How OPEC tries to control the market – and fails

22 May

The OPEC cartel is perceived as a powerful organization, which has the ability to dictate oil prices. History shows us a different picture. While OPEC pushed up or lowered oil prices in the past, today it can only push up prices higher while it lost its ability to lower world market prices.

Our modern world is full of myths, and some of them relate to OPEC, a cartel of crude oil exporting countries. There is a myth that OPEC is a powerful organization which determines the price that crude oil consumers have to pay. Implicated in this myth is just another myth, that OPEC can be seen as one unity, something unified by common goals. The myth is that OPEC is one player on the international scene when, in fact, OPEC is, was and most probably will be an agglomeration of rather different players with differing interests that is no longer able to control world crude prices, at least when it comes to increasing prices. To learn more about OPEC, which nowadays consists of the nations of Iraq, Iran, Saudi Arabia, Kuwait, United Arab Emirates, Qatar, Libya, Algeria, Nigeria, Angola, Venezuela and Ecuador, we should have a closer look at its history beginning in 1960, the founding year of OPEC.

The history of OPEC
OPEC was founded in September 1960 as the major oil exporting countries tried to get a greater share of the price for oil for themselves instead of filling the pockets of big oil companies. Alfonso Perez, oil minister of Venezuela and Abdullah Tariki, oil minister of Saudi Arabia, therefore initiated the formation of a cartel of producers in order to achieve this goal. The first secret meeting between these two men happened in Cairo in 1959 at a conference of oil producers. They secretly contacted the Kuwaiti and Iranian representative at the conference. Together with Iraq, those four countries founded OPEC on 14 September 1960 in Bagdad.
More money for the oil producing countries was one goal of Perez and Tariki, as both men had studied the work of the Texas Railroad Commission, an organization watching and limiting crude oil production in Texas. The Texas Railroad Commission practically avoided that too much oil was produced in Texas. Key to the success of this effort were production quotas. This was exactly what Perez and Tariki wanted to achieve through the foundation of OPEC.
Venezuela soon put the quota subject on the table and pressed for agreement, without any success. Iran didn’t want to limit its production of oil; neither was Kuwait willing to restrict itself. Tariki, who was on the side of Venezuela, was in 1962 replaced by Sheikh Ahmed Zaki Yamani. Obviously, Tariki’s oil policy wasn’t the policy of the “Servant of the two holy places”, as the King of Saudi Arabia prefers to be addressed, so he was replaced and the new agenda was to vote against production quotas.
This brings us to another feature of OPEC. Decisions have to be unanimous. If one member doesn’t like a topic, it is off the agenda – just like production quotas in the 1960s.

Venezuela managed to get an agreement on production quotas in 1965, but this wasn’t lasting for a long time. Libya simply declared four weeks after the meeting that it would not adhere to any production quota and Saudi Arabia stated it had only agreed to a trial period for production quotas ending automatically afterwards.
Just to show another case to prove that OPEC wasn’t a unity; look at the Arab oil boycott of 1967. After a decisive defeat in the Six-Day War of 1967, some Arab oil exporting countries wanted to initiate an oil boycott against Israel as a kind of revenge for the military defeat. Officially, this had nothing to do with OPEC. Nevertheless, two OPEC members, Venezuela and Iran intentionally sabotaged this policy by ramping up production and sales. By the way, the friend of Arab countries who delivered almost all the weaponry used by Arab armies in their wars against the Israelis, the Soviet Union, killed the boycott by offering to supply more oil to the western oil market.
So for the first ten years, OPEC was mirroring the Arab League (in fact, many countries were members of both clubs). A lot of talk which seemed to be important, some decisions to issue a statement, but no results or impact on the real world.
Two men and two events changed this situation and gave OPEC some importance for one decade – and its member states an awful lot of money at this time. The two men were Muamar al-Gaddafi (honestly I don’t know how he wants to be addressed at the moment; at one time he was called “King of all traditional African Kings”, the Arab media calls him the “commanding brother”) and Marc Rich, formerly named Marcel Reich, the Jewish immigrant who fled from Germany to the US and later started a career as a commodities trader. The two events I mentioned were surging demand for crude oil, as more and more countries motorized, and the production peak in the world’s only swing producer at this time, the USA.

