation threat in the USA is due to a tripling of the price from a low of $11 per barrel to a high of $33 per barrel over a short twelve-month period. If prices are kept stable at some acceptable level or allowed to rise slowly over a long period of time there would be no inflationary impact. Volatility is the more serious issue. And volatility is largely due to the interaction between a market with an inherent and strong tendency to overshoot or undershoot and producers’ policy instruments which are far too blunt and far too rigid.
What should the oil-exporting countries do? The worst scenario from their point of view would be a failure to come up with an agreed policy. This would result in a free-for-all with catastrophic consequences for the producers’ interests.
A better course of action is to agree to an increase in production of a moderate size, in the first instance, to test the market response. By moderate size I mean something of the order of 1.2-1.3 mb/d. This is not as small an amount as may seem at first sight because there is already leakage. Actual production may well be higher than the March 1999 agreed ceiling by 0.7-1.0 mb/d. Given the nature of the petroleum market, the uncertainties that surround both the economic fundamentals and the behaviour of punters, and the sensitivity of markets to the direction of change in the level of stocks, it is essential that the production policy be designed as a flexible instrument that regularly responds to prices diverging significantly from the preferred target.
With hindsight we now know that the decision of March 1999 to hold the production cuts for a period as long as one year was a mistake. OPEC put itself, unwittingly no doubt, in a strait-jacket.
The sensible approach is to plan from the outset a flexible production policy which will allow for either increases or decreases in output at the end of every two-month period depending on the behaviour of oil prices during the relevant period.
The market will ultimately give OPEC the price OPEC wants if it becomes convinced that the producers will always take swiftly the measure that reveals the seriousness of their objective.
Nobody can tell today whether an increase of x million barrels a day is too little or too much. The solution to this problem is to announce that output will be increased by a certain volume and that this volume will be raised in two months’ time if the market remained overheated and that it will be reduced if the price fall was too large. The rate of output changes in subsequent two-month periods should be agreed in advance (even if they are not announced) and not left for bargaining and negotiations after the expiry of the agreement.
To open the gates for extra production over a long period of time is a sure recipe for disaster as three or four historical precedents have shown. In 1981 Saudi Arabia increased production very significantly to force the oil price down. The result was a build-up of stocks in the world which was partly responsible for the 1985-86 crisis. In 1986 the netback pricing approach pushed prices down to a dismal $7 per barrel. The 1997 Jakarta decisions about higher quotas were partly responsible for the price decline of 1998.
And once prices fall significantly the task of bringing them up proves to be an uphill task.
To decide on an output increase without planning in advance future responses to subsequent price movements will simply aggravate the volatility of prices. In the order of things, volatility is a more serious issue than a high price level.