Internal Challenges To OPEC and Its Member States

The following is a MEES translation of an extract from a paper by Majid al-Moneef entitled “Internal Challenges And The Effects Of Globalization On OPEC And Its Members Countries” that was delivered to the 6th Scientific Conference of Kuwaiti Economists in Kuwait on 19 October. Dr Moneef is Advisor to the Saudi Minister of Petroleum and Mineral Resources and the kingdom’s OPEC Governor.

Oil producing and exporting states and OPEC face a number of challenges – short or long-term, internal (within the organization as a whole or within member states), and external. These include challenges of an economic and political nature which are related to the market and its relationships, those connected to the operation of the organization in the energy, trade and environment spheres, as well as changes in the operations, structures and technical developments of the global oil and energy industry. One could point to challenges in the sphere of the demand for oil and in its supply, or international economic and political challenges in the short and long terms. Whatever the composition of the challenges under analysis, it is important to stress the fact that they are interrelated. An accumulation of short-term considerations influences long-term choices. Internal challenges and conditions in producing states and in their relations with the organization and the policies they adopt influence the way they deal with external threats. Global economic growth and stability influence demand. And political developments in this or that producing region influence supply – along with other examples of interrelatedness.

Challenges To OPEC Member Countries
In the short term, decision makers in OPEC member states face the challenge of dealing with fluctuations in oil revenue because of variations in prices and levels of production, and the effect of these on both public expenditure and the performance of their economies. Members adopt a number of measures to confront this challenge, including a reduction in public expenditure – particularly capital expenditure at a time of low oil prices – or assuming conservative oil prices in budget estimates, as Saudi Arabia does, for example. Another measure is the setting up of a fund for stabilizing oil revenues whereby revenue that exceeds budget estimates is deposited in such a fund, and withdrawals are made when revenue falls short of estimates – a measure that Venezuela and Iran, for example, have adopted.

In the long term, member countries face a challenge related to the dependence of their economies on a single main source of income. This state of affairs demands channeling investments to develop other productive sectors to diversify the bases of their economies, and to balance between the demands of the current and future generations. OPEC member countries have adopted a number of strategies in this regard, including the channeling of investments – particularly at times of high oil prices – into building infrastructure and developing related industries (petrochemicals) or unrelated ones. Another strategy is the setting up of savings funds into which a proportion of oil revenue is deposited for current and coming generations along the lines of the Reserve Fund For Future Generations in Kuwait and a similar one in Iran.

The second long-term challenge facing producing and exporting states in OPEC relates to the timing and means of directing investments to raise their production capacities. The growth of global demand and the need for OPEC oil require colossal investments in each OPEC country to develop its production capacity in order to keep its share of the world oil market. Member countries have adopted a number of strategies in this regard. Those with strong national oil companies have relied on them to increase production capacity, such is the case with Saudi Arabia, while others have opened the door to international investment to increase their production capacity – as is the case in Venezuela, Nigeria and Algeria. And in either case, the timing of production capacity increases will impact on OPEC member countries and the organization.

For if the increase in production capacity as a whole coincided with a drop in the demand for OPEC oil – and in the context of the ceiling and production quota mechanism which the organization uses to manage the market – this could lead to competition for market share among member countries. The adherence to production quotas would erode, and prices as well as the mechanism for maintaining them would collapse. The path that member countries take to increase their production capacity will also influence the mechanism used by the organization to manage the market. By opening the upstream development to international investment, the ability of member countries to control the volume of their production is reduced since the international investor insists on the minimum restrictions possible on production volumes in order to receive higher return in the shortest time.

It is noticeable that the strategies and policies adopted by OPEC member countries, in the short and longer term, are aimed to some extent at dealing with the consequences of the fluctuations of oil revenues on their economies and intended to give them maximum flexibility in adapting to changing market conditions on their own or in coordination with the organization. As for the investment policies to increase their production capacity, these are aimed at strengthening both the role of oil as an export commodity and the country’s share in world and OPEC production.

