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Warwick Knowles

OPEC: The Flare May Be Over for the Cartel

by Warwick Knowles | Dun & Bradstreet Editor

August 11, 2015 | No Comments »

Colorful stack of oil drumsWill the return of Iranian oil to global markets be the final nail in the coffin of the Organization of Petroleum Exporting Countries (OPEC)?

It may be too early to answer the question definitively — the nuclear agreement reached in July 2015 between Iran and Western leaders has yet to be ratified by all sides. But this is an excellent time to ponder the question. A number of factors are now putting pressure on the continued existence of OPEC, which was formed 55 years ago and reached the peak of its power 40 years ago.

First, the nature of the energy market has changed radically as a result of the rise in unconventional and renewable energy — and that is undermining OPEC’s dominance of the market. This situation has created a repeat of the 1980s, with supply coming on line faster than demand is growing and sending prices spiralling down.

This time the response from Saudi Arabia has been different: Rather than acting as a swing producer to slow the fall in the price, Riyadh has attempted to maintain its market share, putting downward pressure on oil prices.

Second, Iraq has been exempted from the OPEC quota system since the overthrow of Saddam Hussein in 2003. However, despite the ongoing violence in the country, Iraq’s oil production is increasing year by year, which will result in pressure to reintroduce its quotas.

In addition, Iran’s return to the oil market will see its production capacity increase significantly over the next few years. In turn, this will prompt Iran to call for an increased share of the quota. With both Iran and Iraq pushing for higher production quotas, political divisions within OPEC will intensify, which could result in the end of the quota system. If this happens, the last vestige of OPEC’s attempts to control oil prices will be over, at least in the medium term.

That would be a major turnaround when you consider the history of OPEC. Created in 1960 by five oil-producing governments (Iraq, Kuwait, Iran, Saudi Arabia, and Venezuela), the mission of the oil cartel was to counteract the market power of the “Seven Sisters” international oil companies. OPEC, which presently has 12 members, accounts for around 40% of total global oil production, 60% of internationally traded oil, and around 80% of total oil reserves.

In 1973, against the backdrop of the Arab-Israel war, OPEC achieved ogre status when oil prices virtually quadrupled in six months as a result of its oil embargo on the West. Significantly, this event still exerts psychological pressure on traders in the oil market, although in reality since then OPEC has had little impact boosting oil prices above market levels.

As with any cartel, its primary objective is to control prices through the coordination of the members’ oil policies. This is supposed to be achieved by setting production limits for each member, nominally based on the levels of reserves held. This policy has seen countries such as Iraq and Iran both claiming that their reserves are higher than in reality in order to obtain larger quotas.

However, as with any cartel, OPEC has suffered from members cheating on their quotas. If only one country marginally overproduces, then the impact on price is minimal. But if all members ignore their limits, then oversupply becomes a problem and prices fall.

Most notably, this occurred during the 1980s, when oil demand fell as the global economy entered a period of slowdown and oil prices plummeted.

In addition, OPEC no longer controls the world’s oil production. This has further diminished its ability to control the market. This factor has become increasingly more important as unconventional oil sources such as the shale oil and tar sands come on line, as well as the rise of green-energy production.

The cartel has also faced political divisions, which have reduced its effectiveness. Iran and Saudi Arabia have regularly been at loggerheads over policy. Until recently, Riyadh, with its huge reserves, has tended to play a long-run game, seeking price stability rather than optimizing its income.

In contrast, Tehran, with its larger population and greater need for immediate income, has tended to play a short-term game, regularly pushing for higher oil prices in order to boost its revenues, by restricting OPEC’s output.

Dr. Warwick Knowles is the Deputy Chief Economist on D&B’s Global Data, Insight & Analytics team. Based in Marlow, UK, he covers global issues and the Middle East and North Africa for D&B Macro Market/Country Insight Products. Previously he taught Middle East politics and political economy for almost a decade at both Newcastle and Durham Universities and has published widely on regional issues and the hydrocarbon sector.

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