The History and Analysis of Crude Oil Prices - Part IV “OPEC’s Failure to Control Crude Oil Prices”
OPEC has seldom been effective at controlling prices. While often referred to as a cartel, OPEC does not satisfy the definition. One of the primary requirements is a mechanism to enforce member quotas. The old joke went something like this; “What is the difference between OPEC and the Texas Railroad Commission? OPEC doesn’t have any Texas Rangers!” The only enforcement mechanism that has ever existed in OPEC was Saudi spare capacity.
With enough spare capacity at times to be able to increase production sufficiently to offset the impact of lower prices on its own revenue, Saudi Arabia could enforce discipline by threatening to increase production enough to crash prices. In reality even this was not an OPEC enforcement mechanism unless OPEC’s goals coincided with those of Saudi Arabia.
During the 1979-1980 period of rapidly increasing prices, Saudi Arabia’s oil minister Ahmed Yamani repeatedly warned other members of OPEC that high prices would lead to a reduction in demand. His warnings fell on deaf ears.
Surging prices caused several reactions among consumers: better insulation in new homes, increased insulation in many older homes, more energy efficiency in industrial processes, and automobiles with higher efficiency. These factors along with a global recession caused a reduction in demand which led to falling crude prices. Unfortunately for OPEC only the global recession was temporary
– Nobody rushed to remove insulation from their homes or to replace energy efficient plants and equipment — much of the reaction to the oil price increase of the end of the decade was permanent and would never respond to lower prices with increased consumption of oil.
Higher prices also resulted in increased exploration and production outside of OPEC. From 1980 to 1986 non-OPEC production increased 10 million barrels per day. OPEC was faced with lower demand and higher supply from outside the organization.
From 1982 to 1985, OPEC attempted to set production quotas low enough to stabilize prices. These attempts met with repeated failure as various members of OPEC produced beyond their quotas. During most of this period Saudi Arabia acted as the swing producer cutting its production in an attempt to stem the free fall in prices.
In August of 1985, the Saudis tired of this role. They linked their oil price to the spot market for crude and by early 1986 increased production from 2 MMBPD to 5 MMBPD. Crude oil prices plummeted below $10 per barrel by mid-1986. Despite the fall in prices Saudi revenue remained about the same with higher volumes compensating for lower prices.
A December 1986 OPEC price accord set to target $18 per barrel but it was already breaking down by January of 1987 and prices remained weak.
The price of crude oil spiked in 1990 with the lower production and uncertainty associated with the Iraqi invasion of Kuwait and the ensuing Gulf War. The world and particularly the Middle East had a much harsher view of Saddam Hussein invading Arab Kuwait than they did Persian Iran. The proximity to the world’s largest oil producer helped to shape the reaction.
Following what became known as the Gulf War to liberate Kuwait, crude oil prices entered a period of steady decline, until in 1994, inflation adjusted prices attained their lowest level since 1973.
The price cycle then turned up. The United States economy was strong and the Asian Pacific region was booming. From 1990 to 1997 world oil consumption increased 6.2 million barrels per day. Asian consumption accounted for all but 300,000 barrels per day of that gain and contributed to a price recovery that extended into 1997. Declining Russian production contributed to the price recovery. Between 1990 and 1996 Russian production declined over 5 million barrels per day.
OPEC continued to have mixed success in controlling prices. There were mistakes in timing of quota changes as well as the usual problems in maintaining production discipline among its member countries.
The price increases came to a rapid end in 1997 and 1998 when the impact of the economic crisis in Asia was either ignored or severely underestimated by OPEC. In December of 1997, OPEC increased its quota by 2.5 million barrels per day (10 percent) to 27.5 MMBPD effective January 1, 1998. The rapid growth in Asian economies had come to a halt. In 1998 Asian Pacific oil consumption declined for the first time since 1982. The combination of lower consumption and higher OPEC production sent prices into a downward spiral. In response, OPEC cut quotas by 1.25 million b/d in April and another 1.335 million in July. Price continued down through December 1998.
Prices began to recover in early 1999 and OPEC reduced production another 1.719 million barrels in April.
