Friday, December 5, 2008

Are We Watching the Death of OPEC?

On Tuesday, Jim Jubak of MSN Money wrote an article called "Are We Watching the Death of OPEC?" (article is below). It is an interesting article that details several issues, and the last one is the effects of falling oil prices.

With falling oil prices, oil companies are much less likely to go spend large sums on finding oil reserves now, and this means possibly less future supplies of oil. At the same time, a drop in oil prices means that alternative energy will be most likely pushed to the back burner since they will not be profitable. The best case would be for more oil drilling to help future oil supplies AND continued research and development of alternative energy sources. Neither will come "on-line" today, but both would help stabilize the future oil reserves and lead the way to a better, more energy efficient, environment friendly tomorrow.

Are we watching the death of OPEC?
Jubak's Journal 12/2/2008 12:01 AM ET
By Jim Jubak

The fundamental problems of the once-mighty Organization of Petroleum Exporting Countries are being laid bare by falling prices and production cuts.

Is this the end of OPEC?

The plunge from $148 a barrel to $50 a barrel in less than five months has opened huge fissures in the Organization of Petroleum Exporting Countries. Some members, such as Iran and Venezuela, are desperate to raise oil prices so they can balance their national accounts. More-conservative members, such as Saudi Arabia, can balance their budgets even at current prices and have room to fear they will be the scapegoats if the global recession deepens.

We've sat deathwatch for OPEC before, but this time the cartel's future looks especially bleak. Its Nov. 29 meeting in Cairo, Egypt, ended with members deeply divided. The Venezuelas and Irans of OPEC have dug themselves into such a big spending hole that their only way out would be for OPEC to raise prices by cutting production while letting the cartel's hardest-pressed members cheat.

OPEC couldn't agree on any production cuts in Cairo but promised to revisit the issue Dec. 17. The burden of production cuts would fall almost totally on the Saudis and other conservative Middle Eastern oil producers. That's why the Saudis didn't buy into that deal in Cairo and why they might balk again. That result could leave OPEC standing but effectively end the cartel's power to change the balance of global supply and demand.

In the short run, that would be great for consumers. In the long run, it would lead to global energy chaos.

Where oil demand is growing

How did OPEC get into this mess? Consumers in OPEC countries are becoming just as addicted to oil as their counterparts in the United States. According to the latest forecast from the International Energy Agency, oil demand from the world's developing economies will fall by about 3 million barrels a day between 2007 and 2030. In that same period, the countries of the Middle East will be one of the three major sources of oil-demand growth in the world. Overall, about 43% of global oil-demand growth will come from China, according to the forecast, with India and the Middle East contributing 20% each.

It's easy to understand why China's and India's oil demand is growing so fast. They have immense populations -- 1.3 billion and 1.1 billion, respectively -- and emerging middle classes that are just starting to buy cars and the other high-consumption trappings of developed economies.

But the Middle East? Egypt, the most populous country in the region, has just 80 million people. Iran, 70 million. Saudi Arabia, just 27 million. So why are these countries projected to add as much to global demand for oil as India over the next two decades?

  • Demographics certainly play a part. These are some of the youngest and therefore fastest-growing economies in the world.
  • National investment plans heavily favor oil- and energy-intensive projects, such as chemical plants.
  • And subsidies. In 2007, Iran spent almost $20 billion more on energy subsidies than China did. Three Middle Eastern countries -- Iran, Saudi Arabia and Egypt -- make the International Energy Agency's global top eight for energy subsidies in the developing world. Another OPEC member, Venezuela, also makes the top eight. That group is rounded out by China, India, Indonesia and Russia. Subsidize oil prices, and consumers will buy and consume more. Pretty simple.
Governments hooked on oil

The governments that provide these subsidies are even more hooked on oil than their populations are. Politicians in oil-producing countries have gotten used to oil revenue providing the bulk of the national budget, enabling them to keep taxes low and expand services. In Iran, for example, oil revenue provides between 40% and 80% of the national budget, depending on which oil industry analyst you believe. In Nigeria, oil and natural-gas revenues account for 85% of government revenue.

No problem with that -- until oil prices start to fall. Governments that pegged their budgets to $80- or $100- or $120-a-barrel oil are in deep trouble when oil falls to $50. Russia, for example, developed its national budget for 2008 based on $70-a-barrel oil.

According to consulting company PFC Energy, the United Arab Emirates, Algeria and Qatar would be the only OPEC nations able to balance their accounts in 2009 with oil below $50. Saudi Arabia would need oil prices just over $30 a barrel, according to Merrill Lynch, or slightly more than $50 a barrel, according to PFC Energy.

In contrast, Iran needs a price of $90 to $100 a barrel to break even in 2009. And because of President Hugo Chávez's soaring spending on social programs, Venezuela needs an oil price somewhere between $60 and $120 a barrel; the consensus seems to be somewhere around $90. On Nov. 24, Chávez told a news conference that $80 to $100 a barrel would be a fair price.

