Text of Barron's article..... "A must read"
May 17, 1999
Can OPEC Make It Stick?
The latest cutbacks, which have boosted oil prices, are likely
to hold
By James Richard
The price of oil has rallied, thanks to the March 23 OPEC agreement to cut
production by 2.1 million barrels a day. Is it likely to succeed where previous
cuts have failed? We believe so. Most pundits, failing to observe the changes
in market conditions, have analyzed OPEC's latest cuts under the standard
theory of cartels: The lure of higher revenues for each member causes a
member to cheat on its quota, eventually driving down prices by flooding the
market with supply.
This argument may be true in the long run, but it fails to account for the
political dynamics of the cartel that is OPEC. Even a politically feeble OPEC
had managed to remove more than 1.3 million barrels a day from the market
in its March 1998 agreement to cut output, resulting in oil prices bottoming at
$10 a barrel, instead of $5. Further, political changes within OPEC have
greatly improved the prospect for compliance in the short- to medium term.
Any analysis of OPEC's latest move must start with Saudi Arabia, which
provides 10% of the world's daily oil supply. In recent years, Saudi policy has
been based on three tenets: maintaining stability in oil markets; opposing oil
prices so high that they might discourage demand growth or encourage a
rapid rise in non-OPEC production; and retaining the country's dominant
market share, especially in the U.S.
The OPEC agreement signed in Jakarta in
November 1997, which raised output 10%, has
been widely viewed as the source of the 1998
supply glut. For the Saudis, however, the
agreement met critical objectives. First, it blunted what appeared to be a
genuine threat that the Brent crude price of $22 a barrel would encourage
heavy oil investment in the Caspian Sea and in Central Asia. Second, it set the
stage for a new political equilibrium within the cartel.
The impact of the output boost was surprisingly great; the magnitude of the
impending decline in Asian demand was not fully appreciated at the time and,
of course, no one could have foreseen the historic warm winter that was
about to bless North America. In fact, the consequences of oversupply were
especially dire for Saudi Arabia: Its oil revenues fell by almost $14 billion, or
30%, while population growth hovered near 4% and unemployment remained
high. At the same time, it seemed impossible for the Saudis to cut their
bloated public sector or the billions of dollars spent on royal stipends. The
political instability that arises during any severe economic downturn was
worsened in Saudi Arabia by an increased threat from Islamic extremists. The
bombing of a U.S. military base at Khobar in 1997 and the activities of
Osama Bin Laden outside the country raised fears of a brewing indigenous
revolt.
Nonetheless, even through the March 1998 OPEC cuts, the Saudis kept
production at mid-1997 levels and preserved their dominance in the U.S.
market. Saudi oil policy, despite punishing the country with low prices, was
effective in deterring investment in exploration and production, particularly in
the Caspian and Central Asia, as well as destroying many independents.
Actually, in the 17-month period starting with November 1997, marginal
production has been abandoned at a blazing pace. Canadian rig counts are
down 69% and Latin American rig counts fell 26% (whereas Middle Eastern
rig counts have fallen by only 12%). As of March 26, well into the current
oil-price rally, the trend had not stopped: Rig counts in North America were
down 10.7% from the week before (and 44% from the year before). The
American Petroleum Institute's recent figures show U.S. oil production at a
49-year low. While non-OPEC producers were shutting in wells from
Oklahoma to West Africa, most major oil companies were cutting capital
expenditures on exploration and production by 2%-3%. Taken together,
these trends will likely eliminate as much as 500,000 barrels a day from
non-OPEC production in 1999 alone. Such trends, once established, take
time to change.
At the March 23 OPEC meeting in Vienna, the Saudis took the largest
reduction and agreed to take their hit a month earlier than the rest of the
cartel. Significantly, these cuts will move Mexico or Venezuela ahead of Saudi
Arabia as the main supplier to the U.S. market. This is a significant policy shift
for Saudi Arabia, from which one can infer that Crown Prince Abdullah and
the professionals in the Saudi oil industry have suffered enough and are
satisfied that the supply trend is turning. To understand why they are so
confident, we must consider dramatic changes within the cartel over the past
two years.
Most significant have been the altered positions of Iran and Venezuela. During
1997, the cash-strapped Iranians had one policy objective: produce to
capacity. They had also been overstating their production in the hope of
establishing a baseline for future cuts of 3.9 million barrels a day, instead of
the 3.6 million barrels they had actually been producing. Teheran believed the
higher baseline would leave room for potential cuts.
The Saudis, knowing the Iranians were operating at capacity in November
1997, steered OPEC to an agreement increasing production by 10%. Saudi
Arabia and other cartel members were fully aware that the Iranians could not
produce any more oil and that, because of increased supply in the market in
the short term, the "cheaters" from Teheran would receive nothing for their
maneuvering but lower prices and revenues.
By February 1998, estimates showed a decline in Asian demand of 600,000
barrels a day. Although expectations were that two million barrels a day
needed to be removed from the oil market, the OPEC agreement of March
1998 achieved commitments to cut only 1.2 million barrels. After much
wrangling within OPEC and between differing groups of the Iranian
delegation, the Iranians insisted their cuts had to be based on the 3.9 million
baseline. In reality, Iran made no new reductions, a fact that immediately
shaved 300,000 barrels from the cartel's 1.2 million-barrel agreement.
Clearly the deal was imperfect, especially for the Venezuelans, for whom oil
constitutes 18.5% of gross domestic product, 37.5% of government revenues
and 70% of hard-currency revenues. In recent years, Caracas has insisted
that any OPEC deal must be equitable and must include non-OPEC
producers. In the March 1998 agreement, Venezuela was saddled with the
largest percentage cuts and the Iranians walked away taking no pain. Further
cuts were needed in June 1998, and the Saudis mustered most of them out of
the Arab Gulf states.
Throughout this period of discord in OPEC, political change was stirring in
Iran. In fact, over the past 18 months Saudi-Iranian relations have gone from
horrible to almost cordial, which can be attributed to Iran's president,
Mohammad Khatami. Although Khatami was elected in May 1997 with
nearly 70% of the vote, he has only recently been able to exert authority over
vestiges of the conservative-dominated power portfolios: interior, foreign
affairs, and oil and energy.
Compared with Iran's schizophrenic policy at the March 1998 OPEC
meetings -- where moderates supported cuts on the 3.6 million-barrels-a-day
baseline, while conservatives argued for 3.9 million barrels -- the recent cuts
were negotiated under the authority of Khatami.
The new realities in Iran made it possible for leaders of Saudi Arabia, Iran
and Venezuela to attain a more open and transparent agreement. Succumbing
to the reality of economic hardship caused by low oil prices, the Saudi crown
prince agreed to take more cuts in volume, and earlier than anyone else. On
friendlier terms with Iran, he ceded to President Khatami new cuts from the
3.6 million-barrel baseline. In reality, these will be the first cuts from Iran over
the past year. To appease Venezuela's new president, Hugo Chavez, the deal
granted a smaller-percentage reduction to Venezuela than the rest of the
cartel. Finally, after being extremely critical about cheating throughout 1998,
Norway, a non-OPEC producer that participated in the March 1998
agreement, recognized OPEC's prospects for better compliance and added
its stamp of credibility to the deal with a cut of 100,000 barrels a day. As of
Thursday, it appeared that indeed OPEC compliance was on the rise:
Bloomberg reported that April 1999 compliance for previous agreements was
85%, versus 78% in March.
The wild cards in this equation remain the future of Iraqi production and
record oil stocks. OPEC fears that Iraqi production could soon be awakened
from its deep slumber and easily drive prices lower. That country's reserves
are second only to Saudi Arabia's, and its current production of 2.6 million
barrels a day is less than half its 1990 pre-Gulf War levels. The Energy
Intelligence Group estimates that, with proper investment, Iraq could double
its production in less than two years and flood the market.
Perversely, the best news for oil would be Saddam Hussein's continued hold
on power. As long as Saddam is in Baghdad, the United Nations will be
regulating Iraq's production and investment in the oil industry. In any case,
U.S. policy on Iraq follows the lead of the Saudis and Kuwaitis. Saddam may
be removed and/or sanctions may be lifted at some point, but only at a time of
high oil prices, when the Gulf economies can absorb the damage from
marginal Iraqi production.
The other wild cards for supply are the current high inventories and
mysterious "missing" inventories. Standing at 350-400 million barrels, world
oil stocks have reached record levels. OPEC behavior must remain unified for
at least the next nine months to get over this hump, but even at 50%
compliance, this would be achieved.
The "missing" stocks refer to oil that was accounted for in OPEC production
in late 1997 but unaccounted for in consumption or inventory statistics. We
believe this oil probably was never produced in the first place, but was merely
stated for internal cartel posturing at the 1997 OPEC meetings.
Finally, there is cash-strapped Russia, which some observers argue will flood
the market with oil. This is unlikely to happen, however, because most
Russian companies have not had enough money for capital expenditure even
to maintain existing production. Indeed, overall Russian production fell a few
percentage points from 1997 to 1998. We assume that Indonesian oil
companies are having the same problem.
The Russians also cannot flood the market with crude because of transport
constraints. Russian transport capacity utilization is 100% and so, as in 1998,
Russia will export 2.5 million barrels a day in 1999. A new 50
million-tons-per-year pipeline from Timan Pechora to the Baltics is at least
two years off. In the recent March OPEC accord, Russia pledged to cut
100,000 barrels a day, which was a nice gesture, although no one really
expects compliance.
Interestingly, throughout this downturn in oil, Russian oil companies in our
firm's portfolios have been fairly successful at maintaining production and
exports. Because they continue to be unable to rationalize their wells for
efficiency during periods of low prices, most producers with any cash flow
never took wells out of production.
Both because of decreased supply from non-OPEC producers and a better
political environment for compliance within the cartel, we believe it is likely
that this year's OPEC agreement will succeed. Some leakage will occur, but
new realities within OPEC give it the capability to easily remove one million
barrels a day from production.
JAMES RICHARD is a portfolio manager at Firebird Management LLC.
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