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Global recovery, the oil price and OPEC indecision

“It was one of the worst meetings we’ve ever had,” Saudi oil minister Ali Naimi said after OPEC countries this week failed to reach agreement on increasing oil output, despite fears that high oil prices…

US traders respond to OPEC’s move to hold off increasing oil production.

“It was one of the worst meetings we’ve ever had,” Saudi oil minister Ali Naimi said after OPEC countries this week failed to reach agreement on increasing oil output, despite fears that high oil prices were endangering the world economy.

Just how significant is the failure of OPEC members to agree on increasing oil output?

It may or may not be significant. One data point does not necessarily give you enough information.

I think what is more relevant is that while they failed to agree on a change in quotas, they effectively agreed to stay with what they agreed to in December. The lack of agreed change has not led to an uncertainty about what they produce – they will continue to produce what they have been, so from that perspective there is no uncertainty.

Usually what happens with OPEC decisions is if there is an increase or decrease, the market takes a bit of a pause and checks to see whether the actions follow the words.

It takes several weeks, if not a month before you see the implementation of a change because it takes time to ramp up production.

What is likely to happen to oil prices - and exactly who is OPEC anyway?

OPEC has 12 members and has been around since September 1960, starting off with five members, coming out of a meeting in Baghdad.

Membership has ebbed and flowed. Ecuador, which is in there now was in early on, dropped out for a number of years, and then came back in again. Indonesia was in from very early on, but it suspended its membership two to three years ago because it became a net importer of oil.

Although I am not really an expert of this, the intra-politics (of membership) are very interesting. You’ve got more hawkish members which could fall into the category of “anti-western”, like Venezuela and Iran, who pretty much are never interested in expanding output because this has a tendency to, if not actually lower prices, take away upwards movement on prices.

Their interest is to take as much money out of the West as they can and get as much for their oil as they can.

It’s been suggested to me that some members may be at their maximum production right now. If they are, and Saudi Arabia, Kuwait and Qatar want to expand production because they have excess capacity, the tendency would be for the price to fall.

If Venezuela and Iran are at maximum production, their revenues are going to go down because they can’t sell any more barrels and the price is going to fall. They end up immediately losing revenues that way.

(So) if some of the members are at maximum production then the question is whether it’s because they don’t have any more oil they can tap into to expand production, or if they have simply made a strategic decision not to invest in productive capacity.

Fundamentally, I am not a believer in peak oil. There is plenty of oil below the ground but what we’ve been lacking in the last decade or so is adequate investment in productive capacity above ground.

Some of that is strategic decisions that if you are an oil producing country and it’s going to cost you millions to expand capacity, only to have that decision cause the price of oil to fall, you may hesitate in doing that.

There were a lot of reasons coming out of late 1990s and early 2000s where there was very little incentive to expand their productive capacity. Everyone was taken by surprise by China’s expanded consumption in 2003, 2004 and 2005 and a lot of scrambling went on to expand capacity.

Some of the dynamic we’re now seeing is due to a decision in 2004 by OPEC’s biggest producer Saudi Arabia to expand its capacity to provide for 2.5 million barrels a day of excess capacity in the marketplace.

Then they ran right into the global financial crisis and their 2.5 million barrels per day of excess capacity became 4.5 million. So they invested a bunch of money that they couldn’t recoup because they couldn’t use the extra capacity.

However, excess capacity adds insurance to the marketplace. Without it the market gets very nervous.

The reason is that if there is any disruption, say from a terrorist attack in Nigeria or labour union issues in Norway that shuts down any production, if someone like Saudi Arabia doesn’t have extra capacity, then the market gets tight and prices will be bumped (up).

Saudi Arabia’s excess capacity has been very important in keeping prices from rocketing into the mid-US$100s when Libyan production got taken off-line.

The oil media reported that the Saudis immediately got on the telephone to the refineries in Europe and said “how much do you need, and when”. Libya’s total capacity was under 2 million barrels a days and Saudi Arabia had the ability to completely replace that, almost over night.

So while the price went up due to uncertainty in the region and concerns the instability could find its way into Saudi Arabia, the excess capacity they brought online in the mid-2000s modified the volatility and upward rise in prices.

What are the geopolitical implications? Will this week’s decision affect the weak recovery in both Europe and the US?

The Gulf Arab states are much friendlier to the US and more interested in expanding production to moderate oil prices, especially when we still have significant recessionary impact in North America and Europe.

But it is Europe that depends on imports from those regions more heavily than the US does. The US is a heavy consumer but it is also the world’s third largest producer. Most people forget about the fact that the US still has very substantial energy resources and production.

And these days because of the significant expansion of natural gas from shale gas and other unconventionals, where there is any possible substitution between gas and crude oil there will be a moderating effect on the rise of the price in the US.

