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June 29, 2012

Oil Under the Shifting Sands of OPEC

By Jason Simpkins of Wall Street Daily

OPEC has been a major force in the oil market since the 1960s, constantly sparring with demand to maintain favorable prices. However, the alliance has always been an uneasy one.

In the 1980s, for instance, Iraq increased its oil production – despite weak demand – to finance its war with Iran. That helped contribute to a supply glut that ultimately drove down oil prices, as well as the group’s export revenue.

Then in 1990, Iraq caused a price spike when it invaded Kuwait. At the time, Iraq owed Kuwait $14 billion of outstanding debt it accumulated during its war with Iran. Furthemore, Iraq felt Kuwait was overproducing oil, thus lowering prices and hurting its revenue at a time of great financial stress.

Aside from dustups such as these, more subdued, political conflict often centers around Saudi Arabia. The group’s largest producer insists on cooperating with the economic powers of the West to support global economic expansion. But that policy often puts the kingdom at odds with smaller member states which rely almost exclusively on oil exports for revenue and harbor significant anti-Western sentiments.

Chart Source: OPEC (added by EconMatters)

We saw that conflict play out again a couple weeks ago. At OPEC’s June 14 meeting, Saudi Arabia took a hard line on the group’s production quota, keeping it steady at 30 million barrels a day, despite objections from countries like Iran and Venezuela.

Oil prices at the time had tumbled about 24% from their March high. Since that meeting, they’ve plunged another 5% to 6%.

However, while Saudi Arabia may have won that battle, a shift in the group’s balance of power suggests its days of dominance are numbered.

And that means we’re likely to see an increasing amount of volatility in the oil market, which is already being whipsawed by macro market forces that are well beyond OPEC’s reach.

Over the next couple of years, Iraq, Libya and Venezuela will see their influence grow alongside their oil production. And their individual interests are poised to collide with Saudi Arabia’s globally driven mandate.

A Lion in Winter

In its annual Statistical Review of World EnergyBP PLC (NYSE: BP) said that Venezuela last year overtook Saudi Arabia as the world’s largest holder of proven oil reserves.

BP puts Venezuela’s proven deposits at 296.5 billion barrels, or about 18% of the global supply. That compares to 265.4 billion barrels, or 16% of the world’s proven reserves, for Saudi Arabia.

Furthermore, it’s not even certain that Saudi Arabia has as much oil as it portends. American diplomats in Riyadh warned in confidential cables written between 2007 and 2009 that Saudi Arabia’s overall crude reserves may have been overstated by as much as 40%.

One cable written during the 2008 oil shock, when crude prices spiked to nearly $150 per barrel, warned that Saudi Aramco, the Saudi state oil company, no longer appeared to have the ability to raise production sufficiently to affect global oil prices.

And another correspondence suggested that escalating electricity demand in Saudi Arabia could further constrain Saudi oil exports.

Indeed, Saudi Arabia gets 65% of its energy from oil. And between 2000 and 2010, oil consumption in the kingdom rose by 1.2 million barrels per day – growth that placed second only to China. In fact, oil consumption in the entire Middle East region rose 56% during that decade. That’s four-times the global growth rate – and double that of Asia.

So even if Saudi Arabia has something left in the tank – and it’s not a given that it does – a greater portion of its reserves will be staying home rather than being exported. And in the meantime, smaller OPEC producers are looking to increase output.

Shifting Sands

Venezuelan President Hugo Chavez recently pledged to more than double his country’s oil-production capacity to 6 million barrels a day by 2019. According to Chavez’s plan most of the new output will come from the Orinoco oil belt, which is slated to produce four million barrels a day by 2019. The plan also calls for drilling 10,500 horizontal wells from 2013 to 2019 and building heavy crude upgraders.

Venezuela is one of OPEC’s most hawkish members when it comes to oil production. The country’s oil minister, Rafael Ramirez, has said oil prices should be kept above $100 a barrel. And Chavez himself lamented the recent price decline, blaming the drop primarily on overproduction.

Another country critical of OPEC’s output has been Iraq, which is increasing its production, as well.

Iraq recently achieved oil production of three million barrels per day – a level not seen since the 2003 U.S. invasion. That means the country will likely become OPEC’s second-largest producer by the end of the year, topping Iran, which is being plagued by sanctions.

Still, that doesn’t mean there’s any friction between the two countries. Since Iraq stood side-by-side with its former rival and Venezuela, calling for higher oil prices at last month’s OPEC meeting.

In fact, Iraq even took things a step further by nominating Thamer al-Ghadhban, its own homegrown candidate, for the position of OPEC Secretary General. Elections to replace the current secretary general will take place later this year.

Iraq is in a unique position because it’s currently exempt from OPEC’s quota system. However, it will be at least another two years before the country is brought back into the fold.

In the meantime, Iraq, which gets 95% of its revenue from oil exports, will be keen to push prices as high as possible.

Furthermore, since the fall of Saddam Hussein, the country now finds itself more politically aligned with Iran. That’s because Iran’s Shiite Muslim regime has much in common with Iraq’s Shiite-dominated coalition government.

Finally, Libya is looking to boost its oil production by about one-third to two million barrels per day this year. That would surpass levels seen prior to that country’s bloody civil war.

While all of these countries produce significantly less than Saudi Arabia – which is currently churning out close to 10 million barrels per day – every advance they make dilutes OPEC’s power structure.

And that effect will be amplified as Saudi Arabia finds itself unable to produce more oil.

In the end, we’ll likely see a power struggle that increases in intensity over the next several years. And that means more volatility for oil prices.

Still, that’s not necessarily a bad thing. To the contrary, volatility can be an investor’s best friend.

For instance, if you’re a trader willing to take big risks by shorting the market, you can clean up regardless of which way oil prices go. And even if you’re not, market downdrafts will take some energy stocks down to bargain levels before price spikes send them drastically higher.

Courtesy  Jason Simpkins at Wall Street Daily (EconMatters author archive here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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