As usual not all of the quotas were observed but between early 1998 and the middle of 1999 OPEC production dropped by about 3 million barrels per day and was sufficient to move prices above $25 per barrel.
With minimal Y2K problems (big surprise!) and growing US and world economies the price continued to rise throughout 2000 to a post 1981 high. Between April and October, 2000 three successive OPEC quota increases totaling 3.2 million barrels per day were not able to stem the price increases. Prices finally started down following another quota increase of 500,000 effective November 1, 2000.
Russian production increases dominated non-OPEC production growth from 2000 forward and was responsible for most of the non-OPEC increase since the turn of the century.
Once again it appeared that OPEC overshot the mark. In 2001, a weakened US economy and increases in non-OPEC production put downward pressure on prices. In response OPEC once again entered into a series of reductions in member quotas cutting 3.5 million barrels by September 1, 2001. In the absence of the September 11, 2001 terrorist attack this would have been sufficient to moderate or even reverse the trend.
In the wake of the attack, crude oil prices plummeted. Spot prices for the U.S. benchmark West Texas Intermediate were down 35 percent by the middle of November. Under normal circumstances a drop in price of this magnitude would have resulted an another round of quota reductions but given the political climate OPEC delayed additional cuts until January 2002.
It then reduced its quota by 1.5 million barrels per day and was joined by several non-OPEC producers including Russia who promised combined production cuts of an additional 462,500 barrels. This had the desired effect with oil prices moving into the $25 range by March, 2002. By mid-year the non-OPEC members were restoring their production cuts but prices continued to rise and U.S. inventories reached a 20-year low later in the year.
By year end oversupply was not a problem. Problems in Venezuela led to a strike at PDVSA causing Venezuelan production to plummet. In the wake of the strike Venezuela was never able to restore capacity to its previous level and is still about 900,000 barrels per day below its peak capacity of 3.5 million barrels per day. OPEC increased quotas by 2.8 million barrels per day in January and February, 2003.
On March 19, 2003, just as some Venezuelan production was beginning to return, military action commenced in Iraq. Meanwhile, inventories remained low in the U.S. and other OECD countries. With an improving economy U.S. demand was increasing and Asian demand for crude oil was growing at a rapid pace.
The loss of production capacity in Iraq and Venezuela combined with increased OPEC production to meet growing international demand led to the erosion of excess oil production capacity. In mid 2002, there was over 6 million barrels per day of excess production capacity and by mid-2003 the excess was below 2 million. During much of 2004 and 2005 the spare capacity to produce oil was under a million barrels per day. A million barrels per day is not enough spare capacity to cover an interruption of supply from most OPEC producers.
In a world that consumes over 80 million barrels per day of petroleum products that added a significant risk premium to crude oil price and is largely responsible for prices in excess of $40-$50 per barrel.
Other major factors contributing to the current level of prices include a weak dollar and the continued rapid growth in Asian economies and their petroleum consumption. The 2005 hurricanes and U.S. refinery problems associated with the conversion from MTBE as an additive to ethanol have contributed to higher prices.
One of the most important factors supporting a high price is the level of petroleum inventories in the U.S. and other consuming countries. Until spare capacity became an issue inventory levels provided an excellent tool for short-term price forecasts. Although not well publicized OPEC has for several years depended on a policy that amounts to world inventory management. Its primary reason for cutting back on production in November, 2006 and again in February, 2007 was concern about growing OECD inventories. Their focus is on total petroleum inventories including crude oil and petroleum products, which are a better indicator of prices that oil inventories alone.
Part I - The History and Analysis of Crude Oil Prices
Part II - The History and Analysis of Crude Oil Prices
Part III - The History and Analysis of Crude Oil Prices
Part IV - The History and Analysis of Crude Oil Prices
Part V - The History and Analysis of Crude Oil Prices
Will post the final section, Part V tomorrow - “The Impact of Crude Oil Prices on Industry Segments”
If you enjoyed this post, please consider to leave a comment or subscribe to the feed and get future articles delivered to your feed reader.
Comments
No comments yet.
Leave a comment