Oil Pricing: The OPEC View

Abstract: Some, like the IEA, say oil prices are too high. OPEC, the organization that most influences prices, says no. What is OPEC thinking?

Analysis: The head of the International Energy Agency (IEA), part of the 26-member-nation Organization for Economic Cooperation and Development (OECD) said on Monday that low fuel inventories might lead to oil price increases in the fourth quarter as consumers in the United States and Europe use more heating oil.

Last month, OPEC in a surprise move decided to cut its output ceiling by 900,000 b/d to 24.5 million b/d. IEA executive director Claude Mandil was quoted as saying that current oil price rises are not sustainable, would encourage a decline in demand for OPEC oil, and would boost consumption of oil from non-OPEC producers.

Mandil’s comments came on the heels of Brent crude (London) price increases of 20 percent (to almost $31 a barrel). OPEC does not see price increases resulting from its production cuts, which are planned for November.

Quite the opposite. It says there is no shortage in the world market and any shortage of oil is because of local supply conditions. Concerned with rising production in Iraq and Russia, the organization said it needed the production cuts to hold prices for OPEC's reference "basket" of crude oils to within a $22 to $28 per barrel target range. In OPEC’s view, that is a fair price for consumers to pay.

So, who’s right? IEA or OPEC? Oil pricing is a complicated subject, full of surprises, with plenty of expert opinion on both sides of the question. However, there are some important factors affecting pricing that appear not so well known. One of these is OPEC’s view of the situation. It is a good place to begin examining the question of oil pricing.

Prices Too High?
Comments last week from Russia (non-OPEC) and Venezuela (OPEC) indicated one of these producing countries thinks prices are too high while the other believes they may be too low.

While OPEC targets a $22 to $28 a barrel range for its basket of crude oils, Energy Minister Igor Yusufov said last Friday, “We have a disagreement with OPEC, as we believe that prices above $25 per barrel are hurting consumers.”

Russia recently signed an energy pact with Saudi Arabia, but frequently disagrees with OPEC, which has watched Russia ramp up oil exports and output while it has cut back on production. Russia now is producing some 8.7 million barrels of oil a day, second only to Saudi Arabia. However, Russia exports only half those volumes to international markets.

Venezuela said the ideal is to keep prices within the current OPEC range. Just the week before, however, Venezuela’s President Hugo Chavez said it was time to revive the price band and hike it to $25 to $32 per barrel. Although OPEC members haven’t backed the idea, the group has managed to keep the price above $25 a barrel.

OPEC’s View
Last month, in Vienna, where OPEC reduced production again, it issued a summary explanation. OPEC noted an improving global economy, but said it saw only normal, seasonal growth in demand for the fourth quarter and a well-supplied market. Also, OPEC noted "continued rise in non-OPEC supplies, the ongoing recovery in Iraqi production, and replenished stocks rapidly reaching normal seasonal levels, with the supply/demand balance for the fourth quarter 2003 and first quarter 2004 indicating a contra-seasonal stock build-up."

This added up to a "potentially destabilizing effect" on the market, which OPEC said requires a reduction of supplies from all producers to ensure stability.

OPEC members decided to return to the ceiling of 24.5 million b/d, which was the ceiling last year before it upped production in anticipation of supply disruption from the war in Iraq. It asked non-OPEC oil producers to restrain production increases and "share the burden of maintaining price and market stability in 2004 and thereafter."

Finally, "...taking into consideration the market outlook for 2004, with its concomitant uncertainties...," OPEC members further decided to convene an Extraordinary Meeting in Vienna on December 4, 2003, to review market developments and take whatever measures it deems appropriate at that time.

Ministers of non-OPEC countries who attended the meeting in Vienna included the Petroleum & Mineral Resources Ministry of the Syrian Arab Republic and high-level representatives from Angola, Egypt, Mexico, the Sultanate of Oman, and the Russian Federation.

Cooperation the Key
OPEC member countries supply only about 40 percent of oil demand worldwide, so it depends on cooperation of non-OPEC producers to hold supplies at a level that will support prices.

When it comes to reserves, however, OPEC countries hold four-fifths of proven crude oil reserves--nearly 850 billion barrels. This leads the organization to take the long view that, eventually, it will supply most of the crude to the market.

Noting that OPEC expects to supply the majority of the world’s crude, OPEC Secretary General Alvaro Silva said in a speech last month at The Oxford Energy Seminar, "We have been saying this for many years and it seems somehow to be a case of 'tomorrow never comes!' Continued advances in technology, together with price defense policies, have encouraged the rapid development of non-OPEC oil and have helped perpetuate this longstanding imbalance."

So, in the short term, non-OPEC producers are taking the lion’s share of the market "...to the extent that even the IEA has observed that OPEC has a problem with the loss in its market share. But there is a limit to this process," asserted Silva, "and this is provided by the absolute quantity of non-OPEC reserves. In the not-too-distant future, non-OPEC output will reach a plateau. But this imbalance is the reason why the Organization strives so hard to achieve concrete co-operation with its non-OPEC counterparts--efforts which, in OPEC’s view, have begun to bear fruit."

OPEC has a world energy model which indicates that oil demand will rise from 76 million b/d in 2000 to 89 million b/d in 2010 and 107 million b/d in 2020. The model is based on the assumption that world energy demand will grow by an annual average of around two percent during this 20-year period.

OPEC’S reference case forecasts its market share in 2010 as about the same as in 2000, at 40 percent. Nevertheless, during this decade, it is projected to actually fall, for a while, below this figure, with its share being forecast at just 37 percent for 2005. "This is, indeed, what is happening at the present time, with weaker-than-expected global energy demand," continued Silva. "Nevertheless, the outlook is expected to improve for OPEC during the second decade of the 21st Century, with the projected market share at 44 percent in 2015 and 49 percent in 2020. In absolute terms, according to our reference case, OPEC production, including natural gas liquids, is expected to rise from 30 million barrels a day in 2000 to 36 million barrels per day in 2010 and to 52 million barrels per day in 2020."

Looking at the Long Term
OPEC’s thinking goes beyond the issue of who actually produces the oil, to the issue of oil’s share in the world energy mix. "Over the past decade or so," Silva said, "oil’s traditional dominance has been put under pressure on environmental grounds, particularly in the context of the UN-sponsored climate change negotiations. There have also been longer-standing efforts among some consuming nations to diversify energy sources away from oil, on so-called 'strategic grounds.' The chief beneficiary of all of this has been gas. Our reference case shows that the use of gas will almost double in the period 2000 to 2020 and its share in the global energy mix will rise from 23 percent to 28 percent. However, this will still be 10 percentage points below oil’s share of 38 percent in 2020; in fact, oil’s share will have dipped by only a marginal amount since 2000--less than two percentage points--according to our projections. OPEC, needless to say, has huge reserves of both oil and gas."

So OPEC’s long view of things is a key factor in oil pricing. It appears to lead to a couple of ideas: First, its price band of $22 to $28 is not set with the idea of charging all the market will bear: disrupting customers’ economies would in no way serve its long-term interests. Second, pressure on non-OPEC producing countries to boost production and force prices below OPEC’s band may not have much chance of success. With limited oil resources and limited time to benefit from them, non-OPEC producers need revenues and time to develop alternative economic activities. They too seem to have little to gain from dropping the price.