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Global Oil and the Future of OPEC

Mehdi Varzi - 8th June 2017

Mehdi Varzi argues that OPEC members need to address the question of how they intend to exploit their massive oil reserves as the world gets weaned away from oil. This is a chapter from the e-book 'The Future of the Middle East' co-produced by Global Policy and Arab Digest, and edited by Hugh Miles and Alastair Newton. Freely available chapters will be serialised here and collected into a final downloadable publication in the spring.

The link between oil and politics

Over the past decade, the global oil industry has been buffeted by major international and regional developments, many of which have been beyond its control. International recession, turmoil in the Middle East, a resurgent Russia and China, growing nationalism, rising environmental awareness and the inexorable rise of renewables have all had an impact on both consumers and producers and raised concerns about the long-term prospects for the oil market.

In the modern industrial age, oil has never been just an economic commodity.  Oil and politics have been indelibly intertwined ever since Great Britain decided in the early twentieth century to turn away from coal to oil to fuel its mighty navy. Its decision to become a shareholder in the Iranian oil industry paved the way for a century of outside interference in the Middle East which continues to this very day.

At times, when oil prices have declined, many commentators have been all too ready to signal the declining importance of geopolitics in the oil market, failing to understand that political influences are never far from the scene. The Holy Grail of price stability in the case of commodities has been shown to be an unachievable objective. The prices of commodities by their very nature are prone to regular fluctuation. However, no commodity is as affected by political developments as oil. Regular economic models are created to forecast oil prices but are invariably undermined by extraneous factors or unexpected developments. So why is oil such an intensely political subject?

For a start, oil has played a key role in the global industrialization process. Governments have, therefore, tended to exert influence over their domestic oil industries and major powers have tried to gain control of oil reserves abroad both in peace time and at time of war. Following the end of the First World War and the division of the Middle East between Great Britain and France, the former went to great lengths to ensure that the major potential oil-bearing areas came under its control. Access to growing oil reserves was deemed as essential for ensuring prosperity of the domestic economy and preservation of the British Empire.

Oil plays a vital role as a source of fuel for the modern military machine, whether on land, at sea or in the air. For example without oil, it is questionable whether either the First or Second World War would have lasted as long or have seen such a revolution in military mobilisation and tactics. Attempts have been underway to substitute oil as a military fuel but so far with little success. Oil is expected to retain its indispensable military role for the foreseeable future.

Politicisation of oil has been encouraged by the fact that the really big oil reservoirs in the world are overwhelmingly concentrated in the Middle East, especially the Persian Gulf. The massive arms deal just concluded between the United States and Saudi Arabia is as much about exerting political control over Saudi oil as it is about the struggle against terrorism as espoused by the United States.

No commodity is traded as much globally as oil. Moreover, the use of fuel oil has been vital for the expansion of international trade. Control of international sea lanes by major powers has always been a primary consideration.

Some 40–50% of the global trade in crude oil and its derivatives is in the hands of OPEC, all of whose members depend heavily on oil revenues.  Oil prices have a direct impact on their political fortunes, so they cannot afford to leave oil prices solely to the whim of the spot and futures markets.

Oil at times has had a major influence on international currency movements and affects both equity and bond markets. It is thus never far away from political and economic discussions among decision-makers and market participants.

OPEC defies the doomsayers

There is a view among some observers that if OPEC had not been created, the global oil market would have had to find a substitute as a kind of oil price reference point. As the demand for oil grew inexorably in the 1950s and 1960s and spread across the globe, the oil market seemed too important to be left to the vicissitudes of the oil market.

