OPEC’s symbolic move

Jun 20th 2005
From The Economist Global Agenda

In confirmation that OPEC's raising of its production quotas last week was largely symbolic, oil prices have raced towards $60 a barrel. With supplies tight, and new production and refining capacity slow to come online, prices are likely to stay high in the short term. But consumers aren’t cutting back on their spending as a result. Expensive oil may not be the harbinger of doom that economists once thought

FOR years now, pessimists have been proclaiming that oil prices were about to bring a dread reckoning on a world thirsting for energy. These days, there must be more than a few red faces at the Legion of Doom. Their predictions of devastating economic effects from high oil prices came to naught as the black stuff soared past $30, then $40, then $50 a barrel, and the world economy posted the best growth rates in a generation. Even more embarrassingly, the gluttonous United States has outperformed its oil-sipping peers.

Nonetheless, even members of the Organisation of the Petroleum Exporting Countries (OPEC), whose oil wells might as well be pumping out hundred dollar bills, are looking for ways to calm prices. They fear that a sustained period of expensive oil, such as the one in the 1970s, during the cartel’s formative years, will bring about a global economic downturn that slashes demand for their product—or worse, spur consuming nations to make their economies more oil-efficient.
In the latest OPEC meeting, held on Wednesday June 15th, fretful members like Nigeria overcame the resistance of hawks like Venezuela to secure an increase in official production levels. Members agreed to an immediate quota increase of 500,000 barrels per day (bpd), to 28m bpd, and said they would consider a further 500,000 bpd increase later in the year if prices stay too high.

Unfortunately for oil consumers, this is more of a symbolic effort than a real attempt to ease oil prices. Thanks to cheating by members on their quotas, OPEC is already pumping at least 28m bpd, and possibly as much as 30m. The quota increase merely legitimises activity that is already taking place. Worse, OPEC may not be twiddling its thumbs because it wants, despite the rhetoric, to keep prices high, but because its members lack the capacity to increase production.
OPEC members, particularly Saudi Arabia, the cartel’s swing producer, have historically maintained a buffer of spare production capacity which could be brought online if prices surged. In recent years, however, that buffer has been run down, in part due to soaring demand and in part thanks to the bitter memory of $10-a-barrel oil, which has made oil producers leery of ramping up production capacity too quickly.

Non-OPEC sources of oil are even tighter. Russia, which has been growing its production rapidly in recent years, has seen output stagnate over the past few months, largely thanks to government interference in the energy sector. Elsewhere, the big oilfields that were developed in the wake of the 1970s oil crises have begun to decline, and oil companies are having to look to undeveloped regions where big investments in technology are needed to get the oil out of the ground, and political and legal risks are often high. For these reasons, global spare capacity has dropped close to a 20-year low.

But this does not mean, as some alarmists are arguing, that world oil production is nearing its peak. There is room for OPEC’s members to increase the amount they pump; it is the memory of $10 oil, not physical limits, that is holding them back. And constantly improving technology is not only raising yields in oilfields everywhere, but also opening up new sources of oil. Companies are going after the stuff under deep water, or locked in unconventional sources, such as oil shale or Canada’s tar sands.

Refining their thinking

However, the fact that there are additional sources of oil to be exploited does not necessarily mean that oil will be cheap. Already, many—including OPEC—are warning that tight refining capacity is an even bigger problem than oil production. Any extra oil that OPEC produces right now will be heavy, high-sulphur crude, which requires high-tech refineries to make the end products meet western environmental standards. But that sort of refinery capacity is already stretched. OPEC ministers have essentially admitted that the current round of quota increases will have no effect on price, saying that until there is more refinery capacity, there is little they can do. The market seems to agree. The price of West Texas crude, the US benchmark grade, rose in the days following the OPEC meeting, and by Monday June 20th it was trading at a whisker below $60 a barrel, a new record—partly because of terrorism alerts at western consulates in Nigeria, the world's seventh-largest oil exporter.

But there remains fierce resistance to building new refineries in rich-world, oil-consuming nations. Moreover, in America subtle differences between the states’ oil-composition standards mean that refiners are forced to make large numbers of small production runs. This not only limits their efficiency but also sometimes causes price spikes as consumers are left stranded, unable to buy “foreign” petrol that does not meet their local standards. Technological advances have thus far enabled refiners to eke out more production from existing facilities. But the potential bottlenecks leave consumers vulnerable to price swings.

So far, however, consumers don’t seem to care. High oil prices have had little noticeable impact on world demand—even for oil itself—leaving analysts scrambling for an explanation. Some look to governments, which in the 1970s took vigorous action to improve the energy efficiency of their economies by enacting things like gas taxes and fuel-efficiency standards. There has been little such activity this time around.

Others think that price increases up to a certain point may have little effect, but that even moderate increases after that point (whatever it is) might produce sharp changes in consumers’ behaviour. And still others argue that consumer reaction has been muted because the latest round of price increases, unlike past rounds, has been driven by increasing demand, rather than a sudden contraction in supply. The economic growth driving the higher demand, they argue, may be offsetting the negative effects of high oil prices. Or it may simply be that demand-driven increases are more gradual than those following a supply shock, giving consumers, and economies, time to adjust gracefully.

But now that the world economy is bumping up against short-term supply limitations, that may change. Saudi Arabia seems to be in the process of rebuilding OPEC’s buffer, but this will take time. In the meantime, even if prices fall, they are likely to remain volatile, as even small shocks to supply (a few exploded refineries in Iraq, say) will be able to produce a sudden sharp mismatch between supply and demand. Until the world develops some spare capacity, the road ahead looks sure to be bumpy—particularly if you are driving an SUV.

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