OPEC: Open the Tap or Hold the Line?

Abstract: Improving national economies may call for more oil energy soon. But will OPEC open the tap and produce more to keep prices in line?

Analysis: As OPEC's July 31 extraordinary meeting grows near, the world watches to see if the organization will increase its members' oil output quotas or hold current levels. The oil production limit now stands at 25.4 million barrels per day (Mbpd), which was set in April. OPEC member states produce about one-third of the world's oil, and adjust output with the goal of holding oil prices in a band of between $22 and $28 per barrel.

"Price" is based on OPEC's "basket" of seven crude oils which rose slightly from the week before to $27.93 per barrel with a year-to-date average (through July 17) of $28.03. The basket consists of the following: Saharan Blend--Algeria; Minas--Indonesia; Bonny Light--Nigeria; Arabian Light--Saudi Arabia; Dubai--United Arab Emirates; Tia Juana--Venezuela; and Isthmus Crude--Mexico.

To Raise or Not to Raise
At an extraordinary session this past June 11, OPEC held the production limits previously set at 25.4 Mbpd. In the last few days there has been no shortage of advice--on both sides of the question--regarding whether or not to raise output at the second extraordinary session July 31.

. Noting that Iraqi oil production was taking longer than expected to recover, and that prices were near the top of OPEC's target range of $22 to $28 per barrel, the Centre for Global Energy Studies in London (CGES) urged OPEC to raise output.

OPEC's only Asian member, Indonesia, said that OPEC should hold the line and not increase flow since prices will likely drop when Iraqi crude production resumes.

OPEC has enjoyed much success at holding crude oil prices in its target $22 to $28 range since it bootstrapped the oil industry up from $10 oil in 1998. This past April it called for production cuts averaging 2 Mbpd to begin in June, and those cuts have taken place. Not only did the organization convince its members to go along with the reductions in output, but it enlisted many non-OPEC producers in the effort--notably Angola, Oman, Mexico, Russia, and Syria. When necessary, OPEC member countries--usually Saudi Arabia--have increased production to cover shortfalls such as those due to the Iraq war and Venezuela's general strike earlier this year. OPEC called extra meetings (extraordinary sessions) on June 11 and--coming up--July 31, so its members could assess events closely and act fast if necessary.

Before 1998, boom–bust cycles had been the norm for the oil industry. Everyone expected them, and many expect them to continue now. Generations of oil workers have found themselves out of a job because of them; countless talented and skilled people have left the oil business to find a more stable industry--or been forced out when low prices bankrupted the companies they were working for. In position papers, OPEC has been specific about the need to stop these boom–bust cycles because they are so destructive to producers and consumers alike. Its success so far, coupled with its persuasive powers with non-OPEC producers, has clearly worked.

Demand Boost Forecast
Earlier this week, OPEC issued its monthly oil market report forecasting a world oil demand increase to an average of 77.79 million bpd, including a 13 percent greater growth rate than forecast earlier, stemming from increased demand from China and Japan, and an apparent U.S. economic recovery. The expected effect on OPEC members is a demand increase from 880,000 bpd to 1.01 million bpd. This appears to favor some loosening of supply by OPEC. However, the cartel takes many factors into account in its decision-making--among these are the wishes of non-OPEC producers and a sophisticated assessment of conditions around the world likely to affect oil supply.

There is plenty of action globally among oil producers. Following are just some of the situations that will figure into OPEC's decision:

Iraq. Resumption of full production by Iraq anytime soon seems unlikely. Widespread damage and looting of oil production equipment has occurred, repairs will be difficult until a safe working environment is restored, and substantial upgrading will be needed. Production equipment was badly neglected by the Saddam Hussein regime: Almost no new equipment has been installed since the late 1970s. Virtually all that has survived needs replacement. The CGES estimates that Iraqi oilfield rehabilitation could not approach pre-war production of 2.5 million barrels per day and will at best rise to 1.5 Mbpd by year's end.

Nigeria. Nigeria accounts for about 40 percent of U.S. crude oil imports. Crude oil production has been largely resumed after a general strike because of a government attempt to raise fuel prices by partly removing large subsidies. There is unrest again in Nigeria, but oil production of some 2.0 Mbpd is so far unaffected.

Sao Tome and Principe. These very poor island countries sit atop great prospective wealth from apparent huge but untapped oilfields. An army coup last week took place while the president was out of the country. Mediators became involved and were seeking to restore the government on Wednesday.

Chad. An ExxonMobil consortium is beginning to pump crude oil from a multibillion-dollar development in Chad. This is that country's first oil production.

Venezuela. The world's fifth largest oil exporter has seen a violent political conflict between supporters and opponents of leftist President Hugo Chavez for more than a year. Last December and January, thousands of PDVSA employees staged a general strike that disrupted oil shipments. The strike fizzled out in early February, and more than 18,000 PDVSA strikers, including managers, office staff, technicians, and field workers, have been fired by the government. Most have become part of the anti-Chavez opposition movement. Oil production fall-offs have been compensated for by increases from other OPEC members.

Mexico. Mexico's crude oil exports continued to average 1.9 Mbpd and new efforts at production growth were underway. The Mexican state oil company, Pemex, now headed by Raul Munoz Leos, appointed by President Vicente Fox, has begun an ambitious program of exploration, production, and construction of platforms in promising on- and offshore regions. Mexican law prohibits foreign investment in oil and gas exploration and production. So Pemex can't make production-sharing deals as a means of stretching the money available for investment. But Pemex has devised an innovative contract to attract investment in plants and equipment--infrastructure. It is trying out the contracts now in equipment and facilities for natural gas production as well as oil exploration and production.

Gas development in Mexico is lagging so far behind that country's needs that Mexico is having to build a major LNG terminal and regasification plant to fuel a network of power plants in fast-growing Altamira province. The plants lie within a few miles of vast untapped gas reserves.

If industry and suppliers accept the new contracts, Mexico could put more of its investment into wells and production facilities. But the contracts might not be so easy to sell to the construction industries. For one thing, the profit potential of the new contracts is much less than the usual types that permit investment in the producing property.

Also, Pemex faces opposition to many of its programs from PRI, Mexico's largest political party, which held power for many years prior to Vicente Fox's election, and just gained seats in the legislature. PRI does not necessarily agree that the new contracts are legal. This story will play out in the weeks ahead.

Russia and the Caspian. Russia is in an accelerating economy, and the main driver is oil and gas exports. Crude and condensate production ran at a rate of 8.27 Mbpd through May.

Development is just underway in the rich oil and gas resources of the Caspian Sea basin. The region may hold 100 billion barrels of oil and has attracted U.S. and U.S.-British companies, which now control oil, and gas reserves estimated at 27 percent and 40 percent, respectively. Russia is a competitive presence in the region, but also a cooperative one. It recently signed a 25-year contract to purchase all the gas exports of Turkmenistan. Much political instability exists in the region, but when exports become established OPEC is sure to have to adjust.

Will the Tap Open?
OPEC's meeting next week is the last extraordinary session scheduled before its regular meeting in September. On balance, improving economies in Russia and the U.S. and the forecast demand boost would seem to tip the scales in favor of an increase. But, even if an increase is indicated, if it is less than an emergency, OPEC may elect to wait for the September meeting. Anyway, we'll all know in a few days.