August 2016, Vol. 243, No. 8
Features
Understanding OPEC, OECD Influence on Crude Oil Markets
The Energy Information Administration (EIA) accounts for oil supply and demand by reporting on OPEC and OECD countries. So it is worth looking at both organizations to understand better what they are and how they operate.
The Organization of Petroleum Exporting Countries is a permanent, intergovernmental organization composed of 13 major oil-producing countries. It was founded at the Baghdad Conference on Sept. 10-14, 1960 by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. Eight others joined in the intervening years: Qatar (1961), Indonesia (1962), Libya (1962), United Arab Emirates (1967), Algeria (1969), Nigeria (1971), Ecuador (1973) and Angola (2007).
Gabon was a member of OPEC from 1975-94 but withdrew when it failed to get a reduction in its annual fee which was then $1.8 million and is now $3.1 million. Indonesia suspended its membership in 2009, also to save the annual fee, but rejoined at the beginning of 2016.
Initially, OPEC’s headquarters were in Geneva, Switzerland. However, the organization moved its headquarters to Vienna, Austria on Sept. 1, 1965.
OPEC’s stated objective is: “To coordinate and unify petroleum policies among member countries, in order to secure fair and stable prices for petroleum producers; an efficient, economic and regular supply of petroleum to consuming nations; and a fair return on capital to those investing in the industry.”
OPEC’s statute calls for two ordinary meetings a year to decide any policy issues. However, OPEC also meets in extraordinary sessions when required. The most recent OPEC meeting was held June 2, 2016 in Vienna.
Why OPEC Formed
OPEC was formed in response to import quotas on oil. In 1959, the U.S. government established a Mandatory Oil Import Quota Program that restricted how much crude oil and refined products could be imported. This program gave more favorable terms to imports from Mexico and Canada. As a result, countries in the Persian Gulf received lower prices for their oil. Venezuela was another country negatively affected by the import quotas.
In 1960 when Saudi Arabia, Iran, Iraq, Kuwait and Venezuela met in response to the U.S. program to form OPEC, crude oil was selling for $1.63 per barrel. This price is difficult to imagine today, even with oil now selling in the $45-50 range.
OPEC was largely unsuccessful in obtaining higher oil prices during the 1960s. However, in 1973, the organization was able to raise prices by curtailing production. This has since become OPEC’s main tool for influencing prices. OPEC controls a sufficient amount of production worldwide that it can reduce the available supply by cutting production, resulting in higher prices.
OPEC and ‘The Seven Sisters’
When OPEC was formed, the world was not exactly operating under the principles of free trade. Instead, a group of major oil companies, informally called “The Seven Sisters,” cooperated to control much of the world’s oil production and distribution, along with oil prices. According to various accounts, the origin of “The Seven Sisters” goes back to an agreement signed Sept. 17, 1920 among Royal Dutch Shell, Anglo-Iranian, and Standard Oil (now ExxonMobil). Its primary purpose was to control oil prices.
In the following decades, other companies joined this group, and by the 1950s, it included the following companies: Exxon, Mobil, Chevron, Texaco, Gulf Oil, Shell and British Petroleum.
These are all familiar names. This group controlled distribution of crude exports through its ownership of many of the major pipelines in the world. Many members were also partial owners of the major oil companies in the Middle East, such as Saudi Aramco and Kuwait Oil Company.
OPEC is correctly called a cartel, but in reality when OPEC was formed a major portion of the world’s oil was controlled by The Seven Sisters. Hence, OPEC in its formation was simply forming an organization somewhat similar to one that already existed and had operated for many years.
OPEC Since 1970
Oil prices have been volatile on several occasions since their spike in 1970. In 1973, prices jumped due to the Arab oil embargo, and again in 1979 because of the Iranian Revolution. Prices were high in the early 1980s, but crashed in 1986 due to an oil glut and lack of consumer demand. Later in the 1980s, OPEC was instrumental in restoring prices by introducing a group production ceiling. Even so, oil prices were only about half as much as they were in the early 1980s. In 1980, the average price of a barrel of oil was in the $35 range; in 1989, it was $17.
In the 1990s, oil prices remained relatively stable: between $15-22 per barrel. In 2004, oil prices began rising again. This continued until July 2008 when they peaked at $147. However, the ensuing economic collapse and recession cut prices by more than half in 2009.
By 2011, oil prices had recovered to the $100 range and remained in the $80-100 range until August 2014. This was when worldwide oil supply began to exceed worldwide demand and prices began to decline. They have continued to decline until bottoming out at just above $26 per barrel in February 2016.
Why the Decline?
When oil prices are compared to the balance of supply and demand, it seems pretty clear the decrease correlates strongly with the imbalance in the supply/demand equation. Oil supplies increased during a time of perceived economic weakness and the combination of the two drove prices down. Many analysts point to reduced demand from the Chinese economy as a major factor.
There are other factors on the demand side. Cars are becoming more efficient, requiring less gasoline, and many companies are shifting to natural gas as a cleaner alternative to oil. While clean and renewable energy is still in its early stages, it is having an effect on the amount of oil needed by many economies.
Many analysts point to the supply side as the main reason for the imbalance in supply and demand. The advent of hydraulic fracturing has greatly increased the crude oil output of a number of countries, especially the United States. Hydraulic fracturing has made it possible to get more oil out of existing wells and to obtain oil from wells once thought to be dry or no longer viable. According to the EIA, shale accounted for 29% of total oil production in the United States in 2012.
