OPEC at the crossroads with non-OPEC nations

David Knott
Senior Editor

Trading activity is rising at London's International Petroleum Exchange, as companies attempt to hedge their risk ahead of the June 24 OPEC meeting. Just before the previous meeting in March, IPE's daily trading volumes hit an all-time high. Photo courtesy of IPE.

Leo Drollas, CGES
Non-OPEC producers are expected to increase production by 700,000 b/d this year and in 1999. This leaves some leeway for OPEC production increases. [8,433 bytes]
IPE's Richard Ward
The production cutting agreement caught everyone on the hop, and there followed a flurry of trading activity. In the current climate, we expect traded volumes to increase still further. [11,625 bytes]
While Norway pledged, in solidarity with OPEC production cuts, to reduce total oil production by 100,000 b/d beginning May 1, a number of major field developments are expected to be completed soon, bringing new oil to the market. Here, the Taklift 4 crane barge lifts a turret on board a floater destined for ?sgard field this summer. Photo courtesy of Smit Maritime Contractors, Rotterdam. [9,371 bytes]

The next meeting of Organization of Petroleum Exporting Countries energy ministers in Vienna on June 24 is a potential watershed.

If OPEC's ministers come up with an agreement that pleases the markets, crude oil prices will likely be shored up after months of uncertainty. If they make the wrong call, prices could continue drifting down slowly or even plummet.

At a time when oil production capacity is significantly greater than demand, producers face a dilemma: they need increased revenues to balance their domestic budgets, but if they produce too much oil the price will fall.

While the crude oil market fundamentals suggest the bulk of pressure on prices is downwards, OPEC and non-OPEC producers recently forged an agreement that floated crude prices off rock bottom.

In late March, OPEC countries promised total production cutbacks amounting to 1.245 million b/d, while other major exporters pledged to trim exports (OGJ, Mar. 30, 1998, p. 22).

Fadhil Chalabi, executive director of London's Centre for Global Energy Studies (CGES), noted that Mexico, Norway, and Oman were among a group of non-OPEC producers that, for the first time, has pledged formally to make voluntary output cuts to protect oil prices.

"This had a very positive effect on the market," said Chalabi, "and prices initially went up by about $2/bbl. But then the markets realized that the total pledges had not been fully implemented."

Middle East Economic Survey (MEES) reported that OPEC's April production averaged 28.345 million b/d, which was down from the 28.82 million b/d produced in March but less than promised (OGJ, May 18, 1998, p. 40).

"In addition," said Chalabi, "Mexico and Norway announced they were no longer prepared to undertake further production cuts. Again, non-OPEC producers seem to want OPEC to reduce output, and OPEC wants Saudi Arabia to reduce."

Meanwhile, Russia is pursuing the possibility of joining OPEC. A senior Russian energy minister told agencies in Moscow that Russian membership in OPEC was discussed at a meeting between Russian officials and OPEC Sec. Gen. Rilwanu Lukman in Mos- cow.

Russia agreed to take part in the forthcoming OPEC meeting in Vienna on June 24, as an observer. A Mexican delegation attended an OPEC meeting in March 1997, while Russia attended as an observer at a meeting in 1993.

Market status

Chalabi reckons that the industry will need to reduce global production by a further 1 million b/d if it wants to maintain prices at $14/bbl for the OPEC basket crudes during the second half of the year.

"But who's going to do this?" said Chalabi. "Within OPEC, Venezuela, for example, has made huge investments and is not willing to shut in production.

"We are in a situation whereby the financial pressures on countriesellipse should incite them to reduce production to increase prices, but where there is an unequal sharing of the burden of production cuts."

Arnstein Wigestrand, vice-president of crude oil and NGL trading at Saga Petroleum AS, Oslo, reckons current oil prices are already too low for the dominant producers in the Middle East and within OPEC.

"There are signs within OPEC," said Wigestrand, "that members are already discussing further cuts. If oil prices don't move upwards before the meeting, they may decide to do something."

Wigestrand told OGJ that OPEC needs to take a position at the Vienna meeting, even if members only agree to wait a month and look again at oil prices before taking action.

Geoff Pyne, oil market analyst at UBS Ltd., London, reckons that OPEC will agree in Vienna to cut production if the price of Brent crude is below $14/bbl and will not cut if Brent is priced at more than $15/bbl.

"Any sane analysis," said Pyne, "would show that, even in the $14-15/bbl Brent price band, things are getting worse, not better. On balance, I think, OPEC would cut output if the price is in this range."

Pyne said that choosing a desirable higher price and cutting production to achieve it would be wrong for OPEC. Instead, OPEC should look to return oil prices to their long-term equilibrium value: about $16/bbl for Brent crude.