OPEC was established in September 1960 by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. Its creation came after more than a decade of falling oil prices and rising resentment towards the international oil majors. The latter group at one time controlled up to 90% of the global trade in oil and alone decided the level of oil prices and in effect the revenue stream of oil-exporting nations. OPEC’s stated initial objective was to coordinate and unify the policies of member countries not only on the crude pricing issue but on a whole range of problems arising from the unequal relationship between host countries and foreign companies who owned concessions over vast tracts of land. These objectives were outlined in greater detail in the OPEC Statute adopted in 1961. The principal aims were to include “unification of the petroleum policies of Member Countries and the determination of the best means for safeguarding their interests, individually and collectively………..devise ways and means of ensuring the stabilization of prices in international oil markets with a view to eliminating harmful and unnecessary fluctuations……….(give) due regard at all times to the interests of the producing nations and to the necessity of securing a steady income to the producing countries ………(ensure) an efficient, economic and regular supply of petroleum to consuming nations and a fair return on their capital to those investing in the petroleum industry”. The Statute has been amended fourteen times over the course of the Organization’s 57-year history with the aim of updating OPEC’s key objectives and pursuing them in a more effective manner. However, the key twin objectives, preserving the revenue of member countries and maintaining oil price stability, have remained at the very core of OPEC’s ambitions.

From the very beginning of OPEC’s existence, the Persian Gulf area has been OPEC’s producing heart although Venezuela’s decision to join as a founding member followed by entry of other non-Gulf members has provided OPEC with a welcome psychological boost and additional market influence. In subsequent years, the number of members reached a maximum of 13 including countries in Africa and Asia. Today there are 12 members with the Persian Gulf producers accounting for around 75% of total current output. Saudi Arabia is by far OPEC’s biggest producer with output at or above 10 million barrels per day (mmb/d) per day on a regular basis.

OPEC’s downfall has been predicted all too regularly by outside observers throughout the near-six decades of its existence. As the oil price collapsed in early 1986, former President Reagan claimed to have brought OPEC to its knees. In fact not long after President Reagan’s statement, the price of West Texas Intermediate crude oil went from around $10 to $18 per barrel in the second half of 1986 as Iran and Saudi Arabia called a halt to their ruinous price war. Since then, prices have fluctuated hugely rising to well over $100 per barrel and falling to under $30 per barrel. Yet OPEC continues to survive.

Over the years, OPEC’s key members have shown an incredible ability to withstand outside shocks such as the Iranian Revolution of 1979, the Iraqi invasion of Iran in 1980, the Persian Gulf tanker war in the early to mid-1980s, the Iraqi invasion of Kuwait in 1990, the American-led invasion of Iraq in 2003, expansion of sanctions against Iran, the Saudi-Iranian proxy war in Yemen and other instances of major turmoil in the Middle East and North Africa which continue to this very day. However, one of the extraordinary features of OPEC is that all members tend to attend ministerial meetings almost irrespective of outside factors.

In fact, heightened tensions among the key members have failed to prevent the continuation of diplomatic exchanges and regular consultations about oil market developments. Throughout the 1980-1988 Iran-Iraq conflict, both countries sent delegations to OPEC meetings although it was decided to sit them apart from one another, with the Indonesian delegation often sitting between the two parties. (In fact, Iran and Iraq maintained embassies in one another’s capitals during the war although the embassy staff were confined to their respective embassy buildings). Similarly following Iraq’s invasion of Kuwait, both countries attended OPEC meetings. Of course such meetings are often tense reflecting underlying political tension in the region. However, from the start there has been an implicit, collective decision by OPEC members to focus on oil and related technical and economic issues while avoiding discussion of non-oil related matters.

Even today, as the United States attempts to build an anti-Iranian alliance including Saudi Arabia, other Sunni states and Israel, and despite the fierce anti-Iranian statements recently uttered by senior Saudi leaders, the two countries continue to consult on OPEC production ceilings and the role of non-OPEC members in curbing global production. Thus many years of oil diplomacy have kept war and conflict away from the OPEC conference table.

The key challenges facing OPEC

The challenges facing OPEC today are perhaps unprecedented in its long history. While previous challenges have been essentially of an oil supply/demand nature involving the establishment of a quota system to offset short-term market imbalances, the threat facing the organisation today is arguably existential. On the one hand, the cost of non-OPEC crude oil production has been curbed by significant technical advances in the field of shale oil (especially in the United States) and globally via the use of the latest computer technology and drilling techniques. After falling to just over 5 mmb/d in 2007, the lowest level since 1949, total US crude oil production reached an average level of 9.4 mmb/d in 2015 before dipping to 8.9 mmb/d last year as a result of falling prices. (Source: Energy Information Administration, EIA).  Most of that rise was due to higher shale oil output.

