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Opec stares into the abyss

The oil-price collapse has weakened Opec. The cartel is scrambling for a response, write Derek Brower and Tom Nicholls from Vienna

FACED WITH a depression in oil prices, Opec's strategy has always been to cut production. But the cartel's ability to effect a supply side rescue has, this time, been overwhelmed by the fundamental shifts under way in the global economy. Demand rules the game, and Opec's cards are suddenly very weak.

Last month's ministerial meeting implicitly acknowledged this. The group ruled out another immediate cut in supply, pinning its price hopes on a recovery in the world's economy next year and tighter compliance this year with quotas it already has in place.

That strategy drops the ambition, announced at the December meeting in Oran – at which the group slashed quotas by 4.2m barrels a day (b/d) – to secure a "fair price" for oil of $75 a barrel. Some of the oil ministers attending a two-day seminar in Vienna last month, such as Venezuela's Rafael Ramirez, still spoke of pushing oil to $70-80/b. But such talk is now "off message", says one analyst. Opec's policy for now is "stability" in the price.

In the week following last month's ministerial meeting, that strategy brought some immediate rewards: prices firmed above $50/b. But the reasons for that $7/b gain belonged not to Opec, but to the US, where the Federal Reserve surprised markets by pledging $300bn to buy up long-term treasury bonds and $0.75 trillion to shore up mortgage-backed securities. A rumour that Russia might be edging closer to joining Opec – a prospect greeted with little enthusiasm in Saudi Arabia – also drew some bulls back into the crude market.

So at least Opec can be grateful that its decision to roll over December's quotas did not trigger another sell-off. Nonetheless, the movement in the crude price after the Fed's announcement told the bigger story of the oil market: consumers are in the driving seat.

That is the legacy of the great bull run of 2006 to 2008, which peaked with last summer's historical high of $147/b. As oil soared above $100/b, Opec ministers continually said such prices would be bad both for consumers and producers – even while they were reaping the riches for their energy-dominated economies. The analysis was correct, but few within the cartel can have imagined the peak's disastrous consequences for the long-term viability of Opec's business.

This is a triumph for consumers, but they should avoid triumphalism. Cheaper oil now will help stimulate economic growth across the world – the equivalent of a trillion-dollar stimulus package, says Nobuo Tanaka, head of the International Energy Agency (IEA). The wiser heads in Opec understand this, which is why sense prevailed. With the world's economy still spluttering, the cartel revealed that the "time is not right" to pursue its $75/b target. Another output cut, it calculated, would artificially inflate oil prices and delay global economic growth and a recovery in oil demand. Things remain fragile, to say the least: the IMF expects a 0.75% contraction of the world's economy this year.

But cheaper oil, even if it prompts a recovery in demand (which will be at least 1m b/d lower this year than last, says the IEA) is painful for many Opec states. While the sun was shining, there was little incentive to diversify economies and beef up sectors that do not rely on oil and gas. But with prices low, such a strategy is necessary, but more difficult.

There are other problems for the group. Power is now draining away from producers as quickly as they accrued it during the bull run. This will put relations between national oil companies (NOCs) and the international oil companies (IOCs) on a new footing. As recently as last year, Tony Hayward was conceding that the majors would need to scrap the old model "that requires ownership of reserves and production". His company, BP, had been on the frontline of the IOC-NOC battle in Russia. But now, terms for access are easing again as producer countries accept that cash-rich companies with expertise might be useful after all.

Hayward made that speech in July 2008. It seems like an age ago, and the collapse in oil prices since then points to another big problem for Opec and other resource holders. The price peak woke a giant whose reach has stretched from the forecourts of gasoline stations, to the boardrooms of cash-strapped airlines, to the White House and its plans for a green new deal. The oil-price shock has changed oil-consumption patterns with astonishing speed. It is a trend that scares Opec.

So the cartel's frequent argument that renewable energy and biofuels cannot replace hydrocarbons are now at the front of its strategy to shore up demand for its oil when the global economy recovers (see box). Saudi Arabia's oil minister, Ali al-Naimi, made that argument again last month in Vienna (see p2). Shell's chief executive, Jeroen van der Veer, made similar comments – and, for good measure, his company has scrapped many of its green businesses.

