CRISIS MEANS CHANGES FOR OIL MARKET, OPEC

Fereidun Fesharaki, David Isaak
East-West Center
Honolulu

A reasonable observer might ask why the Iraqi invasion of Kuwait makes such a big difference in oil prices. After all, through much of the 1980s, Iran and Iraq were engaged in a full-scale military conflict that squeezed supplies and destroyed billions of dollars of production facilities in the gulf, yet the price sagged and ultimately collapsed.

The answer, of course, is that the current supply/demand balance in crude is far tighter than in the 1980s, but this simple answer masks a situation that is actually quite complex. Throughout most of the 1970s, the balance between productive capacity and demand was not as tight as usually perceived; many countries had excess productive capacity that they refused to employ.

The marginal supply of oil on the export market is governed by a handful of large producers, most of them members of the Organization of Petroleum Exporting Countries. Their absolute productive capacity is not as important to the market as their "preferred production" level-a qualitative concept that is unfortunately vital to understanding market behavior.

An OPEC nation's preferred production level is dependent on a wide range of factors, including financial needs, utilization facilities for associated gas, the crude requirements of government-owned downstream investments, political pressures, and, of course, the geological constraints of the system.

For many of the OPEC members with high populations, the geological constraints have always dominated; they would like, under most circumstances, to produce near capacity. For the low-population, capital-surplus states that range from Saudi Arabia and Qatar to Libya, strategy has always been the most important factor.

At a number of points in the 1970s, demand pressed against preferred capacity, and there was continuous upward pressure on prices as a result. In the mid-'80s, the overhang was huge, but by the end of the decade there was little room for a major cut in supplies.

As a result of the soft markets of the 1980s, many countries cut their investment plans savagely, and a great many, notably Saudi Arabia, lost substantial amounts of capacity. Based on investment plans laid in each OPEC country and the demand growth profiles around the world, our projections were indicating a major capacity crisis as early as 1993.

Saddam Hussein may have unwittingly done the world a favor: By cutting supplies at a time when capacity and strategic stocks are still sufficient to cope with the shortfall, he has caused a major rethinking of capacity planning that may avert a larger crisis in the mid-'90s.

In addition to the basic squeeze on crude supplies that resulted from the invasion, there has been a new component to the latest Mideast crisis: product supplies.

The refinery expansions in the gulf, most notably in Saudi Arabia and Kuwait, have acquired established overseas markets. The cutoff of supplies from Kuwait has caused a major naphtha shortage in the Far East, and the Saudis have curtailed supplies of middle distillates to meet the needs for major military action. The gulf is no longer just a supermarket for crude oil; it has become a major supplier of finished products.

1990 IS NOT 1979

Events in the gulf could almost be ignored through much of the 1980s. The latest crisis does not indicate, however, that we are in for a replay of the industry situation following the Iranian revolution; the industry does not need to tighten its belt just yet.

First, one of the most notable features of the '80s was the near collapse of the refining industry. Capacity was tight all through the 1960s and early 1970s, but the signals of a demand slowdown after 1973 did not affect construction plans; worldwide, the industry kept building capacity at an astounding rate. By 1980, there was over 80 million b/d of refining capacity, when refinery runs had barely exceeded 60 million b/d.

The huge refinery overcapacity has been whittled down by scrapping and demand growth. Capacity utilization is improving, and although building is heating up again, especially in the Far East, only 3.3 million b/d of new capacity is firmly planned. Thus, while overbuilding is always possible in the longer term, the current Mideast crisis is not occurring at a time of rapid construction; the refining industry will not face the kind of slump seen in the early '80s, even if demand growth is slowed.

The second reason that any downturn in the industry will be less severe than in 1979 is that the structure of product demand has been permanently altered.

The great post-'79 slump in demand was largely a cut in fuel oil consumption; the decline in demand for gas oil and lighter products was much smaller. Most of the "discretionary" use of fuel oil has already been cut out of the system where alternatives are available. Although a new price hike will result in some amount of switching, it is unlikely to cut demand as severely as in the early '80s.

Furthermore, the resilience of gas oil and lighter products in the Asia-Pacific region is even greater than in the world at large. Since about half of the anticipated demand growth in the first half of the 1990s is in this region alone, higher prices should have far less effect today than 10 years ago.

Finally, world politics have changed. U.S. troops massed in the gulf in 1979 would have threatened a superpower conflict; today there are options that were unthinkable before.

The events of the 1980s have changed the perceptions of many OPEC members as well. The collapse of revenues during the oil glut has led to a more widespread acceptance of what might be called "the Yamani doctrine":

Stable and reasonable prices, low enough to maintain a steady increase in demand and growing at a steady rate, do more to maximize OPEC nation revenues than pushing prices as high as the short term market will bear.

OPEC will continue to have its price hawks, but in general a more businesslike subgroup within OPEC might actually be able to control prices in future years. Five gulf countries (Saudi Arabia, Kuwait, Iraq, Qatar, and the U.A.E.) are likely to control over 20 million b/d of capacity by 1995.

THE MARKET TOMORROW

The 1980s saw a number of new developments: decreased reliance on OPEC, the expansion of long-haul trade in products, and narrowed crude-quality differentials. All of these trends are likely to reverse in the 1990s. In general, OPEC's share of an even larger trade will grow substantially.

Because of expanded refining facilities and extensive upgrading, as well as a gradual elimination of the capacity surplus that led to aggressive interregional marketing, however, our calculations suggest that interregional trade in products will stagnate in the 1990s.

Some new long-haul trades-perhaps to the U.S. West Coast from Asia, for example-are likely to emerge, but most countries will be increasing domestic crude runs to meet domestic needs. The need for short-haul, balancing movements may actually increase, but many of the major product exporting nations will be consuming an increasing amount of their own production.

Crude quality differentials will return to the market and may widen beyond those seen in the past. Pressure on gasoline and naphtha supplies will give light crudes the kinds of premiums they once commanded, and increasingly stringent environmental standards coupled with a decline of sweet crudes on the export market point to an increase in sulfur differentials in the coming decades.

OPEC itself may also see some changes in the 1990s. Some important exporters, such as Indonesia, will nearly disappear from the market as domestic needs grow. In terms of capacity, Libya and Iraq have been engaged in a long term switching of places: Libya, which once had about 3.3 million b/d of capacity, will fall into the 1-2 million b/d range, while Iraq, which had only 1.8 million b/d of capacity in 1970, will push past 4 million b/d in the 1990s.

The events in the Persian Gulf are likely to result in a major change in OPEC's balance of power, irrespective of whether there will be an actual military conflict or not. The days where three oil exporters (U.A.E., Kuwait, and Saudi Arabia) would together decide the fate of the oil market and then simply announce their decisions to remaining OPEC members may be coming to an end.

While Saudi Arabia will clearly remain the most powerful OPEC nation, the decision making process will become much more even-handed, and inputs of the other OPEC nations will be given more serious weight.

In the end, however, both Iran and Iraq have similar long term interests, as do Saudi Arabia, U.A.E., and Kuwait. These five nations with large oil resources must keep oil prices at moderate levels if they wish to stay in business. Despite current political differences, we feel sure they will end up on the same side sooner or later.