I briefly described in the chapter “From Rockefeller to the spot market” how Muammar al-Gaddafi had managed to tear down the defense from Big Oil against higher prices and a greater percentage share of the oil money. Rich created throughout the 1970s the spot market for crude oil. Together with the peak of US production in 1971, this created the opportunity for OPEC countries to demand higher prices as a surging demand led to the shrinking of spare capacity and therefore to higher oil prices.
Some people still believe that OPEC’s Arab members boycott after the Israeli-Arab war of 1973 was the reason for the rising crude oil prices. Just to be clear: this is wrong. The decision to implement some sort of boycott just acted as a trigger to an already not very well supplied market as spare capacity had practically been eroded.
But what really happened in 1973 after Egypt and Syria waged a war to revenge their crushing defeat of 1967? Once again, OPEC’s Arab members met and discussed what to do in order to help the Palestinians, the Egyptians and the Syrians and in order to harm the Israelis and all the nations who supported them. OPEC was divided.
In the end, the famous oil production cuts of 1973 weren’t even a decision made by OPEC but the decision of six members of the Gulf crude oil producing states, Iraq and Iran excluded. They declared their intention to cut production by 5% immediately and to continue to cut another 5% every month until the world responded to their political demands. Furthermore, the posted price was increased from $2.90 to $5.11. Another secret decision intended to boycott the US, the Netherlands, South Africa and Portugal, to slowly reduce their oil supply to zero.
Of course, a real boycott of certain countries, the kind that was discussed, was ridiculous. Once you sold your crude oil, the buyer could sell it to whomever he wanted at whatever place he wanted. As far as I know, the Israelis never had a problem finding a seller of crude oil.
So the main decision was to cut production. Saudi Arabia and Kuwait decided to cut their production by 30%, not really significant for the overall market, but it was an announced reduction, which had a psychological effect on the consumer’s view. The united OPEC, as it was and still is viewed by many people, never existed, not even at the glorious conference which declared the boycotting of countries supporting Israel.
The Iraqis stormed out of the meeting, demanding greater production cuts, but committed themselves to nothing. As a matter of fact, as prices started to surge after the announcement of Kuwait and Saudi Arabia to reduce production, the Iraqis started to sell as much as possible. As predictable to every knowledgeable expert of the region, deciding between solidarity for your Arab brethren and filling your own pockets with money wasn’t really a hard decision. Money has always come first.

The boycott that wasn’t a boycott didn’t last long. As the Saudis and Kuwaitis watched the oil price surge like children watching the arrival of their gifts on Christmas Day, they soon got back to full production. But that wasn’t of any importance at this point; the fundamentals for a bullish market were there since 1971 and the trigger was pulled in 1973 with the famous OPEC boycott. Once the market is on the move, it is hard to stop and may even exaggerate.
The real impact happened in the minds of consumers. Rising prices in Europe triggered more demand as consumers tried to buy cheap. Furthermore, the general view that the world may run out of crude caused people to stock up oil products like gasoline, heating oil and diesel. Demand surged and caused – according to the laws of demand and supply – surging prices.
The real shortage of oil in the US wasn’t a result of OPEC members reducing output; it was a result of government policies. Prices could only be adjusted once a month. So if you expect higher prices for your products but you can only raise your price three weeks from now, what will you do? You store your product in order to earn more money in three weeks. This happened in 1973 in the US. But it added more to the overall public mindset of the time that oil was scarce.
OPEC soon became the shooting star of the decade, perceived as the masters of crude oil supply and prices, deciding upon boom or recession in the developed western world. A united force of suppliers ready to transfer as much money from our pockets to their own pockets, one of the most powerful organizations on earth.
The details of the boycott from 1973 show a different picture. While the Saudis and Kuwaitis cut production by 30% for three months, the Iraqis protesting that this wasn’t enough and at the same time selling as much as possible, Iran, Nigeria and Indonesia increased their production and partly offset the effect of the production cuts. A united and powerful organization must be something different.
Nevertheless, the 1970s were the golden decade of OPEC. You could get a good price for your crude on the market, expand production and make a show of your own importance, the kind of public relations that the Saudi oil minister Ahmed Zaki Yamani did. The oil minister of Saudi Arabia was now an important figure, at least in the public media. While Yamani wasn’t a member of the ruling Saud family, his real importance in Saudi Arabia may be better described as a consultant to the king or a very well paid office clerk. The king may follow the advice or not. If he doesn’t, you won’t have the job for much longer.
Honestly, the fundamentals of the market were simply good for the oil producers; it was a seller’s market, just like iron ore nowadays. It wasn’t the wisdom of the Saudi minister or the other guys meeting every half year somewhere to talk about oil.
Maybe even the acting persons in OPEC’s cartel themselves believed the image they had created since 1973, but times soon changed. As more and more oil came on the market, prices plunged. The beginning of the 1980s can be seen as the start of two decades of low oil prices. While the revolution in Iran and the beginning of the Iraq-Iran war led to another crude oil price spike, this was short-lived as there was now plenty of oil available on the market. It was a buyer’s market and the stars of OPEC soon started to feel the new crude oil world order.

