ECON3315ECON3315International Economic IssuesInternational Economic Issues

Instructor: Patrick M. CrowleyInstructor: Patrick M. Crowley

Issue 9: Oil and OPEC

OverviewOverview

OPEC – what is it?OPEC – what is it? HistoryHistory The economics behind OPECThe economics behind OPEC FrackingFracking Recent developments in the energy marketRecent developments in the energy market The future of oilThe future of oil

OPEC – what is it?OPEC – what is it?OPEC = Oil Producing Exporting Countries OPEC = Oil Producing Exporting Countries OPEC is a club of oil exporting countries set up to challenge “7 OPEC is a club of oil exporting countries set up to challenge “7

sisters”sisters”OPEC membership consists of OPEC membership consists of

Any country can join as long as they agree with the aims of OPEC and Any country can join as long as they agree with the aims of OPEC and get all the founding members to vote in favor with 75% of total get all the founding members to vote in favor with 75% of total also voting in favor.also voting in favor.

Also associate members who attend meetings but cannot vote.Also associate members who attend meetings but cannot vote.

Interactive map: http://www.opec.org/library/Annual%20Statistical%20Bulletin/interactive/FileZ/worldmapz.htm

OPEC - HistoryOPEC - HistoryFormed by developing countries in Baghdad in 1960

- most activities in 60s related to setting up institutional structure of OPEC

OPEC came to prominence in 1973 when it decided to restrict output as part of an Arab “oil embargo” against any countries that supported Israel in the Yom-Kippur war.

In 1980s oil prices collapsed causing great strains on OPEC members – plus they had trouble restricting output, as this meant lost revenues. Need realized for coordinated action to keep prices stable.

In 1990s OPEC acted to increase output if prices rose too much, and restrict output if prices fell

The economics behind OPECThe economics behind OPEC

OPEC is a “cartel”OPEC is a “cartel” It cannot determine the price of It cannot determine the price of

oil, as there are oil exporting oil, as there are oil exporting countries outside of OPEC (e.g. countries outside of OPEC (e.g. Russia, Norway, Canada, USA)Russia, Norway, Canada, USA)

So instead it influences oil prices So instead it influences oil prices by fixing “quotas” for each by fixing “quotas” for each member at a 6 monthly meetingmember at a 6 monthly meeting

Idea is to stabilize the supply Idea is to stabilize the supply curve, so as to ensure reasonable curve, so as to ensure reasonable prices for OPEC and other prices for OPEC and other producersproducers

For each OPEC member, idea is For each OPEC member, idea is to maximize oil revenue, as to maximize oil revenue, as nearly all OPEC members run nearly all OPEC members run sizeable budget deficitssizeable budget deficits

OPEC produces about 40% of world’s crude oil and 15% of natural gas

OPEC produces 55% of all oil exports though

OPEC has between 70-80% (78% according to them) of world’s proven oil reserves

The economics behind OPECThe economics behind OPEC OPEC members bargain over set of production targetsOPEC members bargain over set of production targets Negotiation of production targets has to end with unanimous Negotiation of production targets has to end with unanimous

approvalapproval Production targets in the past have been non-binding (so Production targets in the past have been non-binding (so

over-runs common), but large divergences frowned uponover-runs common), but large divergences frowned upon In October 2008 split in OPEC as Saudis walked out of In October 2008 split in OPEC as Saudis walked out of

meeting where a 2m/day cut in quotas gained majority meeting where a 2m/day cut in quotas gained majority support.support.

Some (smaller) countries now seeking 100% complianceSome (smaller) countries now seeking 100% compliance

OPEC quotasOPEC quotas

Generally Generally more more production production above above quotas, quotas, which which tends to tends to force force prices prices downdown

The economics behind OPECThe economics behind OPEC Hubbard’s peak theory – idea Hubbard’s peak theory – idea

here is that any oil field will here is that any oil field will have production profile have production profile following a bell shapefollowing a bell shape

Theory suffers from “fallacy of Theory suffers from “fallacy of composition”composition”

But does explain why supply But does explain why supply would naturally be volatilewould naturally be volatile

But it did correctly predict the But it did correctly predict the decline in US production decline in US production

Oil Supply – non-OPECOil Supply – non-OPECIt is clear that North America has been the source of the largest growth in oil supplies

It is also clear here that OPEC is becoming much less important as a supplier of crude than it has been previously

OPEC and the future of oilOPEC and the future of oil

Paradox: production in the rest of the world relies Paradox: production in the rest of the world relies on OPEC to keep oil prices highon OPEC to keep oil prices high

High-cost oil sources (North Sea, NF, Gulf of High-cost oil sources (North Sea, NF, Gulf of Mexico) would not be economic if OPEC didn’t Mexico) would not be economic if OPEC didn’t existexist

OPEC’s quota system based on the concept of OPEC’s quota system based on the concept of “swing producer”.“swing producer”.

Buyers fill their crude oil requirements from non-Buyers fill their crude oil requirements from non-OPEC producers and resort to OPEC oil to fill the OPEC producers and resort to OPEC oil to fill the gap between world demand and non-OPEC gap between world demand and non-OPEC suppliessupplies

In other words, marketing priority given to non-In other words, marketing priority given to non-OPEC oil.OPEC oil.

Result: OPEC’s own market share is in continual Result: OPEC’s own market share is in continual decline, to the benefit of other producersdecline, to the benefit of other producers

OPEC and the future of oilOPEC and the future of oil

Dynamic inconsistency in OPEC objectivesDynamic inconsistency in OPEC objectives Short-term: OPEC members need to maximize Short-term: OPEC members need to maximize

revenue – therefore limit outputrevenue – therefore limit output Long-term: need to control production as higher Long-term: need to control production as higher

prices encourages production elsewhere – prices encourages production elsewhere – therefore lower price to make production therefore lower price to make production elsewhere uneconomic, allowing an expansion of elsewhere uneconomic, allowing an expansion of production, and therefore (eventually) revenuesproduction, and therefore (eventually) revenues

Cost of productionCost of production Offshore > onshoreOffshore > onshore Fracking > conventionalFracking > conventionalSaudi Arabia: < $10Saudi Arabia: < $10

Venezuela: < $30Venezuela: < $30

Nigeria: $20-$30Nigeria: $20-$30

Russia: $40-$60Russia: $40-$60

Canada: $50-$100Canada: $50-$100

Alaska: < $40Alaska: < $40

US SD Bakken: $40-$70US SD Bakken: $40-$70

US TX Permian: $40-$80US TX Permian: $40-$80

US TX Eagle Ford: $40-$70US TX Eagle Ford: $40-$70

Energy substitutionEnergy substitution

Energy substitutionEnergy substitution

Still, not a Still, not a large % of large % of total total consumptionconsumption