OPEC, a current threat or a ghost from the past?

Oil, petroleum, Black Gold whatever way you chose to name it, it has had a huge impact in our way of living. Oil allows people to live extravagant life styles like the fairy tale like stories about Dubai, it also sustains an absolute monarchy of 30 million subjects and has caused environmental disasters of huge proportions. Yet, more notably, it is the blood of the industrialized society. Hence, is not surprising that two announcements made in the last few weeks were of key importance. The first was the announcement of the Organization of Petroleum Exporting Countries (OPEC) to limit production, the second one, were the talks of Russia with the OPEC to commit to such production cut (despite the skeptical position of several analysts of Russia’s actual commitment to it).

The incentives to cut productions are clear, since June 2014 the price of oil has experienced a sharp decline, this has cut a significant chunk of OPEC member’s revenue, with the most spectacular case being Venezuela experiencing three digits inflation and massive popular riots. Although the situation for the rest of the cartel is not as catastrophic, they should be concerned by the sharp decrease in revenue. Furthermore, for Russia it is also significant the decline in prices of natural gas, which has not recovered its pre-crisis levels. On the contrary, gold has remained above its pre-crisis levels albeit far lower than its peak in August 2011. This last fact traditionally points to an environment of high uncertainty for investors which is key to understand the situation and possible repercussions of OPEC next move.

 img-1With the North Atlantic Treaty Organization (NATO), United Nations (UN), World Bank (WB), International Monetary Fund (IMF) and G7 countries overseeing the world and having stakes and opinions in each major event around the globe is easy to forget about OPEC as a leading global power. However, looking at its history one can find some terrifying precedents. The first (and perhaps most devastating one) was the Oil Embargo of 1973. This was as many Baby Boomers might remember, a really dark time.

Except for the media coverage of the Watergate scandal, things were going smoothly, a period that later economic historiography will call the Golden Age of Capitalism had raised the quality of life in all the western industrialized world by a great amount. This system was mainly based on a US based supremacy, a Gold Standard with the US dollar at the center of it, and a wave of investment through the world as part of the system designed by Keynes and his followers in the aftermath of World War II.

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However, the involvement of the US and other western countries in the Yom Kippur War triggered a massive response from the OPEC (mainly integrated by Arab or Islamic states) in the form of an Oil Embargo to the US and its allies. The impact was cataclysmic, the Golden Era of Capitalism was over, the first big contraction general to western industrialized economies was merciless, and it even forced Richard Nixon to abolish the Bretton Woods Gold Standard and let the currencies float freely on the market to avoid a massive outflow of gold from Fort Knox and other US gold vaults. This last event made the IMF what some scholars call a zombie institution, since the system that originated it has been destroyed and its purpose no longer had meaning. The reason is that the IMF was established to maintain the global monetary system of Bretton Woods, in particular to provide financial assistance to countries to keep foreign exchange rates within specified price bands and maintain a stable system of payments to avoid market distress (with the development efforts left in the shoulders of the WB). Yet, with the Gold Standard abolished, there was no further reason for its existence, however, it survived and theoretically has changed to meet the challenges of the new system.

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The severity of these conditions created awareness on the power that advanced economies had let the OPEC gather, this caused a wave of efforts towards reducing the dependence of their oil production. Which was partly achieved in the 1980s when the OPEC share of production was surpassed by the rest of the world. This greatly reduced the global influence of OPEC and also its inner cohesion. The issue of cohesion is linked to another episode in which the actions of OPEC were transcendental to global affairs. As a result of the aforementioned loss of market share in the oil market, prices fell down dramatically during the 1980s and Saudi Arabia pressed the rest of the cartel to cut production in order to increase overall revenue. However, the cartel set up the Saudis as they did not comply with the production quotas and profited from the share not covered by the kingdom. In response to this, the kingdom brought the heavy artillery and flooded the market with oil until the price made most wells around the world simply infeasible due to higher exploitation costs and lack of economies of scale. The fierce movement of Saudi Arabia brought the cartel into order, however, their price target was not completely achieved, the world was different from a decade before. Yet, the move had important effects, one of the most important being contributing to the ultimate collapse of the USSR which was severely hit by the cut in its oil revenue.

There are more examples of the extent of the influence of the OPEC and its members, however, the episode just described showed the internal divisions among the cartel, and too many people thought that such internal divisions signaled the end of their power. Furthermore, the world enjoyed a period of relative stability after the 1980s, phenomena like the Asian Crisis of 1997 or the Dot Com bubble were significant but did not have long lasting effects of the magnitude of the 1973 shock. Yet, after the Great Recession of 2008, economies have failed to generate solid growth as I mentioned in my recent article, giving relevance to the prospective production deal announced in later weeks. Even when OPEC countries do not have the power they used to have, their main clients are not in their best shape either.

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Nevertheless, several things have changed since 1973, and they would make the move of the OPEC mean a totally different thing today. First, the Hydraulic fracturing or “fracking” has allowed the US to increase its oil production to an unprecedented level making the supply control of the OPEC even lower than in the 1980s, this has been an ongoing process since 2014 although many states inside the US are hesitant to continue this practice. Furthermore, the deaccelerating growth of China means that the not only the market has much more strong producers than before but that demand might be falling and is not expected to recover its former levels at least in the medium term. This last issue might be a key factor for OPEC to consider, since it is completely out of their control.

Additionally, the cartel has not fully recovered from the disagreement of the 1980s, many saw the block as a decorative body that was not able to exert any power on global energy markets, and the true effectiveness of the announced deal is yet to be confirmed. It is not clear if the cohesion of the cartel is strong enough to get prices where they want them to be, given the conditions already described (specially with countries like Iraq and Iran pledging for an exemption of the production quotas). Yet, the cartel might have something now that they did not had before, and is the need for such measures.

