Charles A. Kohlhaas

On the Saturday before Christmas, I re-entered the United States and picked up the Friday issue of the Wall Street Journal, among other things, to catch up on the news on the plane from my Port of Entry back to Denver. On page A2 was a short article reporting that OPEC was not sure whether it had the spare production capacity to make up for lost production if Venezuela remained shut down for a prolonged period and if military action disrupted Iraqi production. The article quoted International Energy Agency data showing total Iraqi and Venezuelan production at 5.1 million barrels of oil per day (bopd) in November (before the Venezuelan strike). OPEC had reportedly estimated its spare production capacity at 3.3 million bopd with an additional 1 million bopd from Saudi Arabia in 90 days with "emergency measures." Because non-OPEC producers have little or no spare production capacity, the OPEC estimate is the estimate for worldwide capacity.

In the January 8, 2003 issue of the Wall Street Journal, it is reported that, with Venezuela still mostly off production and military action against Iraq seeming ever more likely, the Saudis want OPEC to increase production quotas by 2 million bopd. Other members, however, only want to increase quotas by 1 to 1.5 million bopd. OPEC believes these changes are necessary because Venezuelan production is down by more than 2 million bopd and, if Iraqi production is disrupted, production must increase now in order to reach the markets when the shortages develop. These increases are portrayed as necessary to keep prices from rising too much because of supply shortages.

Let us review OPEC’s actions over the last couple of years. Two years ago OPEC’s surplus capacity was generally estimated in the range of 5 to 7 million bopd, quotas were at 28.2 million bopd, and oil price was in the $25 to $30 per barrel range. During 2001, OPEC cut its production quotas several times (for a total of 5 million barrels per day) to support prices in the face of increasing production from non-OPEC producers, mainly Russia, and fluctuating Iraqi production. At the time of the last quota reduction in 2001, OPEC prevailed on non-OPEC producers also to cut production by 500,000 bopd. Nevertheless, in late 2001, prices sank below $20 per barrel.

In March 2002, prices increased again over $25 and slowly climbed to about $30 until OPEC reduced quotas again in September by 1.5 million bopd to 21.7 million bopd, after which prices dropped to about $25. At the end of December, as noted above, OPEC then increased quotas by 1.3 million bopd (that reportedly "slashed" production by 1.7 million bopd).

If these actions and effects seem a little strange, just remember that this isn’t Kansas, Toto. A few more considerations may enhance the sense of wonder. First, many of OPEC’s members cheat and produce more than their quotas so quota cuts may be followed by production increases and vice versa. The quota increase on January 1, 2003 was in exchange for a commitment among cheaters (yes, that is correct right – a commitment from producers who are already cheating) to cut actual production. But now OPEC is considering yet another quota increase of about the amount of the overproduction; so much for the "commitment".

A second major factor is Russian production increases; during 2001-2 Russian production increased by about 1 million bopd. During this period, Iraqi production fluctuated by about 1/2 million bopd. Some of OPEC’s production changes were attempts to maintain price stability in the face of these supply changes.

Third, inventories decreased throughout 2002. The United States now has less than 19 days’ supply of crude oil inventory, a level that generally is followed by price increases. These low inventories would put upward pressure on prices even without supply disruptions. We do not know the amount of unofficial inventory; tankers have been known to be very slow approaching their destination during periods of increasing-price expectations. Producers will make an effort to increase production as much as possible to make up for shortages, but probably will have limited success--there is not much slack in the system. These increases and inventory pulldowns can alleviate supply disruptions somewhat for a short time.

Any estimate of surplus OPEC productive capacity must be relative to some base and is rather subjective. At the time OPEC estimated it had 3.3 million bopd of surplus capacity, its quotas were 21.7 million, it had already approved quotas of 23 million (including Venezuela’s quota), and it was producing between 22.5 and 23 million (after Venezuela shut down). It seems that total OPEC productive capacity is between 26 and 28 million bopd.

To put this in perspective, we should consider that at the time of the Arab oil embargo and the so-called "energy crisis" of the mid-1970s, the world’s surplus production capacity was approximately 15percent of worldwide production. By the end of the 1970s, a high level of development activity had increased that surplus to about 25 percent. Those surpluses are now gone. Non-OPEC producers are producing at capacity and our estimates for OPEC’s surplus are in the range of 2 percent to 4 percent of worldwide production based on OPEC official figures and may be as little as 1 percent to 1.5 percent based on the amount of suspected cheating. Those surpluses may also be difficult to replace. 75 percent of OPEC’s production is from 22 fields, the newest of which was discovered in 1965. In the last 20 years, the oil industry has operated at approximately 20 percent of the activity level of the 1970s. The above analysis indicates OPEC’s capacity has declined from the 32 to 34 million bopd range to 26 to 28 million in two years.

If we continue a little further down the yellow brick road, we find that production data are reported by organizations with little or no interest in, or history of, telling the truth. Any attempts to correct these data by balancing production with deliveries to markets must consider various transit times, all of several weeks, to importing countries. In addition, about 5 percent to 10 percent of the world’s production is stolen, smuggled, pirated, and in various black markets.

Next we must consider the most bizarre aspect of all: the oil pricing system, sometimes known as "casino pricing." Oil prices are determined in the trading pit of the NYMEX by traders with a time horizon typically less than two weeks; a market which reacts immediately to rumors and bad data with a long time lag. It is also subject to manipulation; some of those Iraqi production fluctuations must be presumed to coincide with whether Saddam was long or short the market. Insider trading at its finest. Production rate or demand swings of 600,000 to 900,000 bopd (out of a total worldwide production rate of 77 million bopd) can cause price swings of $5 per barrel; in typical market fashion, 1 percent to 2 percent of the world’s oil determines the price of all of it. Such severe price volatility causes OPEC to make many of its decisions based on expected trader perceptions rather than on fundamental considerations of supply and demand balance.

We can, however, perhaps surprisingly, reach some conclusions from all this. First, OPEC’s repeated quota changes are attempts to fine-tune a sloppy system. Second, OPEC is obviously in some disarray. Its control over the market is eroding and may not be restored. Third, oil supply margins are small but are adequate to make up for the Venezuelan cutback, probably for several months, and we can probably squeeze through an Iraqi disruption as well with some price increases but without severe economic impact.

Although most media attention has been focused on the short-term problems, the most important conclusion is that world productive capacity has a very narrow margin above world demand. This has occurred at a time when demand has been reduced by a period of slow economic growth. This conclusion is the major point of this analysis. Even if we work through the short-term problems, once the current crisis period has passed and world economies recover and resume their normal growth, demand will quickly exceed supply, probably within three years. In such a situation, we shall enter a prolonged period of supply shortages and upward pressure on oil prices with all the implications that situation has for the world’s economies and political systems.

Major oil projects require about five years from commitment of capital to full production. So what is the oil industry reaction to this situation? Nothing. The number of rigs running worldwide is down about 15 percent from a year ago. Is development activity increasing to develop new supplies? No. Houston is quiet.

Charles A. Kohlhaas is a former Professor of Petroleum Engineering at the Colorado School of Mines and has worked for, founded, managed, and consulted for major and independent companies in the international oil and gas industry.