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Oil continues to be the world’s most important fuel, contributing 39 percent of the global energy supply. It will remain the leading fuel in the near future, driven primarily by demand from the rapidly growing transportation sector. Crude oil prices have been especially volatile recently, reaching almost US$50 per barrel in August 2004. Why have oil prices risen so significantly, and what is the role of the Organization of Petroleum Exporting Countries (OPEC) in the oil market?
OPEC is an organization of oil-producing governments that cooperate to manage oil supply and prices in order to maximize the revenues of the member states and promote stability in the oil market. The ten producer governments who make up OPEC (OPEC-10), most of them in the Middle East, have economies that are highly dependent on oil revenues, all of whom ostensibly accept production quotas. Iraq, the eleventh member, currently has no quota because it is trying to restore its former oil production after the Iraq war in 2003. OPEC acts like a cartel as it pursues its economic and political objectives.
Although OPEC has about 75 percent of the world’s oil reserves, it currently comprises only about 35 percent of world oil production, much less than the 60 to 65 percent it controlled at the time of the oil shocks in the 1970s. Non-OPEC producers are thus important, led by Russia, whose production is expanding, and the United States, whose production is declining. While OPEC has had some success at managing the world oil market in recent years, it has also made mistakes. At times, it is confronted by challenges beyond its control, as in 2004.
The Oil Price Band
At its disastrous meeting in Jakarta at the end of November 1997, OPEC increased oil production despite the economic crisis in Asian economies, which led to falling demand in 1998 and a price collapse to US$10 per barrel. The price collapse caused severe damage to the economies of producer countries. The cartel was able to regroup and cut production in March 1999 with the assistance of non-OPEC producers, specifically Mexico, Russia, Norway, and Oman. Oil prices recovered and increased above US$30 per barrel by early 2000, driven partly by Asian recovery and low Organization of Economic Co-operation and Development (OECD) oil stocks. OPEC overshot its target of restoring prices to the low- to mid-US$20 range.
In 2000, OPEC increased output four times to try to reduce the high oil prices that threatened to diminish oil demand. At its Vienna meeting in March of that year, OPEC reversed its 1999 decision and increased production, assisted again by the cooperation of several non-OPEC producers. It also announced a price band mechanism designed to keep oil prices in a target range of US$22 to US$28 per barrel for the OPEC basket of crudes.
The OPEC basket is a weighted average of Saudi light and six other OPEC crude oils. It includes an automatic production adjustment mechanism that is implemented if the price goes above or below the band, though the mechanism has not always been implemented. Other production increases followed in June, September, and October 2000, but oil prices remained stubbornly high, finally dropping at the year’s end.
The record of the OPEC basket price is a good indicator of OPEC’s success or failure at managing the world oil market. Oil prices have been within the band only about half of the time and rose well above the band in 2004. The OPEC basket price tends to run about US$2 below the US benchmark oil price for West Texas Intermediate crude (WTI), which is the price quoted on the New York Mercantile Exchange.
In 2001, OPEC faced an economic recession in the United States that gradually spread elsewhere in the world and reduced oil demand. Following several OPEC production cuts, the OPEC basket price initially remained in the mid-US$20 range (within the price band). However, the September 11 attacks were followed by a reduction in air travel and a decline in the stock market that deepened the recession. Oil demand fell off, and oil prices soon fell below US$20 per barrel. To respond, OPEC called an emergency meeting in late November and announced a production cut of 1.5 million barrels per day (mbd), effective January 2002, on the condition that non-OPEC producers led by Russia would contribute an additional cut of 500,000 barrels per day (bpd). The OPEC strategy was largely successful.
A global economic slowdown and a slump in oil demand confronted OPEC at the start of 2002. OPEC was determined to prevent a further collapse of prices and restrained production. Political tensions rose in the Middle East with new Israeli attacks against the Palestinians and US threats against Iraq. Iraq continued its practice of interrupting oil exports. OPEC’s production quotas, the lowest since 1991, assisted in keeping oil stocks low and helped move oil prices back into the US$20 to US$25 range by spring 2003. Economic recovery began in the fall, and oil prices increased. OPEC basket prices were again within the price band. In December, OPEC raised its production ceiling to 23 mbd to align it with actual production.
A strike of Venezuelan oil production workers in early 2003 removed most of that producer’s oil production and exports, causing a shortfall in the market. At the same time, unrest in Nigeria decreased that country’s production. Consequently, at its January 2003 meeting, OPEC decided to raise its production by 1.5 mbd to 24.5 mbd on a pro rata basis, effective February 1, largely to compensate for the Venezuelan shortfall. By March, fears of war in Iraq (the United States and Great Britain were calling for military action), cold weather, and low US product inventories temporarily drove up WTI prices to nearly US$40 per barrel. OPEC indicated that it would keep the oil market well-supplied in a crisis and the International Energy Agency (IEA) agreed to let OPEC attempt this before responding with any release of strategic oil supplies. When the war began in Iraq, oil prices declined to US$30 WTI in the expectation of a short war. OPEC replaced lost Iraqi production in April through increased production by Saudi Arabia (which had gone up to 9.5 mbd) and by Kuwait, Libya, and Algeria.
