What Will OPEC Do?
Posted October 22, 2008 at 1:07 pm 
Filed in: As we near the end of the U.S. trading day for spot market West Texas Intermediate crude, prices are approaching $65/bbl—about a 55 percent decline from July’s record prices. As oil prices continue their downward spiral, most analysts and news outlets have shifted their attention toward evaluating the consequences of the historic fall. It is clear that OPEC members will be under great pressure to cut production quotas. What is not as clear is whether all members—particularly Saudi Arabia—will support a substantial cut.
As a cartel, OPEC depends on cooperation to achieve its objective of a stable oil price. Of course, when individual members’ self interests align with the cartel’s interest, cooperation is generally straightforward. This has been the case for the past several years, as rapidly rising world demand pressured OPEC to produce at very near maximum capacity. What little spare capacity existed was low quality crude reserved in Saudi Arabia, OPEC’s largest producer and a (generally) reliable U.S. ally. A high-demand, high-price environment makes cooperation very easy—all nations can pump as much oil as their system allows and reap maximized profits.
Cooperation is, of course, much more difficult when individual interests fall out of line with those of the group. As world oil demand plummets amid the current economic turmoil, the fourth quarter IEA estimates suggest that the world oil market will be over-supplied by at least 1.0 million barrels per day if OPEC’s current quota remains unchanged. Thus, pressure mounts on the cartel to cut production. But all things being equal, each member of OPEC would prefer that the other members absorb the production cuts so they can maximize export revenue by producing at full capacity. And right now, all members are likely to look to the Saudis. At roughly 10 million barrels per day, the Saudis account for one-third of OPEC production and can probably afford a substantial cut more easily than other members. But will the Saudis be willing to accept responsibility for the symbolism of a production cut in the midst of a global economic meltdown? Friday’s meeting will be truly historic.
In the meantime, the fallout of commodity prices across the board generated two other interesting developments today. First, Russia says it may pursue the capability to maintain spare capacity of its own. In effect, instead of cutting production, a Russian official suggested Moscow could hold back from marketing incremental production from new projects. But with Russian production already declining based on current policies, it’s hard to imagine how this would be possible.
Second, Russia, Iran, and Qatar met this week to discuss efforts to foster cooperation on natural gas production. The three nations hold more than half of the world’s proved natural gas reserves. Although the global LNG market remains relatively unformed (LNG sales currently represent only 7 percent of global gas sales), regional variances in gas supply dynamics suggest that increasing supplier cooperation on gas production is not an insignificant development. For example, Europe already depends on imports for half of its gas supply, much of which is sent via pipeline from Russia. According to BP p.l.c., Japan and South Korea are the world’s two largest LNG importers, and together rely on Qatar for about 20 percent of their LNG cargoes.
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