The story of the Nigerians, members of the OPEC cartel, illustrates this perfectly. 17 February 1983 was a turning point in OPEC’s history. Nigeria tried to sell its crude, which was comparable to Brent produced in the North Sea. Unfortunately, there was more oil available than needed by the consumers. Nigeria tried to sell for $35 but had to reduce its price to $30 because a British company sold its crude from the North Sea much cheaper than the $35 offered by Nigeria.
To decide upon prices was no longer a viable option for OPEC. The only way to influence the price was to influence the supply side via production quotas. For such an organization, whose members were known to disagree on everything, OPEC got an agreement very fast. Production quotas were agreed upon at the meeting on 14 March 1983. There was an overall production quota for OPEC and its members. The problem was, Saudi Arabia acted as a swing producer. There was a need to reduce production in order to keep overall market supply in accordance with OPEC’s policy, so Saudi Arabia would reduce its production.
It was a flawed decision from the beginning and subsequently collapsed within the following three years. OPEC members increased production and violated agreed-upon quotas more or less openly. And Saudi Arabia had to pay the bill for all this. Of course, this wasn’t sustainable. Beginning with the oil boom, Saudi Arabia started to subsidize almost everything in the country. It isn’t a market economy as we know it in Germany or the US. To keep this kind of state economy running, the Saudis needed a minimum of oil revenue or the party had to end, which of course wasn’t an option for the house of Saud.
The final crash came on 13 September 1985. The Saudis officially no longer adhered to the quota system agreed upon by OPEC members two years earlier. The next step was to increase production. In fact, the Saudis flooded the market with cheap crude oil. To make sure that the price plunged, they simply sold it very cheaply; the quantity would make the money.

Pursuing such a policy put pressure on the rest of OPEC as oil revenues plunged. The Saudis were not the only ones running heavily subsidized economies. Not surprisingly, the OPEC meeting of December 1986 resulted in a new agreement on production quotas as the Saudis had demonstrated that they had the ability to hijack the oil market and destroy most of their competitors.
About 20 years later, in 2008, the Saudis declared that they didn’t have the ability to reduce crude oil prices because they couldn’t find buyers for their crude oil while prices surged and everyone asked them to increase production. Back in 1985, the Saudis knew how to sell crude on the market and how to drive prices down – they just discounted the price heavily. 20 years later, the Saudis either didn’t remember that or – and this is my version – simply didn’t find more buyers for their crude at the market prices, which rose up to $147 in 2008.
The important fact here is that OPEC tried to influence the price of crude oil via production quotas during a period of a well-supplied oil market. The classical boom-and-bust cycle had worked and the high prices of the 1970s created an increased production, which was now available on the market.
This period lasted until the turn of the millennium, roughly two decades. We now know OPEC rather well, so we are prepared to analyze its steps during the surge of oil prices in the first decade of the new millennium.
To make a start, in 2002 OPEC had a policy of keeping the oil price within a certain range. It wanted to keep the price of crude oil between 22 and 28 dollars per barrel. If the price went below $22, OPEC would reduce its production in order to increase the price for crude oil. Prices just above $28 would lead to the opposite reaction. OPEC would then increase production in order to reduce the world crude oil price.
The reason for installing this price range is enlightening. Everyone inside the OPEC cartel cheated and produced well above agreed-upon production quotas. In November 1997, the Saudis asked for the adoption of higher production quotas and everyone agreed upon that. Unfortunately, the markets believed the official increase meant more crude oil on the market, not just matching reality with official OPEC perception.
The prices for crude oil started to decline. Prices collapsed until 1999 as analysts searched for the mysterious oil glut – they assumed that the additional oil must be somewhere, but didn’t find it. At the beginning of 1999, OPEC announced a cut in oil production, and prices surged again.
With their game of cheating, OPEC distorted markets and destabilized some of its members’ economies. To avoid this, OPEC created an official price band between 22 and 28 dollars.
The theory looks simple, but reality is something different. As Kenneth Deffeyes wrote in 2005, OPEC can no longer control the crude oil price as its production is at maximum capacity. As a matter of fact, OPEC didn’t succeed in its fight to defend the price range as oil prices surged during the period from 2002 until 2008. Honestly, I doubt whether they ever intended to fight. Would you fight against something that fills your pockets with an awful lot of money?

These are the prices for the period from 2002 until 2008. I once again used BP’s Statistical Review; these are the spot prices for WTI (West Texas Intermediate), not exactly the OPEC price range, which is calculated from a basket of different crude oil sorts, but related to it.

