OPEC’s Dilemma: Forgotten lessons and Abandoned Strategies
- Khalil Zahr
- Aug 14, 2017
- 9 min read
A New Paradigm
Stimulated by a long run-up in oil prices that started in 2001 and reached a historical high in 2011, non-OPEC supplies, particularly new shale oil production, rose at a fast pace over the period. This development, coinciding with moderating world demand and reduced concerns over supply interruptions, precipitated a price collapse in 2013. Prices fell by more that 50 percent off their peak value over a short period of two years. Halfhearted attempts by OPEC to arrest the fall and shore up prices failed.
OPEC faced a dilemma, defend the oil price and lose market share, or reduce the price further by increasing production in the hope of driving out higher cost competing supplies. OPEC chose the latter and this has also failed. It was a case of too little-too late, tools that were dulled by failing to learn the lessons of the past, and a new paradigm for the market brought about by the shale revolution.
Beware of High Oil Prices
Back in 1980, during the Iran Revolution and the Iran-Iraq war, the price of a barrel of Brent oil reached a record of 107 dollars in 2016 money, which was broken, for the first time in 2011. The price then doubled over two years and was almost eight times its level of 1965, three years after the formation of OPEC. This meteoric rise in prices, stimulated higher cost non-OPEC production. Consequently, OPEC market share decreased from a peak of 49 percent in 1996 to 45 percent in 1980, the year in which prices peaked (Figure 1).
Price Defense and Production Quotas
With its appetite wetted by windfall oil revenues and oil prices starting to decline after 1980, OPEC adopted a price defense strategy by restricting its production under a quota system. As a result, its market share dropped over the five-year period 1980-1985, from 45 percent to a record low of 28 percent. Worst of all, these sacrifices in production failed to arrest the decline in prices which continued a downward trajectory to about 62 dollars per barrel in 1985. A double jeopardy for OPEC revenues but still a healthy level at which competing non-OPEC supply could keep growing and gaining market share.
The War for Market Share
Enter Ahmed Zaki Yamani, the Saudi Minister of Petroleum and Mineral Resources 1962-1986. Exasperated by the ineffectiveness of the price defense strategy, and becoming impatient with the price hardliners within OPEC, Yamani unexpectedly abandoned price defense and switched completely to an opposite, race- to- the- bottom price strategy. The primary aim was to regain market share by keeping out higher cost non-OPEC supplies. Saudi Arabia, along with few of her allies within OPEC declared their willingness to sell as much oil as demanded to refiners at the net-back price. In other words, oil will be sold at the price that will insure a positive refining margin, irrespective of how low petroleum products prices may go.
The market reaction was swift and drastic. The price of oil dropped by over 50 percent over few months, sending shock waves around the world. All energy producers suffered a sudden substantial reduction in income, high cost production capacities had to be curtailed or shuttered, and investments in new capacity dried up, particularly in non-OPEC countries.
The Fruits of Victory
The new Saudi strategy worked spectacularly. Oil prices declined to around 30 dollars per barrel in 1986 and remained below the 40 dollars level for the next seventeen years until 2003. OPEC’s share in world oil supply grew steadily from a low of 27.6 percent in 1985 to 41.8 percent in 1998. Over the same period, world oil consumption increased by about 16 million barrels per day (mbd), of which 15 million barrels or 94 percent of this increase were supplied by OPEC producers.
The Costs of War
This strategy, never the less, generated fear and anger among all stake holders in the world energy markets. Except for consumers and Saudi oil refining customers who benefited from reduced oil prices, all others suffered its consequences. High cost oil producers took sizable losses or much reduced returns on their investment, while marginal production was mothballed. The new policy was also deeply divisive within OPEC, with price hardliners strongly resenting it. All OPEC members had to endure a sharp and substantial decline in their revenues, on which they heavily depended for financing their economic development.
Even Saudi Arabia, the owner of the policy, was challenged with reduced revenues that fell short of recurrent fiscal needs. The resulting immediate pressures from international and domestic interests led to the abandonment of the policy, and contributed to the unceremonious dismissal of its architect Minister Yamani in 1986. The effects of the strategy however were more lasting, establishing a ceiling on prices which stimulated growth in oil consumption. World oil demand grew consistently over the period, thus contributing to a subsequent sustained growth in OPEC revenues driven by growth in its market share in an expanding market.
Lessons Not Learned
When prices broke the 40 dollars threshold in 2003, it was clear that the lessons of the 1980’s had been forgotten, or not well learned to start with. It was also clear that OPEC’s long-term strategy has shifted to defense of a market share of around 40 percent, a level that has prevailed over the previous decade, irrespective of the oil price.
From 2003 onward, oil prices rose consistently and rapidly, and except for a brief correction caused by the international financial crisis of 2008, proceeded to register a new record high of 119 dollars per barrel in 2011. This also coincided with steady growth in world demand for oil, which was driven by moderate below forty dollars prices from the middle eighties and through the nineties, and subsequently by rising demand from the developing world, particularly from China and the oil exporting countries. It was significant however, that out of the 11 mbd increase in world production over the period 1998-2011, the share of OPEC was only 5 mbd or 45 percent. A share that confirms the new OPEC 40 percent market share policy (Figure 2).
Taking the Path of Lowest Resistance: A Mistaken Strategy
In hindsight, it seems that allowing prices to rise above the important 40 dollars threshold was a serious strategic mistake. While prices were under this threshold, non-OPEC supply seemed to have peaked at this price level, allowing OPEC to increase its share to meet the growth in demand. However, when prices crossed this threshold to much higher levels, it stimulated the supply of various non-traditional oil supplies, such as deep-sea oil, extra heavy oil, and most importantly shale oil. This development is believed to be at the heart of the present dilemma facing OPEC.