OPEC on the Sidelines
OPEC is responsible for over 30 MMbpd of the world’s 92 MMbpd of petroleum output. In the past, OPEC has used its clout to support higher oil prices by cutting production. By the time the group met on Nov. 27, 2014, oil prices had already declined from a high of $98 that August to as low as $74. In a surprise move, OPEC, led by Saudi Arabia, kept its official production target at 30 MMbpd. This was the same production target set in December 2011.
The decision was a victory for the wealthiest OPEC countries, especially Saudi Arabia, which are able to weather the storm of lower oil prices. Poorer members of OPEC, such as Venezuela and Algeria, called for cuts of 2 MMbpd. They are heavily dependent on oil revenues and suffer greatly from reduced prices.
Many analysts believe Saudi Arabia’s decision to maintain production levels is an explicit attempt to undermine the U.S. shale industry. The advent of shale production in the U.S. and elsewhere has undercut Saudi Arabia’s dominance as the world’s leading oil supplier.
Because of the advanced technology involved in shale production, many shale wells are not profitable when oil is below the $50 or $60 level. Saudi Arabia, by contrast, can easily produce 10 MMbpd at relatively low cost and do so indefinitely. Low prices are clearly having an effect on Saudi Arabia, but the kingdom is in a position to play a waiting game. As a result, oil prices dropped to the $30 level and below, and many U.S. shale companies were hurt badly.
As of March, Saudi Arabia and Russia were talking about a possible freeze on production. On April 17, 18 oil-producing countries met in Qatar to discuss a production freeze at January 2016 levels. Chief among these were Saudi Arabia, Russia, Qatar, Oman and other OPEC countries. After meeting for 12 hours, the countries could not agree on a freeze. The chief stumbling block appeared to be Saudi Arabia’s insistence that Iran be part of such an agreement. Saudi Arabia and Iran have been at odds historically, due in part to ethnic differences.
Despite the lack of agreement, there has been a slow increase in oil prices since the meeting. Since bottoming on Feb. 11 at $26.12, oil prices rose slowly to the high-$40 range, even passing $50 on May 26. Given the pattern of prices since February, it is likely they will reach $55 by September.
The EIA has projected a gradual narrowing of the gap between oil supply and demand in 2016 and 2017. This is supported in part by the impact that lower oil prices have had on smaller U.S. shale producers. According to estimates from the law firm Haynes and Boone, between 60-70 American drilling and oil service companies have filed for bankruptcy since January 2015.
This has reduced oil output in the U.S. and is in part responsible for the rise in oil prices. This is supply and demand at work, though its effect can at times be cruel for certain companies.
What the EIA forecast does not take into account is the impact of unexpected supply disruptions that reduce the total amount of oil produced, thus narrowing or even eliminating the gap between oil supply and demand. In 2016, disruptions in supply from Nigeria, Venezuela and Canada have taken over 1 MMbpd out of the supply equation. Coupled with increased demand from China, India and Russia, the result has been a steady rise in oil prices.
Saudi’s New Oil Minister
On May 7, Saudi Arabia replaced its longtime oil minister Ali al-Naimi with Khalid al-Falih, chairman of Saudi Aramco. The expanded position is now called the Ministry of Energy, Industry, and Mining. Saudi Arabia has again made clear that it will not agree to a freeze unless Iran participates.
It seems unlikely this change at the top will generate a significant policy change. Instead, it appears Saudi Arabia is positioning itself for a time when it will rely less on oil as a source of revenue. Saudi Arabia knows its oil-generated wealth will not last forever and is making long-term plans for its future.
On June 2, OPEC met again in Vienna for a regularly scheduled meeting. Despite some talk about a production freeze or cut, the organization agreed to leave current production policy in place. That, in effect, means each country is free to produce as much oil as it wants to; there are no country production quotas, and there is no OPEC-wide ceiling on production.
Given that oil prices have risen, OPEC appears to feel the law of supply and demand is sufficient to control prices. Its next meeting is scheduled on Nov. 30.
OECD’s History
The roots of the Organization for Economic Cooperation and Development date back to 1948 when the Organization for European Economic Cooperation (OEEC) was formed to administer the Marshall Plan, which was designed to help in the reconstruction of a European continent that was ravaged by war.
Encouraged by the success of the OEEC, Canada and the U.S. joined its members in signing the new OECD Convention on Dec. 14, 1960. The OECD was created officially Sept. 30, 1961 as the OECD Convention went into effect.
Since 1961, other countries have joined, including Japan in 1964. There are 34 member countries and while most are European, with an orientation toward some form of democracy, there are Latin American and Asian members as well. These include Mexico, Chile, Australia, New Zealand and South Korea.
Purpose of OECD
The OECD works with member countries on matters of finance, regulatory reform, environmental issues, fiscal policy and other issues. OECD monitors events in member and non-member countries and prepares projections of economic developments.
OECD countries can form agreements on matters of mutual interest, including methods for combating bribery, arrangements for export credits and procedures for capital movements. Other matters of agreement include cross-border cooperation in enforcing laws against spam and guidelines for environmental practices.
OECD’s budget for 2015 was 363 million Euros. Unlike OPEC, which has a flat rate annual membership charge for all members, OECD uses a formula based on the size of each member’s economy. The U.S. contributes the most at 21%.
Comparison to OPEC
The OECD is quite unlike OPEC. OPEC is a cartel whose primary purpose is to exercise control over oil prices. The OECD is mainly focused on broad issues of economic development among its members.
The so-called “Seven Sisters,” to the extent that they were organized at all, are much closer to OPEC than is OECD. The reason the EIA uses the OECD as a prism for reporting on oil prices is not so much because it is involved in determining oil prices as that it is a convenient way to group the countries that are not members of OPEC. Some countries, such as Russia and China, are not members of either OPEC or OECD.
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