"Any price above this level would set in place market forces that would lead to price cuts in the future," said Pyne. "A high price level would not be sustainable.

"If OPEC tries for too much, other problems will appear: there will be less cooperation with non-OPEC producers, and the risk of defaulting on production agreements would be higher.

"Most importantly, if there were a further big cutback and production were shut in, the underlying growth in spare production capacity worldwide would lead to more pressure on producers to get their oil out."

Trading boom

Mexico brokered the exports reduction agreement as a direct result of prices reaching a 10-year low, with prompt Brent falling almost to $11/bbl in mid-March.

Crude oil markets have been plagued by uncertainty since the first quarter, and this has been reflected in volumes of crude oil traded. London's International Petroleum Exchange saw trading volume records break almost daily at one point.

Richard Ward, IPE's director of product development and research, said: "When OPEC meetings occur, traded volumes increase because of uncertainty in the market."

Ward said companies are trying to optimize their positions using the market's hedging mechanisms. They are doing so ahead of the June 24 meeting, but not so feverishly as before the March meeting.

At that earlier meeting, OPEC sanctioned an agreement with non-OPEC producers to reduce global oil production by 1.636 million b/d, but traders greeted the news with skepticism (OGJ, Apr. 6, 1998, p. 35).

Ward said that, since the agreement took effect on Apr. 1, average daily trading has been 73,000 contracts, equivalent to 73 million b/d of Brent crude.

The first quarter trading average was just more than 52,000 contracts, but the average for March, when the previous OPEC meeting occurred, was 83,400 lots/day.

Just ahead of that meeting, said Ward, IPE's Brent futures reached a new peak with 101,776 contracts-equivalent to almost 102 million bbl of oil-changing hands in a day.

"The production-cutting agreement caught everyone on the hop," said Ward, "and there followed a flurry of trading activity. In the current climate, we expect traded volumes to increase still further."

OPEC long view

OPEC Sec. Gen. Rilwanu Lukman predicted recently that, by 2020, OPEC will be producing 50 million b/d of oil, compared with 28 million b/d today.

OPEC's share of worldwide production is expected to grow, mainly because today's global oil demand of 70 million b/d is expected to rise to 100 million b/d by 2020.

"Non-OPEC oil supplies may continue expanding in the short to medium term," said Lukman, "particularly from the North Sea, the former Soviet Union, and non-OPEC developing countries, but it is unlikely that these sources can sustain their disproportionate market share in the long run.

"In this event, the world would need to rely more and more upon OPEC for petroleum supplies. OPEC member countries should experience strong and rapid growth in their oil sectors in the foreseeable future. And that means large-scale investments and associated developments that will create jobs and spur economic development, not only within OPEC but worldwide."

Lukman paints a similarly healthy picture for OPEC gas prospects. OPEC expects worldwide gas demand to grow by 2.5% a year from now to 2020, with members' share of worldwide gas supply growing from 22% of the market today to more than 26%. OPEC countries' domestic gas demand is expected to rise by more than 4% a year up to 2020.

Near-term concerns

Leo Drollas, chief economist at CGES, told OGJ that global oil demand is expected to rise by 1.6 million b/d/year to 2000, and that, by 2000, OPEC and non-OPEC producers are expected to have raised combined output by 2 million b/d.

Non-OPEC producers are expected to increase production by 700,000 b/d this year and in 1999. Some of this, said Drollas, will be "catching up" after delays in major developments.

"This leaves some leeway for OPEC production increases," said Drollas, "but if OPEC producers go flat out now, they won't be able to increase later because of the stock overhang."

Drollas sees this as the problem OPEC will face if it does not cut production by enough at the June 24 meeting. He anticipates demand for OPEC oil will be 29 million b/d in 2000, up only 1 million b/d from now.

"This is not much of an increase," said Drollas. "Lower prices and 29 million b/d production is not a great outlook for OPEC. It appears now that there was false euphoria within OPEC in 1995-96."

However, Drollas feels the Asia demand outlook is not as bad as might be expected (see related story, p. 26). While some countries are in bad economic shape, actual demand has not fallen much.

In Indonesia, for example, said Drollas, the government brought products prices down, so demand has been maintained, while in South Korea, demand from refiners is returning after they ran down stocks in the first quarter.

Non-OPEC freeze

Christopher Chew, head of global energy research, ING Baring Securities Ltd., London, said most non-OPEC producers are operating at close to full capacity and have no significant capacity to spare.

"After the first quarter results from the oil majors," said Chew, "I figure that lots of projects will be delayed. Non-OPEC production will not grow in the near future as it has in the last 12 months."