Since January this year when OPEC decided to limit output with the help of certain non-OPEC producers especially Russia, the trend has reversed and US output has rebounded to around 9.2 mmb/d in April according to the EIA. Most of the recent rebound has been due to long-term non-shale field investments in the Gulf of Mexico and Alaska. The huge rebound in the US rig count (up nearly 120% since its recent low and set to rise further still) is likely to result in further production growth. In fact, the EIA forecasts production to rise to over 9.6 mmb/d by end-2017.

This higher than expected rise in US output has confounded most market observers and undermined OPEC’s attempts to rebalance the oil market. Since 2014, the cost of US onshore drilling has declined by an estimated 40% (25th May Financial Times article entitled, “A changing oil market threatens Saudi reform”) raising concern about how oil prices can stay much above $50/bl. In recent months key producers led by Saudi Arabia have been forced to seek an extension of the current production cuts into 2018. Even so, there could be major problems ahead. Iraq has failed so far to curb output to the agreed level and Iran is continuing its efforts to increase production capacity although much will depend on the lifting of US sanctions.  Other smaller but significant wild cards include Libya, Nigeria, Angola and Kazakhstan. Should, for example, Libya’s political situation stabilise in the coming months, output could rise by well over 500,000b/d short-term.

However, a far greater threat is facing OPEC – the worldwide campaign against fossil fuels, especially coal and oil which are considered the main sources of greenhouse emissions. Focusing on oil, until recently the key area where oil faced little competition was as a fuel for land and air transportation. At the heavy end of the product barrel, the global demand for residual fuel oil has been on a long-term decline falling by a third from 12.3 mmb/d in 1986 to just short of 8 mmb/d today (BP Statistical Review of World Energy). The middle range of products (middle distillates) has faced growing competition from natural gas especially as feedstock for major industrial plants, although the (perhaps misguided) support for diesel especially in Europe has proved to be a partially offsetting factor. This may, however, no longer be the case given the growing anti-diesel movement in Europe which could eventually spread worldwide. In the case of gasoline which has seen consistent global growth for many years, greater engine efficiency and the rapid rise of hybrid and electric engines are likely to provide a growing threat in the years to come. Electric cars accounted for just 1% of total global sales in 2016. However sales rose by 42%. Unfortunately, there are few indications that OPEC are thinking long-term. The latest Ministerial Communique issued on 25 May this year stated blandly as follows: “Member Countries confirmed their commitment to a stable and balanced oil market, with prices at levels that are suitable for both producers and consumers”.

Meanwhile renewables demand has been surging in recent years, albeit from a fairly small base. The surge is likely to continue and even accelerate over the coming decade. According to the International Energy Agency (IEA)’s Medium-Term Renewable Market Report, “renewables are expected to cover more than 60% of the increase in world electricity generation over the medium term, rapidly closing the gap with coal. Generation from renewables is expected to exceed 7600 TWh by 2021 -- equivalent to the total electricity generation of the United States and the European Union put together today”. This trend is not only being driven by government policy in a growing number of countries but also by rapid advancement in technology which has been reducing the cost of renewables.

Given this growing long-term threat to oil, one wonders whether OPEC’s traditional policy of curtailing production to underpin oil prices is the right approach. Short-term, it may well underpin oil revenues but long-term it will serve not only to underpin production from non-OPEC producers but also encourage alternative energy sources thereby undermining the prospects for world demand growth. Clearly, OPEC members need to diversify away from their dependence on the oil sector and some of them are already doing so. Ironically, Iran (possibly because of sanctions which are often the mother of invention) has progressed the fastest among OPEC members along this route with the oil sector accounting for less than 20% of Gross Domestic Output (GDP) in 2016 and with petrochemical exports booming in recent years.

Saudi Arabia, by far the biggest producer in OPEC, faces particularly sensitive challenges. Its dependence on oil revenues has made it the prime mover behind the current OPEC production accord and forced it to reduce production to even below its implied quota – something that in the past it vowed never to do. Clearly the tepid oil price recovery to just over $50/bl is causing it ongoing concern and raising long-term questions about its economic and, by implication, political stability.