Challenges To OPEC From Within
As for the challenges within OPEC as an organization, the short-term challenge relates to its ability and effectiveness in dealing with the crises of supply interruptions for whatever reason from its member countries and the resumption of supplies thereafter. The history of the organization is full of examples in dealing with such crises, whether successfully or not. The ability of the organization to deal with this issue is related to the availability of spare production capacity in some member countries. In this respect there are differences among member countries with regards to the available spare production capacity depending on the size of their reserves and the level of their production capacity – and their ability to maintain and increase them in a timely manner. The burden (or advantage) of dealing with the interruption and resumption of supplies has historically fallen onto a few member countries, most notably Saudi Arabia, which was able over the past 30 years to sustain or increase its production capacity. Over the coming few years the organization will face the issue of the return of Iraqi production and how it is to be gradually incorporated into the OPEC ceiling and quota system, having been virtually out of it for the past 13 years.

The second challenge that the organization faces in the short term relates to its ability to achieve stability and balance in the market. Seasonal demand changes, especially in the Northern Hemisphere whereby the first and fourth quarters demand is higher than the second third quarters are not matched by the same seasonal pattern for non-OPEC production. This means that the organization has to adjust its production, perhaps by increasing output at times of high demand and vice versa. Success in doing this depends on the accuracy of its market assessment. Over the past five years, the organization has, to a large extent, been successful in intervening at the appropriate time to prevent a crash or surge of prices by adjusting the production ceiling to keep prices within the agreed band.

In the long run, the organization faces a challenge related to its ability to maintain its reference price band and a quota system. Since abandoning the fixed official pricing system in 1986, it has adopted a basket reference price of $18/B until mid-1990, $21/B price during the whole of the 1990s, and a price band of $22-28/B since 2000. During these three periods, the actual average price for the basket was $15/B, ie $3/B under the target price, during the 1987-90 period, around $17/B during 1991-99 ($4/B under target) and $25.3/B since 2000. The last period is the only one in the 1986-2003 time span in which the organization has been able achieve its target price. On the other hand, the organization was able to increase its market share by 5.4mn b/d in the first period and 4.7mn b/d in the second, while its production decreased by 4mn b/d in the period from 2000 until today. In other words, the organization’s commitment to maintaining a price band in the last period through production curtailments has kept prices within the band, but reduced its market share, while the opposite happened in the two earlier periods.

When the organization sets a target price it aims to achieve the highest income possible for its members without the price adversely affecting global demand, the role of oil or OPEC’s market share. But the organization has to carefully follow market developments where, at the end of the day, the level of prices influences demand and non-OPEC supplies. The low prices of the 1960s and the high prices of the 1970s led to developments in supply and demand, forcing prices up in the first case and forcing them down in the second. The dynamism of the oil market requires the market leader to keep monitoring its developments and even to change course when the need arises. The history of the organization is full of examples where short-term gains overshadowed long-term objectives.

The second long-term challenge facing the organization is to make the quota system effective to maintain OPEC’s coherence and unity. The quota system as it stands today is the result of long years of negotiations and not based on agreed criteria, although the production quotas of member countries indirectly reflect production capacities and historical production. Since production capacities of member countries change for different reasons, whether increasing as a result of investment or decreasing because of internal circumstances, quotas tend to deviate from production capacities, which weaken the production management system. The organization has tried more than once to agree on objective criteria for quota allocation, but has failed. It has now become clear to the majority of member countries that quotas must be based on oil-related factors (such as reserves and capacity).

A sustainable and fair quota system which is acceptable to member countries minimizes quota violations and keeps the one single instrument in OPEC’s hands to influence the market. If, on the other hand, this instrument were to weaken, then the strength of the organization and its future would be in jeopardy. There is no doubt that the existence of the system for the past 20 years, despite its shortcomings and the differences among member countries, shows that the latter are convinced that the system should continue, since the experience of the price collapse of 1986 and 1998 showed that an imperfect system is better than an abandoned one.