Why OPEC cuts will work

Key members of the Organization of Petroleum Exporting Countries will succeed where they have failed before. They will make enough of the production cuts they promised in Vienna this month to return benchmark crude prices to levels they find acceptable. They will succeed, because they bear most of the cost of failure.

July 6, 1998

4 min read

It is easy to be skeptical about the Vienna production agreement. OPEC's past attempts to coordinate production have quickly unraveled. Producers seldom cut as much as they promise to do. And it's a rare producer that sticks with output limits once restraint begins to hurt its economic interests. Saudi Oil Minister Ali al-Naimi thus was correct to warn that OPEC members probably won't make the full 1.355 million b/d of reductions announced in Vienna (see related story, p. 33).

The goal

If OPEC doesn't exactly achieve its production targets, however, it will cut enough to lift crude values. What it must do, with whatever help it can muster from nonmember producers, is align production with total demand less the sum of a) 2 million b/d of Iraqi crude pouring into the market oblivious to price plus b) volumes available from surfeit inventories. It won't be easy. But it will happen.

In past price slumps, OPEC could talk about production cuts and count on outsiders for much of the sacrifice. The outsiders had higher costs and thus hurt earlier and more intensely than OPEC members did as prices fell.

This time, OPEC producers are more vulnerable than before and have incentive stronger than ever to lower output in defense of price. They now suffer at least as much as other producers do when the crude price drops toward $12/bbl.

Oil costing $15/bbl to produce is long gone, victim of the price collapse of 1986. And private oil and gas companies have spent the 1990s slashing costs to previously unimaginable levels.

In direct contrast, costs have risen in OPEC's oil states, where oil incomes dominate national revenues. In places like Saudi Arabia, Kuwait, Abu Dhabi, and Venezuela, field operating costs remain comparatively low. But they can't be isolated from the costs of operating governments and sustaining populations that in many cases have grown dependent on state largesse. In the Persian Gulf oil states, national overheads include outlays for an accelerating military build-up.

Economists can debate the quantities of these effects. Whatever the amounts, OPEC's big guns have lost much of their comparative advantage from field costs held low by splendidly performing reservoirs and scale economies. Doubters should note that despite low prices, and notwithstanding operational trimming announced by commercial companies, non-OPEC production is still expected to increase this year.

As a result of all this, pressure on OPEC's major producers to cut output is unusually strong. This is why prospects for the Vienna agreement are unusually good.

Longer-term questions remain. OPEC's major exporters certainly retain an overwhelming long-term advantage with reserves that are orders of magnitude larger than anyone else's. But how many cycles of $12/bbl oil can they endure trying to wait out attrition of the competition?

Pain thresholds

The other option for oil states is to replicate cost-cutting and risk-management tactics of their competitors in the crude oil market. That means trading and hedging crude and products, reducing welfare, ending subsidies for oil products, putting nonoil-producing enterprises on a commercial footing, and trimming military expenditures. Especially in oil states of the Middle East, the political obstacles to this option are high. Yet the biggest mistake these states can make is thinking new competitive pressures can somehow be ignored.

Outside of OPEC, a big mistake would be to believe that the Vienna production agreement will fail solely because past efforts of its kind haven't worked. The lesson for everyone is that pain thresholds have shifted in very important ways.