There are many challenges but clearly the most important one is the pressing need to reduce the level of unemployment, currently officially put at 12% but almost certainly higher given that less than 50% of the Saudi work force is currently deemed as employed. (Chronic under-employment is another key problem). The state sector dominates the economy accounting for 70% of total employment, (the same FT article quoted above). According to UN data, the Saudi population grew by an average rate of 2.3% from 2010-2015, equivalent to an additional 600,000 persons per year. While the rate appears to be declining, the authorities will continue to face major challenges. Above all, with plans currently underway to shrink the state sector, the private sector which accounts for 30% of the domestic economy will have to undergo an unprecedented rate of expansion. To put matters into perspective, according to a report issued by the McKinsey Global Institute in December 2015 (“Saudi Arabia beyond oil: The investment and productivity transformation”), in the best case scenario there would still be some 800,000 unemployed in Saudi Arabia by 2030. In the worst case, the figure could rise to 2.2 million.

It is difficult to see how the best case scenario outlined above can be achieved or even approached. In January this year, the IMF cut its forecast for Saudi GDP growth to just 0.4% this year, possibly rising to near 2% in 2018. Under these circumstances, Saudi unemployment is almost certain to rise further.  According to www.gulfbusiness.com, most of the private sector is involved in export-import, finance, investment and services for state. Moreover, this sector to a large extent depends on state contracts. In any case, in terms of employment, these are low-intensive labour activities. Their expansion is hardly likely to have an appreciable effect on the level of unemployment.

Clearly, implementation of the officially announced Saudi Vision 2030, while praiseworthy in its objectives, depends very much on the will power of the Royal Family. Recent evidence is hardly encouraging, given the decision to restore government salaries to previous levels. The fear of widespread social dissent or disaffection remains foremost in the minds of senior members of the royal family.

The problems facing Saudi Arabia are not unique. Other key OPEC members with large and growing populations including Nigeria, Venezuela, Iran and Iraq face similar social, political and economic challenges. Moreover, given the growing global anti-fossil fuel lobby, OPEC members need to undertake some serious heart-searching.  Focusing largely on just defending oil prices with or without some non-OPEC co-operation could prove to be OPEC’s undoing.

OPEC members need to address the question of how they intend to exploit their massive oil reserves as the world gets weaned away from oil. Too much time continues to be spent in some of the key OPEC capitals on the sterile debate about control of national oil reserves and a reluctance to undertake measures to boost investment and technology transfer with the assistance of major international oil companies. Such attitudes are perfectly understandable given the role of outside powers in the past. However, time is now of the essence. OPEC needs to move the debate on. Otherwise it could be overwhelmed by irreversible events and several decades into the future could be sitting on billions of barrels of reserves without the demand to exploit them.

There are many issues that OPEC members could address other than the oil price. These could include the role of foreign private companies in upstream activities, privatisation of midstream (pipeline) and downstream projects via joint ventures involving both domestic and foreign companies, reduction in duplication of docking, shipping and tanker facilities, especially in the Persian Gulf, and regional co-operation in all aspects of the energy business.

However, at the moment, OPEC shows no such inclination to evolve into a more business friendly rather than diplomatic or political organisation. To reverse course would be to grant the Secretariat many more powers to initiate and propose rather than act as a bureaucratic go-between among members. Greater co-operation would also require an improvement in relations among its key members, especially Saudi Arabia and Iran, of which there is little sign at the moment of writing.

OPEC is a turning point. The world is gradually weaning itself away from fossil fuels. Unless it rises up to the challenge it will become increasingly an irrelevance.

 

 

 

Mehdi is an independent Global Energy Consultant. From 2001-2017, he was Director of Varzi Energy Ltd, an independent international energy consultancy, during which time he sat on various oil company boards either as non-executive director or adviser to the chairman. Prior to that, he had a 20-year career in the City of London. He is also a former Iranian diplomat and executive at the National Iranian Oil Company. He has been a regular speaker in international oil and gas conferences and has written extensively on strategic and political issues relating to global oil and gas.

Photo credit: Foter.com