OPEC production capacity exaggerated

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If all OPEC members are cheating, why are oil prices on the rise?

What should OPEC be blamed for? Production cuts? Or withholding information about the status of its oil fields?

A. F. Alhajji, Ph.D. Colorado School of Mines

Date: March 8, 2000

Across the world, oil prices have been steadily rising due to last year's production cuts by OPEC countries, Mexico, Norway, Oman, and Russia. Many oil analysts, myself included, predicted that these cuts would have a mild impact, lasting only few months and that OPEC members would cheat, non-OPEC production would increase, causing prices to decline. Unfortunately, these predictions were wrong. Prices have been inclining for a year and, recently, exceeded $33 per barrel.

Why were analysts' forecasts wrong? Why didn't OPEC members cheat as economic theory predicts? Why didn't non-OPEC oil production increase with higher oil prices? Why did previous production cuts by OPEC members lead to lower prices while recent cuts led to a three-fold increase? Why are oil prices on the rise despite the fact that world oil production increased by 700,000 barrels per day last month? Why do oil prices keep increasing despite commitment from major oil producers to increase production? Was the recent increase in oil prices caused by OPEC cuts a year ago? What is the role of lower oil prices in 1998 and early 1999 in the current price increase? Will oil prices keep increasing or have they reached their peak?

Last month, an OPEC official hinted that OPEC would increase production in March. On the very same day, the Department of Energy announced that it is considering the release of some oil from the Strategic Petroleum Reserves. The expectation was that oil prices would decline, but prices went up by almost one dollar that day. Last week, Secretary of Energy Richardson, after visiting Saudi Arabia, Venezuela, and Mexico, secured a commitment from the major oil producing countries to increase production. Splashed across every newspaper was the headline that oil prices should go down. Once again, the expectations were incorrect for prices almost reached $32 per barrel that day. So what's going on?

The answer to all these questions is simple, existing production capacity is exaggerated! Even the production capacity of Saudi Arabia is highly overestimated. Until the end of May, Saudi Arabia cannot produce more than 8.7 million barrel per day! The current increase in oil prices is due to the long period of oil price stagnation, which reached dangerous levels in early 1999. Such low prices have led to lower upstream investment and lack of maintenance. Consequently, world oil production declined and many oil wells suffered from severe technical problems that lowered production. Because of low oil prices, even Saudi Arabia was not able to maintain its capacity, which reached its peak in 1997. Lower capacity prevented OPEC members from cheating and prevented non-OPEC members from increasing their production. When oil prices increased, countries increased oil production by putting pressure on their existing oil wells, and prices decreased a little. Such a pressure led to additional technical problems and decreased production further, which in turn, kept upward pressure on prices.

Looking back at the March agreement, only Saudi Arabia, Kuwait, and the UAE, reduced production voluntarily with Saudi Arabia making the largest cut, while all other oil producing countries were forced to reduce their production due to a variety of factors. The political turmoil in Venezuela, Nigeria, Colombia, Ecuador, and the Caspian countries slowed production. In addition, natural disasters reduced production capacity in some areas such as Venezuela and the North Sea, and sanctions on Iraq and Libya influenced their oil output and led to severe technical problems. In fact, Venezuela produced less than its quota for about two months last year.

Given the fact that we live in a "Global Village", one would predict a fast and accurate flow of information about the status of the oil fields in the oil-producing countries, but analysts were unaware of the technical problems plaguing Venezuela, Iraq, Norway and Russia. This led to the underestimate of the damage caused by low oil prices. The lack of such information, which is kept secret, led to the failure of forecasts even by the most respected agencies such as the International Energy Agency (IEA) and the US Department of Energy (DOE).

The reason for the success of March agreement, despite the failure of all previous agreements in lifting prices since 1984, is the inability of many countries to produce even their quota. This is the reason why Venezuela and non-OPEC members Mexico, Norway, and Russia participated in the cuts in the first place. In hindsight, the announced production cuts equaled the decline in production that took place before the agreement. In other words, prices would have increased even without March agreement. Without the March agreement, prices may have settled around $22-24 a barrel. Prices went higher mostly because of the Saudi cuts.