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Unfortunately, the recent tensions between multilateral organizations and Iran make the data unavailable for this country, which surely is a big contributor for the figures of the block. However, the analysis would appear to be coherent with Iran’s situation given the recent nuclear deal signed with the US. This deal would appear to be a symptom of the damage that international sanctions have made on Iranian economic welfare aligning it with the rest of the block.

Despite the relative stability of prices between 2011 and 2014, the GDP of the block has deaccelerated significantly to levels only seen during the Great Recession, meanwhile, the current account has been debilitating since 2011 and entered in negative territory in 2015. Furthermore, inflation (excluding the pathological case of Venezuela for a more accurate analysis) stood over 5% for all the observed period, a high level considering the slow pace at which the economic expansion is happening, signaling that the quality of life of the population in these states is worsening.

However, despite these traditional signs of economic weakness, unemployment seems to be under control (however, the availability and reliability of this data is not as one would hope it to be).  Additionally, government revenue has been higher than total investment for all 21st century, indicating a remarkable level of fiscal responsibility. Though, this occurs only at a global level as countries like Venezuela have not been that reasonable on their spending. Another issue that raises concerns is the level of debt of the block, before the crisis the block was a significant creditor, whereas now this margin has been sharply shrunk as their creditworthiness evaporates.

The above analysis can be synthetized by saying that the block as a whole is facing enough economic challenges to force itself into action. Unlike the oil embargo of 1973 or the 1980s dispute, the economical (and hence pragmatic) reasons for the deal may have a much higher weight in the decision. The previous decisions were motivated in a much significant way by ideological and political issues, now the block is experiencing severe conditions as are the advanced economies. Furthermore, the Arab spring, the ongoing conflicts derived from it and the unfulfilled demands, remain a threat to several of the OPEC members. All this might prompt them into a desperate measure, a cornered beast move.

As mentioned before, there was another key aspect of this deal, it might include Russia. Nonetheless, one should not rush to think that the situation in Russia is the same as for the cartel. First, the margin between government revenue and total investment is much higher than in the OPEC case. Additionally, unemployment again appears to be stable and inflation (albeit above 5%) have steadily declined from the levels originated when the government defaulted on its debt. On the other hand, GDP has slowed its pace as in the case of OPEC. Yet is true that international sanctions contribute a least partially to this effect, meaning that is an exogenous occurrence and not a structural problem.

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Furthermore, the current account balance has worsened over the period of study but still remains in positive territory. Likewise, government debt is in negative territory but it has been improving since the crisis. The combination of these facts shows that although Russia’s economic condition might not be ideal is far better than the OPEC cartel members. This issue should be taken into account in order to assess the possible outcomes of the situation. The cartel might have a stronger influence on energy markets than Russia, but the reality is that Russia can withstand far longer for a change in the dynamic of prices.

Additionally, there are at least two main reasons why Russia might not be able to commit to production quotas even if the government has such an intention. The first one is that a significant portion of Russian drilling is carried out in artic regions, where shutting down (even temporarily) a well would imply significant reopening expenditures which make cheaper to operate at current price levels with the expectation that prices increase in the future. Additionally, a substantial amount of Russian drilling is carried out by private companies that are not obliged to commit to the government pledge to a production limit.

Summing up, OPEC today does not have enough power nor cohesion to execute another Oil Embargo as it did on 1973, we will not experience catastrophic events by their hand this time. However, their influence remains important and this time they have strong economical and structural factors to prompt them into action. Furthermore, the alignment with Russia (although not certain) might give them an increase in leverage in a moment where global economy is not expanding as everyone would expect, maybe their next move cannot be as spectacular but is sure that it can have a significant impact in the medium term.

Lucas Buenahora

lucasbuenahora@gmail.com

Glossary:

Baby Boomers: generation born in the two decades following the end of World War II. For more info click here.

Oil Embargo 1973: Move of the OPEC on 1973-1974 to cut the supply of oil for western economies. For more info click here.

Golden Age of Capitalism: Period ranging from 1946 to 1973 that saw a huge economic expansion in the western world through several forms of US sponsoring. For more info click here.

Gold Standard: Monetary system in which the currencies have a fixed (or slightly volatile) exchange rate for gold in physical form. For more info click here.

Keynesian Theory: Theory devised by John Maynard Keynes after the Great Depression that advocated for the intervention of government to guarantee economic growth by using monetary stimulus and investment to sustain aggregate demand. For more info click here.

Yom Kippur War: Military conflict between Arab countries and the state of Israel that occurred in October 1973. For more info click here.

Bretton Woods Agreement: Monetary system put in place in the aftermath of World War II to regulate international payment systems through the actions of IMF and a Gold Standard. For more info click here.

International Monetary Fund: Multilateral body in charge of maintaining a stable international system of payments and exchange rates. For more info click here.

Asian Crisis of 1997: Monetary crisis that occurred as massive cash outflows occurred in south Asian countries in the summer of 1997. For more info click here.

Dot Com Bubble: Rapid increase of equity prices fueled by investment in internet based companies, which had no real justification for such valuations. The increase was followed by an abrupt market correction between 1999 and 2001. For more info click here.

Fracking: Method of extraction of oil based on the fracturing of the subsoil injecting specialized fluids. For more info click here.

Current Account: Difference between exports and imports for the overall economy, plus net currency transfers. A positive (negative) current account indicates that the country is a lender (borrower) to the rest of the world in trade terms. For more info click here.

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