Oil markets have recently been experiencing severe oil price slumps. The OPEC Basket crude price fell from a level of $140.73/B on 3 July 2008 to less than $40/B by the end of the year. The price fall comes at a time when oil exporting countries are highly dependent on their oil revenues. Oil production and export hikes aimed at making up for the shortage of oil revenues at a time when the market is experiencing surplus production will certainly be followed by irreparable consequences. This is particularly the case under circumstances when declining demand for oil as a consequence of a global financial crisis underlies the market down-trend. Other factors such as a big boost in the storage of crude oil in the member states of the OECD, an increase in surplus oil production capacity, an easing of geopolitical tensions, a strengthening of the dollar's value, and the behavior of speculators should also account for the slipping oil prices. Meantime, surplus oil production capacity has increased due to the development of new oil fields in the OPEC and non-OPEC oil producing states and also the recent production cuts by the OPEC member states.
OPEC has learnt a lot from previous oil market panics. In response to the current situation OPEC member states have initiated production cuts in order to impede slipping oil prices. At their 149th ordinary meeting on 9-10 September 2008, OPEC member states stressed observation and adherence to OPEC's September 2007 approved production ceiling of 28.8mn b/d. In the course of their 150th extraordinary meeting on 24 October 2008, OPEC member states reached consensus over daily production cuts of 1.5mn b/d beginning from 1 November 2008. At the 151st extraordinary meeting on 17 December, OPEC member states agreed that cuts would amount to 4.2mn b/d from actual September 2008 OPEC-11 production of 29.045mn b/d. However, such decisions by OPEC have failed to revive oil prices. It appears that the wide-scale global economic crisis has diminished demand for oil beyond OPEC's intended oil production cuts.
To what extent is OPEC planning to reduce its production rate is a question that requires the specification of price targets. When oil prices were at their peak, OPEC officials frequently proclaimed that they were not pursuing any price target and that the oil market itself would best determine prices. At that time, restricted production capacity had made it impossible for OPEC member states to determine prices. In addition to the high growth rate of the global economy fostering demand for oil, there were also geopolitical tensions, unforeseen cuts in oil and gas supplies from OPEC and non-OPEC producing states, high costs associated with the development of new oil fields, and ultimately the behavior of speculators. All these factors were beyond the control of OPEC and contributed to the emerging price hikes.
Key To Adjusting Production
Today, after OPEC has experienced a rapid dwindling of oil prices, it can confine its members within production limits and somehow make up for poor prices. However, production cuts in the absence of a price target will prove to be futile. The success of a production adjustment plan is subject to the design of a mechanism that would reconcile production policies and price targets.
How can OPEC concentrate its efforts on maintaining control over production and stabilize the market? The response to this question would be possible if one takes a glance at the recent history of this Organization. In its 109th ordinary meeting in March 2000, OPEC unofficially introduced its price band mechanism to the market. Within this mechanism, in the case of the average OPEC Basket crude price falling under $22/B for more than 10 successive working days, OPEC member states would be obligated to cut their daily production by 500,000 b/d, and in the case of the price exceeding $28/B for 20 successive working days, OPEC would increase production by 500,000 b/d. Although OPEC took advantage of this mechanism only once, increasing production by 500,000 b/d beginning on 31 October 2000, and gave up the whole idea in January 2005, introduction of this mechanism affected the market psychologically and stabilized prices during the period that OPEC was not inclined to change prices beyond specific limits.
OPEC can revive this mechanism under the present circumstances. Concurrent with OPEC's 150th meeting, the President of Venezuela declared that the organization should specify oil prices within the price region of $70/B, $80/B or even $90/B. These statements revealed that at least some OPEC member states are well prepared to utilize this mechanism, which is not intended to rule out market fluctuations; rather it is meant to preserve a price average within a specific band.
Should OPEC member states wish to restore a price band mechanism, they are recommended to introduce the following amendments:
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A price target should be defined – by making use of the OPEC Basket price – within a band that would make investment in the oil industry attractive.
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A period of one month should be specified for the calculation of the price average.
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The production adjustment date should be prior to the regulation of oil loading programs by the member states.
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The specified price band and production changes should be observed and adhered to by all.
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The scope of price band should not be very extensive, otherwise it would make no sense to implement such a band.
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Within the mechanism, decision making should be activated automatically and communicated to the member states by the OPEC Secretary General or President.
Behrooz Baik Alizadeh is Senior Oil Market Analyst at the Iranian Ministry of Petroleum (email balizadeh@nioc.org). This analysis is based upon the personal opinion of the author and does not represent the official view of the Ministry. Petroleumworld does not necessarily share these views.