ING Baring reckons the 33% collapse in first quarter oil prices had a devastating effect on oil companies' upstream profitability, particularly among the independents, several of which had losses on the quarter.

"The multinationals," said Chew, "were in most cases better able to defend profitability, but even here, earnings contractions of 60-70% were not uncommon."

As a result, said Chew, reductions in planned 1998 capital spending are being announced. Most recently, BP Exploration Operating Co. Ltd. put development of U.K's marginal Clair discovery on hold once again.

Earlier, a BP official disclosed that the company will drill no exploration wells off the U.K. this year: "The oil price is very low at the moment, and there is a lot of uncertainty about the fiscal regime. Both of these made it difficult to maintain momentum on Clair."

Both BP and Shell U.K. Exploration & Production said recently that they could make a profit with Brent crude at $14/bbl, but Shell said it would cut investment plans if the price was expected to stay low (OGJ, Apr. 13, 1998, p. 26).

Complacency fear

CGES said that OPEC's April production cuts fell about 400,000 b/d short of the agreed target, yet prices rebounded high enough to lull OPEC into a false sense of security.

While the market was suitably impressed with OPEC's output-cutting initiative, said CGES, only Saudi Arabia, Qatar, and Kuwait met their pledges for April production.

Iraqi production rose 280,000 b/d from March output, while Indonesia was apparently late in notifying its producers. Iran's reported output remained unverifiable, and all others fell short of the pledge.

"Another 200,000 b/d of promised cuts, though, should materialize this month (May)," said CGES, "taking OPEC to within 200,000 b/d of its target, but any further movement towards it is unlikely.

"On the other hand, the Indonesian story could lead to supply losses, the North Sea is in maintenance, and there is still much uncertainty about actual Far Eastern oil demand.

"Nevertheless, on present indications, it is a matter of weeks at most before another wave of oil hits the market, which is why the OPEC cuts needed to be on schedule."

OPEC should have tried to meet its cutback targets, said CGES, to reassure its non-OPEC partners that it means business.

"As it is," said CGES, "higher prices have lulled OPEC into a false sense of security. There are always upside price factors to contemplate, such as the 13% annual decline in active workover rigs in North America to February 1998, suggesting that low oil prices are affecting upstream activity.

"However, if Iraqi oil keeps on flowing-as we believe it will-additional OPEC cuts will be needed in June. What might surprise OPEC members is the size of such cuts."

CGES reckons OPEC needs to reduce combined output to 26.5 million b/d in third quarter 1998, rising to 27.3 million b/d in the fourth quarter, to stabilize prices.

"This is a tall order..." said the analyst.

"Soon, we will be back to square one, looking once more for price leadership."

Iraq

CGES said that, while political unrest in Indonesia could raise concerns about the country's oil production, Iraq remains the most likely source of major supply disruptions.

"The current oil-for-food program ends in early June," said CGES, "and exports could be halted again. A 2-month absence of Iraqi oil exports would give other OPEC members a welcome breathing space.

"Although such a disruption is unlikely to boost oil prices substantially, it should be enough to yield an annual average price for dated Brent of $13.90/bbl without requiring huge cuts in output in the third quarter."

If there are no further disruptions to Iraqi oil exports, however, CGES predicts Iraq's production will exceed 2.1 million b/d for the rest of the year, with further increases likely if rehabilitation of oil export infrastructure proceeds unhindered.

"Were OPEC's total output to remain at around 28 million b/d throughout the second half of the year," said CGES, "prices would fall below $13/bbl (for Brent crude) and would be unlikely to recover this year.

"In this case, dated Brent would average just $12.50/bbl in second half 1998, (and have) an annual average price of $13.20/bbl. Maybe the best that oil producers can hope for in 1998 is to stabilize prices at around $14/bbl for Brent for the rest of the year and wait for a long, cold winter."

Saga's Wigestrand said another major factor affecting the run-up to the Vienna OPEC meeting is renewal of the oil-for-aid deal between Iraq and the United Nations: a new 6-month period was scheduled to start on June 3.

At the end of May, said Wigestrand, Baghdad was canceling cargoes due for export via Ceyhan, Turkey, and Mina Al-Bakr: "We think it is likely there will be a stop in Iraqi exports, but for how long is the big question.

"Last summer, Iraqi exports were halted on May 25 and did not resume until mid-August. Some are now saying they could be out for a couple of weeks, some for a couple of months."

Wigestrand expects both political and technical issues to decide when Iraqi exports will resume. However, crude oil traders are expected to have factored the Iraqi situation into their prices.

