OPEC Learning the Lesson of Its Past?

RelevanceVenezuela has signaled its willingness to comply with December’s round of OPEC production cuts by informing ONGC that it will have to reduce output from the San Cristobal field. This is significant as Venezuela (along with Iran) has a poor record in meeting its OPEC production quotas – it has been a persistent quota buster over the years. OPEC, as a whole, has a poor record in responding to weaker economic conditions. In the past it has been slow to cut production as economic growth slows or turns negative, leading to ever decreasing oil prices. Venezuela’s action, along with preemptive cuts in production by Saudi Arabia and the UAE, demonstrates a new determination by OPEC to get ahead of the game. All eyes will now be on Venezuela to see if it means what it says. 

AnalysisVenezuela has instructed ONGC that it will have to reduce output from the San Cristobal field. This is in response to OPEC’s December production reduction agreement of 2.2mmbd. The San Cristobal field is relatively small (at around 30mbd) but the significance of this move by Venezuela is huge.

Venezuela has shown itself to be one of OPEC’s most persistent quota busters over the years. This reduction request, if followed through and repeated in other fields to hit Venezuela’s targeted reduction of 350mbd, would send a strong signal to world oil markets that OPEC is determined to keep up with economic events (and a falling oil price). Added to production cuts already implemented by UAE and Saudi Arabia, OPEC would gain serious momentum in its efforts to prop up the oil price. This would be an achievement in itself – historically OPEC production cuts have seriously lagged demand destruction, leading to a downward spiral in 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. In the current environment, economic growth also presents the greatest uncertainty to OPEC policy makers. In contrast to the 1980s oil price collapse, where OPEC action in the mid to late 1970s actually induced a recession in consuming nations, today’s economic malaise is mostly due to the so called credit crisis, whose nature and impact is only just beginning to be understood.
  2. Cohesion of OPEC as a cartel. Cheating by OPEC members in the late 1980s and mid 1990s was rampant. The scope for cheating this time around is significant, given the amount of spare capacity implied by the quota reductions. Much will depend on Saudi Arabia, traditionally OPEC’s swing producer. Here, the signs for OPEC are good as Saudi Arabia has indicated a willingness to cut production to whatever it takes to restore the oil price to around $75. It has already aggressively reduced production in anticipation of reduced quotas.
  3. Market power of buyers. This remains low as the big consumers are happy to rely on the mechanics of the free market to satisfy demand for oil. There is little evidence of coordinated, private deals for the supply of oil.
  4. Price elasticity of demand. We usually think of low short term price elasticity providing support to OPEC in a rising oil price scenario. Now that prices are falling, can OPEC expect support in the form of a return to oil by energy consumers? In the long term (when the elasticity of demand for oil is very high) sustained low oil prices will certainly increase demand. But the real risk to OPEC is that the latest period of high prices was so long and deep that the will of consumers and politicians to conserve and find substitutes for oil has become significant and irreversible. A quick return to high oil prices will only harden these attitudes further.
  5. Elasticity of supply from competing oil/energy sources. Support is provided for OPEC’s price policies 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. 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 non-conventional oil alternatives only offer a glimmer of hope (despite the huge resources). A threat to OPEC also comes in the form of increased interest in nuclear and renewables in consuming nations.

31 December 2008

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