Saudis Losing Grip on Oil Prices

Two months ago, everything seemed to be going right for OPEC. Demand for oil, besides being at its seasonal peak, was strengthened by exceptionally cold weather in Europe. For 1986 as a whole, oil demand rose 2.5% among industrial nations and 3% in the United States, while U.S. production of crude declined 3%. The Aramco partners--Exxon, Mobil, Chevron and Texaco--had just agreed to buy Saudi oil at $18 per barrel, ending the “netback” system under which the price of oil was linked to the prices of the refined products. Finally, Saudi Arabia was resuming its role as a “swing producer,” adjusting its oil exports to balance supply with demand. To the extent that it could carry out this role, oil prices could be set at any desired level.

In this environment, oil prices should have easily surpassed $20 per barrel and headed to $30; instead, they rose only to $18.50 on the futures market--the first clue that the Organization of Petroleum Exporting Countries was in trouble. It’s now clear that the cartel faces a number of problems:

- The 2.5% growth in industrial nations’ oil consumption in 1986 was largely the result of an inventory buildup that occurred when oil prices collapsed. In contrast, the International Energy Agency forecasts a meager 1% growth in demand for 1987.

- The rates for chartered oil tankers have fallen sharply in recent months, a modest pickup in early March notwithstanding. Lots of oil is already being stored in oil tankers around the globe, forming, in effect, a huge floating pipeline.

- Inventories of petroleum products in the United States are running nearly 20 million barrels above last year’s levels: Gasoline and fuel oil supplies are, respectively, 5% and 7% higher than a year ago.

- Many refiners are refusing to sign long-term purchase contracts at $18 per barrel because they expect prices to fall. Instead, they are relying on their inventories to cover their current needs. Normally, worldwide primary stocks are drawn down by, at most, 2 million barrels a day in the first quarter of the year; this year, however, the drawdown rate may have reached 3.5 million barrels a day. Secondary stockpiles may be falling by about 500,000 barrels a day.

- Meanwhile, petroleum products continue to pour out of refineries. The American Petroleum Institute reported that U.S. refinery utilization in late February stood at 80.1% of capacity, compared to 78.7% last year. Yet there has been no net increase in demand for gasoline in this country, compared to last year. Many refiners are losing money and have cut the price they are willing to pay for crude.

- Some OPEC members have, in effect, become involuntary swing producers: The official price of Qatar’s oil, for example, is so high that it is unable to sell more than a fraction of its assigned quota.

- Financially weak members, on the other hand, are consistently exceeding their quotas in violation of last December’s pact. Nigeria is allegedly offering big discounts in order to maintain export volume. There is evidence that Venezuela and Libya are doing the same, and even Saudi Arabia and Kuwait reportedly have sold refined products at market prices that are far below those needed to justify $18-a-barrel crude.

Renewed cheating among OPEC members was to be expected. The new accord is simply a return to the strategy that failed so miserably in 1986. The Saudis, by agreeing to balance worldwide supply and demand, have sent a clear message to other producers: Open the oil valves full blast! Already, they have cut their output from their quota of 4.1 million barrels a day to about 2.5 million, and they are determined to reduce their output enough to sop up excess supplies and ride out the storm. They are fully aware that the stakes in this game are high and that if they fail a second time to maintain the price--and hence their credibility as a swing producer--they may not get a third chance.

Meanwhile, oil companies and refineries are unconvinced that prices can be held at $18-a-barrel levels. They are holding out for better deals, which their excess inventories of crude and refined products allow them to do. This suggests that OPEC’s output, even though it has fallen an estimated 1.8 million barrels a day from the 15.8-million-barrel ceiling set in December, is too high and may be softening the market further. However, even if in the short run OPEC is able to push oil prices up, the fundamental reality that it faces is not about to change.

After the second oil shock of 1979, oil prices rose so high that demand for oil fell and remained weak even when the world entered a business recovery in 1983. As expected, high oil prices encouraged conservation, promoted a switch to alternative energy sources and stimulated exploration of new or previously uneconomical deposits. The Saudis had to keep reducing their output to accommodate not only the cheaters within OPEC but also new production constantly coming on line. Their output fell to 2 million barrels a day from 10 million, and it was only a matter of time till their patience ran out.

If the current attempt to set a firm $18-a-barrel price fails, it will show that the cartel is no longer effective, and its financially weak members may rush to raise their output. They must maintain their foreign exchange earnings to service their debts, so once the price of their leading export commodity falls, they try to make up the lost revenue on higher volume.

If OPEC loses credibility, how low could oil prices fall? Possibly down to the cost of pumping oil in the Middle East, estimated anywhere from 50 cents to $3 a barrel. There’s a lot of hot air between those numbers and current prices, but even this is not necessarily the floor. As we’ve seen in the case of copper, when a country needs foreign exchange to make debt payments, it will continue to sell its export commodity even if world prices fall below production costs.

The outcome of the tug of war between the Saudis on one side, and cheaters in their own camp and oil consumers who are holding out for lower prices on the other, will be known soon. This is the inventory-reduction time of the year, when excess production is the most damaging. Who will win is far from certain, but the Saudis may well emerge as losers, which could lead to another oil price collapse. If so, it will be one more manifestation of the world of low inflation.