OPEC Shoots Itself in the Foot

The last bastion of world oil demand, the transportation sector, is coming under siege. The internal combustion engine is no longer the only power source in town.

Published: 07-Jan-2008

Meeting in Abu Dhabi on Dec. 5, 2007, OPEC became the organization of price hawks and superhawks. OPEC decided to hold the line on production, despite near-record crude oil prices of about $90 per barrel - prices have since hit a record $100. The three major drivers for substantial and effective energy policies in the major consuming countries are high prices, energy security and environmental concerns. As a result, if OPEC fails to mend its greedy ways, it may come to regret its recent actions, just as it came to regret its actions of the 1970s and early 1980s.

In the meeting's final communiqué OPEC claimed the world oil market is "well supplied," and high oil prices were the result of speculative activity and geopolitical uncertainty. It is true OPEC has lost control of oil prices several times since the early 1970s, generally because of a combination of geopolitical uncertainty and a lack of supply flexibility.

However, what is the difference between the final four months of 2006, when oil prices dropped from around $75 to $50 per barrel, and the final third of last year? A high degree of geopolitical uncertainty is common to both time frames.

On the supply flexibility front, spare production capacity in the OPEC-10 countries is similar in the two periods, at about three million b/d, while refinery upgrading capacity - which allows refiners to run a higher proportion of low quality crude - was somewhat slacker last year.

The important difference between the two time frames is the level of commercial oil inventories during the autumn, and their expected trajectories through the winter. In 2006, commercial oil stocks increased to almost 56 days of future demand in the fourth quarter, and were expected to continue to rise through the winter until OPEC announced two rounds of production cuts, turning the tide on expectations and stocking behaviour.

Commercial oil inventories currently are less than 53 days of future demand, and are widely expected to decline substantially through the winter - about 48 to 49 days are required for transit and refinery operations.

Under these circumstances, if OPEC were to announce a substantial increase in oil production, expectations should again shift, and oil prices should decline.

About three years ago I was in Vienna as a guest of OPEC, chatting about crude oil. The head of research, Adnan Shihab-Eldin, asked my opinion about his organization potentially abandoning its price band of $22 to $28 per barrel, and replacing it with an unofficial target of around $30. OPEC was concerned that "high" oil prices may harm demand for OPEC oil in both the short and longer term.

How times have changed! Demand for OPEC oil depends upon world oil demand and non-OPEC oil production. There is a widespread belief that strong oil demand growth is a given, assuming sufficient supply.

However, oil demand growth has not been nearly as strong as one would expect based on the recent strength of the global economy.

From 1999 to 2004, when oil prices were relatively low, world oil demand trailed global economic growth by 2.2 percentage points per year. In 2005 and 2006, the difference almost doubled to average 4 percentage points.

Strong global economic growth also should not be taken for granted. Despite several years of excellent growth in the U.S. (and globally), protectionism is on the rise among the American public. The American lower and middle classes have not benefited from the recent economic boom - per capita income has stagnated.

Finally, the last bastion of world oil demand, the transportation sector, is coming under siege. The internal combustion engine is no longer the only power source in town. Hybrid automobiles are replacing oil demand with onboard electricity production.

Plug-in hybrids will have an even more negative effect on oil demand, partly benefiting fuels feeding the power grid. Fuel-cell-powered vehicles are on the horizon.

No doubt the low-hanging fruit in the non-OPEC oil-producing countries has already been picked. However, high oil prices increase the chance of discovering "elephants" in increasingly difficult surroundings and geology.

In addition, tertiary production techniques, which squeeze additional oil from current fields, become increasingly viable at higher prices.

Finally, the International Energy Agency (IEA) expects biofuel production to increase by 350,000 barrels per day (b/d) in 2008, marking its first time to have a significant impact on the global market.

A couple of years ago at an Aspen Institute event I asked a prominent, former high-ranking American government official - his name cannot be disclosed because the meeting was held under Chatham House Rule - if his country would ever adopt a strong, effective energy policy. His answer was concise: "No."

However, this past summer I asked him the same question, again at the Aspen Institute, and with oil prices at a lower level than they're at presently he said, "It's only a matter of time."

Vincent Lauerman is the president of Geopolitics Central Inc. (http://www.geopoliticscentral.com), and the former editor of the journal, Geopolitics of Energy.

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