2 possible solutions

There are really only two ways out of this bind:

  • A government could, of course, cut spending and live within its means. (No, I mean it. That's not a joke. Stop rolling on the floor.) That's no more likely among the ranks of oil-producing countries than it is in the good ol' U.S. of IOU.
  • OPEC as a whole could cut production, raising global oil prices, while allowing the most hard-pressed countries to cut production only minimally. A cartelwide reduction in production might be able to raise prices, but that wouldn't solve the problem confronting Nigeria, Iran, Venezuela and the like. To fill the hole in their budgets, they need to see oil prices climb and to keep pumping at current rates.
The problem confronting OPEC is that it increasingly looks like it would take huge production cuts to just stabilize the price of oil. OPEC agreed to cut production by 500,000 barrels a day in September and then an additional 1.5 million on Oct. 24. It now looks like those two promised cuts -- not completely carried out -- reduced production in November to 30.98 million barrels a day, down from 32.2 million barrels a day in October.

Even cuts of that magnitude haven't stemmed the decline in the price of oil, however. And now some OPEC members are calling for production cuts of at least 1 million more barrels a day and perhaps as much as 2.5 million.

Taking (another) one for the team?

The burden of the cuts so far has fallen most heavily on Saudi Arabia. The Saudis accounted for about 44% of November's projected production cuts. And as OPEC's biggest producer, Saudi Arabia would be expected to pick up the bulk of the next round of cuts, too. The Saudis produced 9.45 million barrels a day in September. That's roughly a third of OPEC's total production.

OPEC's Nov. 29 meeting showed that the Saudis aren't yet willing to step up to the plate with another 500,000- to 1-million-barrel-a-day cut in production at a time when the government is announcing cancellations and delays in its plans to diversify the Saudi economy. Adding up all the cuts actually delivered showed that OPEC had cut production by only 850,000 to 1.2 million barrels a day instead of the 1.5 million promised in October.

And the Saudis seem convinced that Iran, OPEC's second-largest producer, and Venezuela have cut their output by less than they claim. No wonder that the Saudis wanted to wait for more production data before agreeing to further cuts. If what the Saudis hear, or think they hear, is that they've made cuts but that other OPEC members have reneged on their promises, then you can expect them to agree on Dec. 17 to cuts that are much less than Venezuela and Iran are talking about.

The Saudis also got in a not-so-subtle dig at Iran and Venezuela at the Cairo meeting by calling for a $75-a-barrel price for OPEC oil. That would be a huge improvement from current levels but noticeably short of the target championed by Venezuela and of the $90 to $100 a barrel that many experts believe Iran and Venezuela need to balance their budgets.

OPEC's inability to agree on any additional production cuts in Cairo means oil prices will fall further and that the problems confronting the governments of oil producers such as Nigeria, Venezuela and Iran will ratchet up toward crisis. That would pressure OPEC to do something dramatic at its Dec. 17 meeting.

Where Russia fits in

At the same time, the lack of production cuts in Cairo will increase short-term pressure on Iran and Venezuela to cheat on the October production targets and keep production above quotas. (Due to a near civil war in its oil fields, Nigeria's production is falling with or without OPEC quotas.) That, in turn, will make the Saudis even less likely to want to cut production to bail out OPEC members who haven't kept to their quotas.

Even though it isn't an OPEC member, Russia will play a big part in deciding how the future of OPEC plays out. Russia, which produces roughly as much oil as Saudi Arabia, has made noises about coordinating its production policies with OPEC. So far, those noises are exactly that, and the country shows no signs of following OPEC's lead by intentionally cutting production. The sight of a non-OPEC Russia taking advantage of improvements in oil prices created by Saudi Arabia's cuts in production will just increase Saudi resistance to disproportionately sacrificing for the profit of others.

If the September and October production cuts don't do the job (and almost nobody in the oil industry thinks they will) and OPEC goes into its Dec. 17 meeting faced with tumbling oil prices and massive quota flouting, the cartel could slip into public disagreement. An increased level of suspicion and recrimination entering 2009, a year that will see massive budget distress for many OPEC countries, could make it impossible for OPEC to agree on any course of common action.

A shadow of its powerful self

That wouldn't be enough to cause the formal breakup of OPEC. But it would be enough to reduce the cartel to a powerless shell. OPEC might effectively break up into regional or ideological subgroups, each pursing its own market agenda. A further breakdown could see individual oil producers inside and outside OPEC pursuing strategies based only on self-interest.

Consumers around the world would cheer at the breakup of OPEC or even at its devolution into a powerless shell organization. Without OPEC, individual oil producers would pump as much oil as they could in the short term, and oil prices would fall.

That's not good news, of course, for companies that make their money selling oil field infrastructure, because lower oil prices would mean less money to invest in oil field development. It would be really bad news for companies developing more-expensive unconventional sources of oil because they couldn't make a profit competing against cheaper oil. And it would be potentially devastating to emerging alternative-energy technologies, which would be forced back into reliance on government subsidies at a time when governments have plenty of other things to do with their money.

If you believe in some version of peak oil, which I do, then a post-OPEC free-for-all in the oil markets looks like a disaster. As it becomes more and more expensive to extract conventional and unconventional oil, the world is already looking at a bad case of underinvestment. The International Energy Agency has warned that a huge supply crunch awaits the world on the other side of the current supply glut because of underinvestment in new supplies of oil. Lower oil prices would just make that underinvestment worse.

Source: MSN Money

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