Why there's too much oil

An unstable market is not good for the industry that supplies it. A volatile market is endurable; an unstable one is not.

The difference between these market characteristics has been suggested here before (OGJ, Jan. 11, 1999, p. 23). A volatile market changes rapidly. An unstable market inclines toward upset.

By these terms, the oil market is unstable because it tends to create excess supply. To some extent this is beneficial. A market for something as important as petroleum must resist supply interruption, which is why reliable suppliers pay money to hold oil in inventory. It is also why the capacity to produce crude oil usually exceeds demand, which in turn is why mechanisms have always been in place to govern the excess.

Governing mechanism

Since the turbulent 1970s, the market's governing mechanism has been a group that includes the world's least-costly producers-the Organization of Petroleum Exporting Countries. In due course, OPEC began assigning its members production quotas in an effort to support the crude price at target levels. The group still sets quotas but now generally calibrates its overall supply limit to expectations about demand rather than to elusive price targets.

The burden of holding production capacity idle thus gravitates to OPEC, mainly Saudi Arabia. And in times of price weakness, such as the present, the group calls upon members to sacrifice some of their generally low-cost production before higher-cost nonmembers cut theirs-to forgo cost advantage when competition gets tough, in other words. The reverse incentive usually keeps OPEC from achieving all of its agreed cuts, which forces some measure of higher-cost, non-OPEC production to give way, too.

It's a messy process, reliant on OPEC politics and economic pain. And it tends to protect production on the economic margin-the costliest flow that should cease first in a price slump. This is one way the market sustains excess supply.

Aggravating that tendency toward surplus is a distortion of capital flows. Important producers, mostly around the Persian Gulf but also until lately including Venezuela, have spurned foreign capital for exploration and production. Denied access to world-leading prospects in, for example, Saudi Arabia, Kuwait, and for other reasons Iraq and Iran, but encouraged by OPEC's exertions on behalf of the crude price, investment capital thus has found its way to Alaska, the North Sea, offshore West Africa, the Caspian region, and other modern upstarts.

For these two reasons-OPEC supply restraint and rejection of foreign capital by key producers-capacity to produce has grown more than it would have otherwise outside the exporters' group. All in all, such growth is good, certainly for a consuming world assured of supply at low cost. It was especially helpful while demand for oil was steadily rising.

When demand sags in a market inclined toward surplus, however, adjustment turns into jolt. The Asian demand slump occasioned by a financial crisis in 1997 threw the oil market into a tailspin from which it has not yet recovered. With the cheapest production at uneasy idle and expensive production flowing precariously at capacity, and with new production due on stream outside OPEC, the predisposition to supply became a monster now squashing companies and careers.

Hurting the industry

This is not to say that oil should come strictly from the least-costly producers. Nor is it to deny the need for some inevitably political mechanism to align supply with demand and maintain a cushion.

It is clear, however, that the mechanism now in place hurts the oil-producing industry overall, not because of what it is but because of how it works and how that destabilizes the market. If OPEC reaches the same conclusion this week and begins looking for a better way to handle oil supply and capital attracted to its development, the meeting in Vienna will have been a long-term success.