The decision of the Organization of Petroleum Exporting Countries to cut production means that oil prices are set to stay high. This will keep Europe’s consumers spending less and will dim prospects for eurozone recovery.
Why is Opec cutting production? Saudi Arabia is the swing producer in the cartel. The Saudis are worried that the US is considering ditching them as allies in the Middle East. By cutting production, the Saudis are telling the US that it needs them just as much as the Saudis need the Americans. Significantly, the Russians have backed the Opec cut for the same reason.
Saudi-Russian collusion Until the Opec meeting, the consensus was that the crude oil price would fall to below $20 a barrel over the next year. Energy traders thought Saudi Arabia had no cards to play, as Iraqi oil was set to come on stream and stocks were recovering. However, early in September, Saudi Arabia’s crown prince Abdullah visited Russian president Vladimir Putin. Russia, it transpires, agreed with the Saudis that Opec production quotas would be cut by 3.5%.
The official reason given for the cut was the likely rapid return of Iraqi oil production. But the real reason is political. The House of Saud is warning that if it is to be left to fend for itself, the Americans will pay with a high oil price. Russia is the wild card in this game. It’s a win-win situation for Putin.
If Russia doesn’t raise production, the oil price will remain high and boost government revenues. Every dollar rise in the benchmark Urals oil price adds $1 billion (1.5%) to these. That makes it easier to pay pension shortfalls and boost spending before Putin’s re-election bid next March. And defying the US is a vote winner in Russia.
Alternatively, Russia could agree to increase production to take up the Opec slack. But if the US wants that, there is a price to pay. First, the Americans must turn a blind eye to Russia’s repression in Chechnya. And what about a few juicy contracts in Iraq? Also up for grabs are arms sales in the Middle East and the sale of nuclear reactors to Iran.
The Opec decision shows that US strategy in Iraq has weakened its cards in the Middle East oil game. The US invasion effectively destroyed Iraqi oil production. Before the conflict, Iraq produced 2.8 million barrels a day. That fell to 1.7 million b/d in September, with much less exported. The Iraqi oil minister announced that output would be raised by between 1.8 million and 2.3 million b/d over the next year. But this is a pipe dream. Under-investment and terrorism will keep production well under 2 million b/d for the next year.
There are other factors that will continue to restrict oil supply. The strike in Venezuela earlier this year has damaged oil capacity. Almost 19,000 skilled workers were sacked. With insufficient engineers and gross under-investment, previous production levels will not be regained soon. Terrorist attacks in Indonesia have reduced production levels there. Both countries are struggling to match quotas.
Mexico too looks like having trouble raising production. State oil company Pemex must hand over 60% of its revenues to the government, which raises only 12% of GDP in taxes. That means there is little left to reinvest to sustain or increase capacity.
With Saudi Arabia controlling 50% of remaining sustainable Opec capacity, the kingdom has gained more control over the oil price than it has enjoyed at any time since the 1970s. The Saudis and Russians have contributed nearly all oil supply expansion since the end of 1999. So, over the next year they will control world oil supply.
No relief on the demand side And what about demand? Opec expects global real GDP growth to accelerate to 3.9% in 2004. If so, oil demand will rise by 1.2 million b/d to 79.3 million b/d. I expect slower global growth, with oil demand rising by just 0.6 million b/d. Even if world growth remains below par, oil demand could still be strong. US crude oil demand has soared to its strongest growth rate for four years. That’s partly because of the urgent need to rebuild stocks before winter.
Rampant growth in China is also driving up demand. The People’s Republic accounts for nearly 7% of total oil demand and in 10 years’ time it will be consuming around 13% of total production.
Global oil supply is set to stay tight. It’s a recipe for prices at least as high as the top end of the Opec target range of $28 a barrel through 2004. What will be the impact on the global economy and financial markets? As an inelastic commodity, oil is effectively a tax on consumption and an unavoidable input cost. If oil prices stay high, as I expect, consumers in Europe, Japan and the US will have to spend more on energy and so less on other things.
That means global economic growth will be weaker and jobs expansion will be put further back in all three economic areas.