 Year Spot Price WTI ($)
2002 26.16
2003 31.07
2004 41.49
2005 56.59
2006 66.02
2007 72.20
2008 100.06

According to the official statements of OPEC, we should expect OPEC to increase its crude oil production in order to keep the crude oil basket price within the official price range between 22 and 28 dollars. So let’s take a look at the figures to see what happened. I just included Angola, which joined OPEC in 2007. It allows us to assess OPEC’s future production potential. OPEC’s crude oil production in tb/d 2002 – 2007:

2002

2003

2004

2005

2006

2007

Total OPEC

30,420

32,061

34,721

35,809

35,983

35,574

Algeria

1,680

1,852

1,946

2,015

2,003

2,016

Angola

905

870

1,103

1,405

1,421

1,684

Libya

1,375

1,485

1,623

1,745

1,815

1,820

Nigeria

2,103

2,238

2,431

2,499

2,420

2,305

Iraq

2,116

1,344

2,030

1,833

1,999

2,143

Iran

3,709

4,183

4,248

4,234

4,286

4,322

Qatar

764

879

992

1,028

1,110

1,197

Kuwait

1,995

2,329

2,475

2,618

2,690

2,636

Saudi Arabia

8,928

10,164

10,638

11,114

10,853

10,449

UAE

2,260

2,553

2,664

2,753

2,971

2,900

Ecuador

401

427

535

541

545

520

Venezuela

2,895

2,554

2,907

2,937

2,808

2,613

Indonesia

1,289

1,183

1,129

1,087

1,017

969

First observation: OPEC’s crude oil production peaked in 2006. I marked the peak production for OPEC and selected countries in bold. Second, this happened because the production of seven of the 13 member states of OPEC peaked during this period. Once again, the bold numbers tell you the year of peak production. Nigeria peaked in 2005, Kuwait in 2006, Saudi Arabia in 2005, the UAE in 2006, Ecuador in 2006, Venezuela in 2005 and Indonesia – if we only consider the period between 2002 and 2007 – in 2002.

Furthermore, two countries showed a kind of production plateau. I underlined these figures; it is Algeria during the period from 2005 to 2007 and Libya in 2006/2007. I could add Iraq to this list, for the Iraqis could certainly produce more, and we will take a closer look at the Iraqis in chapter two.
So the overall picture is that seven of the 13 members saw their production peak during this period of rising crude oil prices, while two more countries seemed to have reached a production plateau. What is even worse, it was the big producers who peaked.
I mentioned that Saudi Arabia, together with six other countries who are members of OPEC, accounted for 62.94 percent of OPEC’s total crude oil production in 2007. Add Algeria’s and Libya’s production and the percentage is 73.73.
In my opinion, these figures allow only one conclusion. OPEC lost its ability to stop crude oil prices from rising. Technical limits of its production capacity simply make it impossible to increase crude oil production in order to lower market prices.
So Deffeyes was right in his book when he stated the good news was that OPEC no longer controlled prices but that the bad news was that no one else was in control either.
I have to add another conclusion. OPEC still has some control over the price: It still has the ability to stop prices from declining.
Once again, the period from 2008 to 2009 proved this. September 2008 not only saw a financial meltdown on Wall Street; commodity prices were also hit. Crude oil prices started to decline faster and faster.
In December 2008, WTI hit $40, down from the record highs of $147 during the summer of 2008. It was time for OPEC to meet again. They needed money.
So OPEC members agreed to cut production quotas in order to stabilize the crude oil price. What can I say; it worked. January 2009 witnessed the lowest crude oil prices, but soon afterwards the price for crude oil recovered.
OPEC can’t stop the next price surge, but it can still prevent a period of very low crude oil prices. That’s bad news for oil consumers, but great news for commodity investors.
Since history isn’t always the best thing to look at when you want to know what happens in the future, so let us take a closer look at OPEC in 2010.

The OPEC of today
Once again, there is a price range for the OPEC crude oil basket the organization wishes to defend. The new price ranges are a little bit above the one OPEC once defended, which was $22 to $28. Nowadays it is between $70 and $80.
Once again, as I write this, I have a smile on my face. WTI crude oil for delivery in February 2011, the next delivery date you can buy at the moment (December 2010) is well above $90. What happened?

Again, $80 wasn’t so serious; at least it didn’t cause anyone inside OPEC to do anything. Ali al-Naimi, Saudi minister of oil, gave a speech in Singapore in November 2010. He declared that current prices support economic recovery and that consumers are happy with oil prices ranging between 70 and 90 dollars. This isn’t a typo, he said 90 dollars.

So this was OPEC’s line of defense for the price range at $80. There is only one thing I still can’t figure out, which is what al-Naimi will tell us when crude oil passes the $100 mark.

About these ads

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Follow

Get every new post delivered to your Inbox.

%d bloggers like this: