Is it over? Was that the oil shock? Can we relax, sit back and expect our energy bills and prices at the pumps to tumble? It is true that the price of oil is down. In early July, the price peaked at US$147 a barrel. On Friday it hit US$106. A fall of almost 30 percent in two months suggests the old rule that “nothing cures high prices like high prices” may finally be working in the oil market.
Americans used less in their cars over the summer: Demand in the US fell by 800,000 barrels a day in the first half of this year, the largest decline for 26 years. In the UK, Ryanair is grounding more planes this winter. The global economy is slowing — even China, the biggest source of new demand, may soon be feeling colder breezes. But what’s this? Leading members of OPEC, the Organization of Petroleum Exporting Countries, want to reduce oil supplies to keep the price high.
The 13 members of the cartel meet in Vienna next week and Iran and Venezuela have made their position clear.
“Oil supply must be well proportioned with demand, and control over OPEC’s excess oil supply is an issue that must be discussed,” said Gholam Hossein Nozari, Iran’s oil minister, this week.
Translation: He doesn’t want to see the price fall below US$100.
To many in the West, the stance will seem outrageous. British Prime Minister Gordon Brown was furious with OPEC in May, when the price was US$135 a barrel.
“It is, as people will recognize, a scandal that 40 percent of the oil is controlled by OPEC, that their decisions can restrict the supply of oil to the rest of the world and that at a time when oil is desperately needed and supply needs to expand, that OPEC can withhold supply from the market,” he said.
Brown sounded like a buttoned-up version of the property tycoon Donald Trump, whose regular rants against OPEC have entertained viewers of US financial television channels in the past year.
“It is an illegal monopoly,” Trump told CNBC a few months ago. “If businesses ever formed OPEC, everybody would be put in jail. Every time a country hits oil, they are invited into the cartel. It’s a disgrace.”
BACK IN THE DAY
A decade ago, the West’s view of OPEC was different. The organization, having enjoyed its heyday in the 1970s, was regarded as a spent force. Its summits in hotels in Vienna and Geneva were dismissed as squabbles over who had been cheating on quotas by over-producing — usually Venezuela or Nigeria. After 25 years of trying to control the oil market, OPEC seemed doomed — damned by internal indiscipline and the success of the West in finding alternative supplies of oil.
Its nadir was 1998, when OPEC was persuaded to increase production quotas. The timing was awful. The Asian currency crisis slowed the region’s Tiger economies and the price of oil fell to close to US$10 a barrel. The following year, The Economist magazine famously predicted the price could be heading to US$5.
The world was “drowning in oil,” and OPEC seemed irrelevant and powerless.
Then the boom started. The 1990s were revealed as a decade of under-investment, not only by OPEC but by non-OPEC producers, including the big oil companies. New fields hadn’t been discovered. Refining capacity hadn’t been built. Shell had over-stated its reserves. Existing oil fields were depleting faster than expected, especially in Mexico and the North Sea. China and India began to industrialize and to subsidize oil for their citizens. Demand was accelerating and supply was struggling to keep up.
The ability of the US to bully Saudi Arabia, OPEC’s most important member, into increasing production quickly came under question. The Saudis guard closely their data on the oil reserves and production capability. Why? “Peak oil” theorists argue it’s because the big reserves aren’t as big as advertised.
Even US President George W. Bush seemed to endorse the thought in January this year.
“If they don’t have a lot of additional oil to put on the market, it is hard to ask somebody to do something they may not be able to do,” he said.
In the fall of 2006, with the price having fallen from US$75 to US$60 a barrel, OPEC demonstrated it was willing to use its newly restored influence over prices. It briefly reduced its production quotas, a signal that it was prepared to defend a price of US$60 a barrel. With barely a blip along the way, the price climbed to that record of US$147 this July.
Was that OPEC alone? Was it the combination of growth in China and India and the Western oil companies’ inability to increase production? Was it the weakness of the US dollar, creating an incentive for producers to leave their appreciating asset in the ground rather than turn it into a depreciating currency? Was it a classic investment bubble, fueled by the growth of financial speculation in the futures market? Probably some or all of the above. Either way, the approach of US$100 is a critical test of OPEC’s mood and power.
In the old days, the Saudis were the voice of restraint. After the oil shock of the 1970s, then-Saudi oil minister Ahmed Yamani urged fellow members to be cautious, arguing that high prices would lead to a reduction in demand and cause the West to become more fuel-efficient. Yet the Saudi ruling families have a huge social welfare program to fund — as a rough guess, some analysts say, a price of US$70, if sustained for a long period, would now create political tension.
Add US$20 or so for the economies of Iran and Venezuela, also built on the single commodity of oil.
NEWFOUND DISCIPLINE
“Could the price go below US$100, to US$90 or even US$80?” asked Mike Wagstaff, chief executive of Venture Production, a North Sea oil and gas producer. “Well, yes, it could but I can’t see it going much lower than that. OPEC has shown itself to be a much more disciplined organization over the past seven or eight years.”
He also says “the reality is that the West can’t afford the price to go much below US$100 because people need to fund investment.”
His point is that the industry’s costs have risen as oil has become harder to find and to produce. A deep-water rig used for drilling in the deep waters off Brazil or west Africa costs US$600,000 to US$700,000 a day to hire; three or four years ago, the price was US$200,000 to US$350,000. Analysts at the investment bank Goldman Sachs calculate that the marginal cost of production, a critical figure for all commodities, now lies between US$80 and US$90 a barrel.
Hugo Navarro of Capital Economics expects to see a classic fudge from OPEC next week. He thinks official quotas will be left unchanged but actual production will be quietly cut in the coming months.
He said that Saudi Arabia is sensitive to Western public opinion and doesn’t want to be seen to be putting pressure on prices at a time when global growth is slowing.
“Even at current price levels, the cartel will still reap massive profit, given that OPEC members have amongst the lowest production costs in the world,” Navarro said.
At the same, he said, the cartel has good reason to try to reduce output.
The last time OPEC significantly increased production to stave off a global economic slowdown in the late 1990s, the results were a disaster for the cartel,” he said.
Even so, he thinks, attempts to support a price floor of US$100 will be unsuccessful — Capital Economics sees prices fall to US$90 in a year.
Most other forecasters are more bullish, but even Goldman Sachs, which coined the phrase “super spike” more than three years ago, said on Friday that oil was “nearing a critical inflection point.”
It still expects US$130 a barrel for the fourth quarter of this year and US$140 next year, but attaches a big qualification: “In the event that a global recession and hard landing in China does materialize, spot crude oil prices would likely fall well below US$100 per barrel.”
For consumers in the West, it’s hard to find a reason to be cheerful in that forecast — expect either high energy prices or global recession. The shock isn’t over.
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