Talking down renewables

Opec has good reasons to talk down the renewables revolution. And its argument is correct – for now. Renewables are too expensive, unreliable and too small to provide a genuine power-sector alternative, let alone for transportation. Reminding the world of this is helpful, lest the green rhetoric create unrealistic expectations for consumers. Even during the worst economic downturn since 1945, the world is still consuming 85m b/d of oil. And the IEA still expects demand to grow well beyond 100m b/d within two decades. Renewable energy cannot replace that.

Not yet, anyway. But the logical consumer response to Opec's dampening of the renewable agenda ought not to be to abandon the project, but to step it up – quickly. Speed is necessary because, Opec says, another sharp rise in oil prices awaits when world economic recovery begins. Opec's argument on this front should also keep planners in consumer countries awake at night. Abdalla El-Badri, Opec's secretary-general, says its members are scrapping some 35 upstream projects that are not viable at today's oil prices.

Outside Opec, the trend is already evident in costly regions such as the oil sands, where forecasts of $100bn of investment by 2020 now look foolish. That is a threat to Alberta's oil-sands-dominated energy sector. But Canada will find it easier to survive the downturn than many Opec members, because the country's economy has more successfully diversified into other areas, such as manufacturing and financial services.

With few exceptions, Opec states are far more exposed to the price collapse and its effect on revenues (PE 1/09 p4). But Qatar, for example, can get by nicely at much lower oil prices; and Algeria's energy minister, Chakib Khelil, told Petroleum Economist that his country is in "very good health" economically (see box).

Nonetheless, as a group, Opec's message about the downturn is that it will hit upstream spending plans; and that this will lead to a repeat of the tightening in the oil market witnessed between 2006 and mid-2008. The solution, Khelil said, is a "reasonable price". Without that, "it's definite that people will not invest, or will postpone their investments." Another price spike "in a couple years" is, therefore, "very likely ... We're going to have a crunch again – a worse crunch."

This argument is true as far as it goes: low oil prices cause investment to decline and demand to rise. Even Saudi Aramco – whose capacity will reach 12.5m b/d by the middle of this year, according to al-Naimi – is cutting back on its spending. Last month, it halved to $60bn its planned investments to 2014. The problem, said Khelil, is that costs have not fallen nearly as quickly as the oil price. Building a refinery, for example, costs three times as much now as in 2000. But oil prices are only about twice as high as they were a decade ago.

Yet if an oil-price spike is just two years away the group's argument is weak. Oil producers – companies and countries both – are fond of saying their decisions are made for the long term. Chevron boss Dave O'Reilly said at last month's Opec Seminar that, even at present levels, oil prices are within the major's planning range. Why would a producer cut back on spending if prices were about to rise rapidly again?

The answer might be that Opec is more scared of the market fundamentals than it has been before. The group's spare capacity already amounts to as much as 6m b/d, according to some analysts. And it will rise still further as the new Saudi fields come on stream and if compliance with the existing cuts rises beyond 80%. Those are both bearish signals to the market. So are forecasts for the call-on-Opec crude, which the IEA says will remain flat this year.

Cheaper oil should, eventually, force down some of the costs that remain stubbornly high. Oil-sands producers, for example, will have to bring down the marginal cost of their production to adapt. The industry's history of technological innovation suggests that will happen.

So what can Opec do, beyond bickering about biofuels and pleading with consumers to abandon green dreams? Compliance with quotas is high by the cartel's standards, but more could be done. Adhering fully to its quotas would at least give Opec's strategy a chance to work. And Saudi Arabia, suggests the IEA (see Table 1), is doing the bulk of the cutting. More equitable compliance would prevent an internal conflict between the cutters and the quota cheats. But the real answer is that Opec members should start tidying up their own economies and mitigating their exposure to a sustained period of low oil prices.

For now, the world cannot afford $75/b oil. If Opec wants to ensure oil retains its long-term share of global energy demand it should not talk up another price spike. The last one was a nightmare for consumers and the reaction has fundamentally altered the balance of power in oil markets. The global addiction to oil is threatened now more than ever. The environmental reasons to reduce consumption are irresistible. Opec would be unwise to oversee another price shock any time soon. Some members think their economies depend on an oil-price recovery. In reality, Opec's survival depends on keeping oil cheap and available.

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