Opec Has Power – Learns from Past, but Future Less Certain

RelevanceMohamed al-Hamli, OPEC President, has every right to feel smug. OPEC has learned the lessons of its past and now has oil prices where it wants them. OPEC’s cut backs in 1973-74 proved that demand and supply of oil is very inelastic in the medium term. New supplies took time to come on stream, and an economic boom in Europe and the US ensured that short term demand remained high. Add in political unrest in the Middle East, and the result of OPEC’s action was a quick and dramatic price increase. When the Iranian revolution sent oil prices sky rocketing even further at the end of the 1970s, OPEC must have thought there would be no end to the party. The hangover for OPEC duly came when high oil prices induced a deep recession (1980s) in consuming nations, and consumers found alternative energy sources (e.g. gas and nuclear). There’s no sign of that this time around. Ironically the biggest risk is that OPEC’s capacity increases will not keep pace with further hikes in the oil price. 

AnalysisOPEC’s recent success in manipulating oil markets sits in stark contrast to previous attempts by the cartel to manage prices. We can trace the power of OPEC in the current market to 5 key factors:

  1. Economic growth in consuming countries. This is by far the biggest determinant of demand for oil. Consuming nations (powered by the US) have enjoyed a long period of growth. Now that the US economy is cooling somewhat (but not heading into recession) the EU’s is picking up. Added to that China, India and other countries are rapidly becoming major consumers. There is no sign that $60 oil will induce a recession.
  2. Cohesion of OPEC as a cartel. The level of cheating by OPEC members is nowhere near as prevalent as in the late 1980s and mid 1990s. The scope for cheating is reduced as many members are already close to capacity leaving Saudi Arabia as the true swing producer.
  3. Market power of buyers. This is low as the big consumers are happy to rely on the mechanics of the free market to satisfy demand for oil. Little evidence of coordinated, private deals for the supply of oil.
  4. Price elasticity of demand. This is still low for oil in the short to medium term, providing support to OPEC. Consumers of gasoline are faced with problems if they wish to convert their cars to another fuel, as are owners of ships who use fuel oil and airlines who use jet fuel. Even power station owners, who have more flexibility, will take time to convert to gas, coal and other fuels. Even here though OPEC members’ risk is mitigated somewhat through their ownership of gas reserves. In the long term, of course, elasticity of demand for oil is very high, but OPEC has learnt its lessons from the 1970s debacle and will not repeat the mistake of allowing a large scale switch to substitutes.
  5. Elasticity of supply from competing oil/energy sources. Here, again, support is provided for OPEC’s policy through the reasonably long lead times to bring on stream other oil and energy sources. That Non-OPEC projects are in technically and more politically challenging locations is manifested by the poorer growth projections reported by some of the IOCs. Problems with projects have been reported in Kazakhstan, deep water GOM and Russia. In the 1970/80s high prices spurred growth in Non-OPEC oil from politically stable regions such as Alaska and the North Sea. Very few such regions exist today. High inflation in oil F&D costs has not helped Non-OPEC production, and ultra high cost shale oil alternatives only offer a glimmer of hope (despite the huge resources).

OPEC’s performance in manipulating oil prices is more impressive now than at any other time in its history. However, future manipulation is in danger of being lost due to its current high capacity utilization. As pointed out in an earlier post in this series (Mr. Michael E. Lynch), there are many indications that OPEC (as well as other Non-OPEC) countries are finding it increasingly difficult to increase production capacity.

Leaving aside political considerations and coordination amongst OPEC members, there is a growing concern that the Middle East may not be able to deliver increased supplies, even if it wanted to. Perhaps the most pessimistic in this respect is Matt Simmons, the respected energy banker. In “Twilight in the Desert” he articulates the fear that production from Saudi Arabia may have already peaked

Having found a way to increase prices to sustainable levels, the biggest risk to OPEC may now be a severely reduced capability to limit price rises.

14 May 2007

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