MEES reported that Iraq had agreed in late May to continue exporting oil for a fourth 6-month period but was waiting on U.N. Sec. Gen. Kofi Annan to approve a new $4.5 billion aid distribution plan.

Although the U.N. has approved raising of Iraq's output to a total of $5.3 billion worth of oil every 6 months, Iraq is expected to continue exporting about $2 billion worth every 6 months because of limited production and export capacity.

MEES said Baghdad is pushing for an agreement with the U.N. that will enable it to import $300 million worth of spare parts to renovate shut-in or damaged production and pipeline equipment.

Pyne believes Iraq's production will be the main factor holding crude prices in check for the coming year, and that the borderline between sanctions and allowable projects will become increasingly blurred.

Iraq is now producing as much oil as it can to meet the U.N. oil-for-aid conditions, said Pyne, and will soon be allowed to import equipment to help boost production capacity.

"From there," said Pyne, "it would only be a short step to allowing foreign oil companies help Iraq get the oil out. As time goes by, sanctions are becoming more and more irrelevant. I can imagine in a year or so that French oil companies will be operating in Iraq."

OPEC's mood

In the run-up to the OPEC meeting, OPEC officials have been making their concerns and views public through press reports and conference speeches.

U.A.E. Oil Minister Ubaid bin Saif Al-Nasiri, current OPEC president, told a conference in Abu Dhabi that further production cuts might be needed to bolster oil prices.

"The world oil market has relatively stabilized," said Al-Nasiri, "but oil prices are still low. We are not satisfied with the current level of oil prices. I think measures will be needed to correct the situation if there is any increase in supplies."

Saudi Arabia's Foreign Minister Prince Saud Al-Faisal revealed that Saudi Arabia and Iran have agreed to draw up a long-term oil price strategy.

Al-Faisal said, "We will not allow the price of this vital material to fall from its standard level, with assistance from other producers."

Meanwhile, Saudi Oil Minister Ali Al-Naimi told MEES the main issue for OPEC now is, "...how much oil needs to be taken out of the market if prices remain low. I think the right number should be approximately 500,000 b/d."

Also, Iran's Industry Minister Gholamreza Shafei told reporters during a visit to Kuwait late in May that Iran and Kuwait had agreed that OPEC and other producers should cut output further to strengthen oil prices.

"This move is in the interest of all these countries," said Shafei, "as their state budgets depend on oil revenues. It is important for OPEC to decrease production and to convince others outside the organization to do so."

What's ahead

Production cuts should be viewed as a short-term market stabilization mechanism, said Pyne, not a long-term method of choosing an oil price.

"On balance," said Pyne, "a further cut of 500,000-600,000 b/d for the short term, maybe over 3 months followed by a review, would be the best advice to OPEC."

Chew said the OPEC/non-OPEC cutbacks deal has worked so far: "It has stabilized prices, and it has stabilized expectations, which is even more important. Before the deal, there was much gloom and talk of $10/bbl oil."

Now, said Chew, the acceptable norm for the oil price is seen as $14/bbl for Brent crude. Now OPEC and non-OPEC producers must decide whether to try to push the price higher still, to $18/bbl.

"I have my doubts whether they will," said Chew. "There is still too much oil supply, and OPEC cohesion is unlikely to last. There is unlikely to be a push before the third quarter, and then people will be thinking about coming cold weather."

Chew feels OPEC and non-OPEC will only act to cut production further if oil prices slip significantly again: "OPEC will make further noises about commitment to raising the oil price, but no concrete action at the OPEC meeting is my bet.

"OPEC this time has proved itself quite adept at managing news and putting a spin on things. This enables them to keep something in reserve if prices fall again."

If, on June 24, OPEC gambles on further cuts lifting oil prices, and if those cuts do not work, Chew believes the crude market "...could go into a tailspin. There is still lots of potential for overproduction, especially if Asia's crisis deepens."

Chalabi predicts that, if prices fall below $11/bbl for Persian Gulf region crudes, then many countries, including non-OPEC producers such as Mexico, will be hurt so much they may change their position and seek further output cuts (see related story, p. 20).

"The recent relationship between OPEC and non-OPEC producers will not get any closer unless prices fall further," said Chalabi. "If the price is above $13/bbl for Brent crude, the producers will do nothing."

Wigestrand said he did not expect the current concerted actions by OPEC and non-OPEC producers to become a permanent development: "That will depend on market conditions, but we should never rule out the possibility of further non-OPEC cutbacks at a later stage, if oil prices remain low."

Chalabi concluded: "As for the OPEC meeting, the organization has a history of doing something to protect prices only when the oil price is falling very sharply. Otherwise, nobody will be willing to make a sacrifice."