There were many causes for OPEC’s complacency regarding rising price levels of which the following are believed to be the most consequential:
The growing revenue needs of welfare economies: By the end of the last century, most oil exporters were amid very ambitious social and economic development that required ever growing revenues. Huge investments were made in infrastructure and services, particularly in health and education. Almost all these services were heavily subsidized along with energy products and water services, while hard to reverse social welfare programs expanded to meet the needs of fast growing populations.
High unemployment, especially among the young, caused by structural and policy impediments to their employment by the private sector, lead to bloated public sectors that became the employer of last resort. Thus, adding to the fiscal burden.
While, due to low levels of economic diversification, and low or absent taxation, oil revenues were the primary source of finance. Consequently, the state of the economy was strongly coupled with state of the world oil market, effectively tracking the world oil price. When oil revenues fell short, as was the case for most of the eighties and nineties, most of those oil exporters had to revert to borrowing to meet their needs.
Consequently, when oil prices and demand started rising in the late nineties, it was a welcome relief. It enabled the oil producers to pare down their debt and meet their fiscal needs. With oil revenues rapidly rising due to the rapid rise in prices, and its market share unchanging, OPEC was able reduce its debt, meet its growing fiscal needs, and limit its investment in additional oil production capacity to the level that preserved its forty percent market share. Blindsided by its new fortunes, it neglected to objectively assess the strategic impact of record high oil prices.
Believing the myth of peak oil: The failure of non-OPEC producers to significantly grow their production over the period when oil prices were below the 40 dollars threshold reinforced the traditional belief in the peak oil theory. Many believed that oil not produced today will have higher value in the future. Well respected contrary opinions were conveniently discounted.
It was none other than the aforementioned former Saudi oil minister Ahmed Zaki Yamani, the architect of the 1985 price war, and now the head of the London based Center for Global Energy Studies (CGES), who warned in a June 2000 Interview: "Thirty years from now there will be a huge amount of oil - and no buyers. Oil will be left in the ground. The Stone Age came to an end, not because we had a lack of stones, and the oil age will come to an end not because we have a lack of oil".
Even when new technologies, such as horizontal drilling, deep water production, and fracking enabled the extraction of non-traditional oil and gas, pundits conveniently underestimated their potential impact. Various reasons were cited including high initial costs, environmental impact, or limited resource size, among others. This however was not to be the case.
Appeasing the price hardliners: OPEC is a unique organization. Notwithstanding the adversarial relationships among some of its members which at one time or another included direct and indirect armed conflicts, their real strategies in the oil market are usually conflicting and lack a unified vision. One fundamental attribute that divides the membership and has the most impact on policy is the size of oil reserves that members are endowed with. Those with relatively smaller endowments are naturally high discounters of their oil resources. They prefer the maximum possible price for oil in order maximize their revenues while stretching the life of their reserves. While members with large reserves are low discounters, whose interest lies in protecting the market for oil over the longer term, by keeping the price at moderate levels.
On most occasions since its inception, OPEC’s production policy has been more influenced by the high discounters than otherwise for two main reasons: The first is that the high discounters form most of its membership. Consequently, preserving the unity of the organization and its survival requires accommodating them. The second reason is that, due to the revenue requirements that often surpassed their income, and their sole reliance on their oil revenues, low discounters, lured by high oil prices, often behaved as high discounters.
Moreover, with the contentious quota system that OPEC has adopted since the late seventies, it became an impediment to increasing its market share. Since this would have required countries with high reserves to increase their share in total OPEC production. Consequently, advise given from various expert quarters to the organization, particularly to its high reserve holders, to increase their production capacity in line with their share in total oil reserves were ignored. If this advice had been followed, and given that OPEC’s share in world reserves of traditional oil exceeds sixty percent, it would have been very unlikely for prices to have risen high enough to allow non-traditional oil resources to be developed at the time they had.
Sensitivity to over dependence on OPEC supply: Security of oil supplies has been an issue since OPEC’s formation as a cartel. This issue came to the fore in 1973 because of the Arab oil embargo, which was the only politically motivated event ever to impact oil consumers. However, due to the conflict prone state of the Middle East Region, where most of OPEC’s reserves are located, along with other geo-political considerations, this issue has always been a concern for major oil consumers.
Consequently, growing OPEC’s market share would have proportionally raised world dependence on Middle East oil. This would have raised world concern about supply security, which in the thinking of many, could have negative consequences on Middle Eastern OPEC members by motivating the world search for alternatives to oil sources from that Region.
The irrelevance of OPEC’s spare capacity: Marketed as a tool to moderate undesired rise in oil prices, some OPEC members have always kept a certain level of production spare capacity. This capacity has often come handy when supplies were interrupted due to conflict or unforeseen industrial accidents. Without such spare capacity, oil prices would have certainly risen to higher levels than actual if such reserves were not available.
This spare capacity however, was never sufficient as a strategic tool to defend or grow market share by capping the oil price for an extended period as required. Over the fifteen-years period 2001-2016, OPEC’s spare capacity averaged 7.2 percent of its total capacity, but only 2.9 percent of world production capacity, hardly covering an average two-year growth in demand. When oil prices crossed the 40 dollars threshold in 2004, the spare capacity was only 1.7 percent of total world capacity, (Figure 3).
Source: EIA, BP
Later in 2014, when OPEC decided to defend its market share by driving out higher cost shale oil, its spare capacity constituted 2.4 percent of world supply capacity. This margin subsequently dropped to 1.3 percent in 2016 before it abandoned its short-lived attempt.
These reserve margins are well below the size needed to drive prices to a desired level and keep them there for the long term, as will be needed by OPEC to be able to successfully defend its market share.
KZ
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