One way to see that is to observe the signicant change in the dynamic between North America’s benchmark crude oil, West Texas Intermediate, and the European benchmark Brent, which is coming out of the North Sea.

For the last decade, WTI was normally a one dollar or two more than Brent. For the last six months it’s gone very radically in the other direction. At the moment Brent is at US$120 and WTI is at US$102.

Recent general indicators are that the recovery in Europe and the US is weak. In effect, both Venezuela and Iran would be saying, if we expand production we could end up having a big fall in price because those economies are not recovering - and they don’t have a great desire to help those economies out by lowering the price of oil.

If you’re thinking just in terms of how one looks after their own revenue, Venezuela and Iran may have been very wise in leaving the price where it is and seeing whether there is any recovery forthcoming.

It’s also not clear right now, because the world has changed a lot, how much the price of oil would have to fall before it really had any significant impact on economic recovery and growth. Because oil has become a much smaller part of the economic activity of both Europe and North America.

What’s the future for OPEC? Are they likely to remain as powerful as they are now? What about other energies such as renewables and gas?

OPEC will continue to play a significant role in world energy, particularly the Middle Eastern countries. If the world economy continues to grow we’re going to need all the energy we can get from all sources, including OPEC and the Middle East, as well as renewables and other sources of energy.

This week, the International Energy Agency (IEA) released a new world energy update called “The Golden Age of Gas” which made alterations to their underlying assumptions of how the world was going to operate and how gas is going to play a much bigger role.

A bunch of that gas is still going to come from the Middle East. Qatar is the single largest producer of LNG with 77 million tonnes per year, so it has a very big role to play.

But Australia is going to close in on that capacity – if we put everything in place that is planned for the Northwest shelf on the west side and off the coal seam gas in the east, we’ll actually surpass Qatar by around 2020.

All of that gas will find a market. In terms of prospectivity outside the US, China also has the greatest prospects for shale gas of any country in the world by far; they’ve also got coal seam and tight gas and conventional gas, all of which they are looking at actively ramping up.

Plus they’ve got one pipeline out of Kazakhstan and looking at bring in gas out of Russia both out of East and West Siberia, so in effect pipelines coming in from either side of Mongolia.

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7 Comments sorted by

  1. Thuong Nguyen

    logged in via email

    Professor Ripple, thanks for the informative article. Recently the US took couple of traders to court (one trader is Norwegian and the other might be Saudi if my memory serves me well) because they vast volume of oil trades to push the price up and then suddenly released it into the market a few years ago causing the price collapse.

    If OPEC is able to agree or regulate on how many barrels are produced in a year then I think there should be some tighter regulation on the volume of oil trade contracts…

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    1. Ronald Ripple

      Professor and Director, Centre for Research in Energy and Minerals Economics at Curtin University

      In reply to Thuong Nguyen

      Dear Mr. Nguyen,

      I am unfamilair with the Norwegian and Saudi trader case you mention, and I pay a fair bit of attention to these markets. Can you point me to the actual case?

      From my understanding of how these markets operate, the "trading operation" you suggest does not sound credible to me. Moreover, speculators definitely do not dominate these markets. The market traders are still dominated by hedgers. However, these markets simply will not operate effectively and efficiently without the participation of speculators. And perhaps more important, speculators in the crude oil market are on both sides of the market, taking long and short positions, so there is no unambiguous directional pressure being placed on price by the participation of speculators.

    2. Thuong Nguyen

      logged in via email

      In reply to Ronald Ripple

      Thank you Professor Ripple. I've just searched the internet and there are a few articles on it. I am slow and a bit lazy to type so I'll copy some quote for you:

      "NEW YORK/WASHINGTON, May 24 (Reuters) - U.S. regulators launched one of the biggest ever crackdowns on oil price manipulation on Tuesday, suing two well-known traders and two trading firms owned by Norwegian billionaire John Fredriksen for allegedly making $50 million by squeezing markets in 2008.

      The Commodity Futures Trading Commission…

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    3. Ronald Ripple

      Professor and Director, Centre for Research in Energy and Minerals Economics at Curtin University

      In reply to Thuong Nguyen

      Dear Mr. Nguyen,

      Thank you for these stories and links.

      I will note, though, that it is very interesting that this manipulation was driven from the physical market, not the futures market. It is typically argued that "excessive trading" in the futures market is responsible for price rises (and volatility) due to speculators taking long positions. In this case the speculators actually took significant physical positions, driving price up, and then employed the futures market to make their profit…

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    4. Thuong Nguyen

      logged in via email

      In reply to Ronald Ripple

      Thank you, that makes it a lot clearer for me and saves me the time to find materials to read on it.