OPEC's misdeed is not its production cuts, it is the secrecy surrounding its capacity and the status of its oil fields. Consumers, analysts, and governments are entitled to this knowledge and the US government should increase pressure on its allies in the Middle East to provide such information, which is more valuable than pressing these countries to increase production. If such information were available last year, the world oil market would look completely different from today's market.

What's next?

Even if OPEC decides not to increase production at the end of March, additional capacity will increase cheating. Most of the additional capacity that will be added within the next two months is the capacity that was lost because of lack of maintenance when oil prices were low. Given the current available capacity, oil prices may linger around the current levels until May. Average prices are expected to be between $22 and $25 per barrel for the rest of the year, and Oil prices may have most likely peaked or around their peak. Unfortunately, if political turmoil erupts in one of the hot spots such as Nigeria, Iraq, Venezuela, or Indonesia, oil prices may be on the rise once again.

Why did oil prices increase recently?

Comparing the current increase in oil prices with previous "oil shocks" yields astonishing similarities! In all of these cases, in 1973, 1979, 1991, and 2000, we have an important political incident that ignited the crisis. In all cases, many small incidents took place and prolonged the crisis. In all incidents, the effect of political incidents was minimal in term of supplies but they sparked a panic in the market. In all cases, Iraq was an essential player to help in reducing the effect of the crisis! Iraq did not participate in the embargo of 1973; instead, Iraq increased its production to compensate for the shortages in the US. In 1996 and thereafter, it was the Iraqi oil, which flow to relief the market. In 2000, the increase in Iraq production kept oil prices below $30 a barrel for a while. In all cases, major pipelines were exploded or shutdown. In all cases, major waterways were closed or tightened regulations on oil tankers. In all cases, some oil producing countries announced cuts in production and exports. In all cases, spare capacity of the producing countries were declining while consumption was growing. In all cases, strikes by oil and coal workers exacerbated the crisis.

OPEC production cuts may have little to do with the recent increase in oil prices during the past three months. Last month's data shows that all OPEC members, excluding Venezuela, are cheating on their quota.

Many factors may have contributed to the recent increase in oil prices including severe weather in the North Sea and Venezuela which halted production for many days, technical problems that have plagued many countries such as Iraq, Venezuela, Ecuador, and Russia. In addition, the cold weather in Northeast US increased the demand for heating oil. Also, Pipelines explosions in Sudan, Colombia and Yemen, stopped the flow of more than 500 thousand barrels of oil per day. Furthermore, speculators are bidding on higher oil prices. Recent figures indicate that the net speculative position has doubled from the 30,000 long contacts reported two weeks ago. An increased demand for oil, especially in Asia, contributed to the recent increase in oil prices. The International Energy Agency adjusted its world oil demand forecasts upward in its recent report. The war in Chechenya stopped the flow of oil from that region. In addition, the war efforts diverted some of Russia's exports to military use. Finally, the strike by Venezuelan and Nigerian oil workers, and the threat of strike by Ecuadorian oil workers may have contributed to higher oil prices in last few days.

Given the world limited production capacity and various technical problems in many areas, oil prices are not expected to reach a "fair" level until next year. The oil companies, being cautious on one hand, and busy with mergers and cost cutting on the other, may have exacerbated the problem by not increasing capacity in response to higher oil prices. It seems that oil is coming back with a vengeance, we were happy under-pricing it, now it exploded in our face!


A. F. Alhajji, Ph.D. Colorado School of Mines ++ 1 (303) 273-3604 aalhajji@mines.edu

-- Cave Man (caves@are.us), September 08, 2000


Saudi Arabia: oil production MB/D


-- Cave Man (caves@are.us), September 08, 2000.

You know, this oil debate kinda reminds me of something....except, send in the trolls, there ought to be trolls.......

-- KoFE (your@town.USA), September 08, 2000.

BTW Caveman, I wasn't trying to diss you. I was just thinking about the old days.

-- KoFE (your@town.USA), September 08, 2000.

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